Theoretical Background and Capital Market Evidence – A European Perspective
All these issues are of considerable interest for standard setters and policy makers, whose primary aims are in fact to provide investors with useful information for their decision-making process and to allow firms to have access to a more efficient and cost-effective capital market.
Chapter 1: The Decision Usefulness Approach to Financial Reporting and Capital Market Research 17
17 Chapter 1 The Decision Usefulness Approach to Financial Reporting and Capital Market Research 1. Introduction Standard setters, regulators and policy makers all have a vital interest in the effect of financial reporting on the economy. This interest is due to the economic consequences associated with financial information. Financial information influences investors’ behaviour with respect to portfolio selec- tion, which affects security prices and, therefore, the terms on which a firm obtains additional financing. This, in turn, affects the firm’s cost of capital and alters the nature of the projects undertaken. In a capitalist economy, securities markets are the primary vehicle whereby capital is raised and allocated to competing investment needs. Consequently, it is socially desirable that these markets work well, that is, security prices provide correct values to guide the flow of investment funds. For example, a firm that has high-expected-value capital projects will be encouraged to invest in them if it receives a high price for its securities, and investment should be discouraged in firms that do not have high-expected- value capital projects. This will happen to the extent that security prices are close to fundamental value. Of course, this is what society would like, since investment capital is in scarce supply. Social welfare will be enhanced if scarce capital goes to the most productive alternatives. However, security prices do not fully reflect fundamental value in the presence of inside information. Investors are aware of the estimation risk resulting from adverse selection and insider trading. Thus, a “lemons...
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