Speaking Information, The Language Of The Markets

The capital markets hinge on financial information, and accounting researchers like SMU Assistant Professor Lou Yun are poised to decode it.

AsianScientist (Jun. 6, 2018) – Sim Shuzhen – What comes to mind when you think of accounting? For most people, it might be balance sheets, row upon row of numbers or the tedious process of bookkeeping.

But for Assistant Professor Lou Yun of the Singapore Management University (SMU) School of Accountancy, accounting is all about the flow of financial information.

“When I did my PhD, I realised that accounting at that level is not about accounting numbers per se, but is actually very closely linked to questions of economics, finance and how the capital markets work. Academic accounting focuses more on the role of accounting information,” says Professor Lou, who studies the role that such information plays in debt markets, disclosure, auditing, corporate governance and private equity.

“That’s the research question that connects the majority of accounting research, and also what fascinates me,” she says.

The perils of being forward-looking

Information dissemination is indeed central to one of Professor Lou’s research interests: corporate disclosure, the process by which firms communicate information about their performance and governance to the outside world.

“A very important question in research accounting concerns the factors that affect firm managers’ decisions to disclose certain pieces of information,” she says, adding that there is often a trade-off between the costs and benefits of disclosure.

On the benefits side, greater disclosure can reduce the information asymmetry between firms and the capital markets, thus helping firms lower their cost of funding and at the same time improve their access to different funding sources, says Professor Lou.

On the flip side, disclosing information may also come at a cost, especially if that information is forward-looking, as in the case of earnings projections or predictions of firm performance.

“Firm managers make these kinds of projections to give investors a better idea of how the firm will perform in the future,” explains Professor Lou. “But given that these projections are forecasts, they may not always be accurate.”

Thus, firm managers sometimes shy away from disclosing forward-looking information because of the fear—in the event that the forecast turns out to be inaccurate—that investors will sue them for misleading their investment decisions.

“Firm managers have to weigh the costs against the benefits; here the costs are essentially litigation costs.”

So sue me!

In a study titled ‘Shareholder Litigation and Corporate Disclosure: Evidence from Derivative Lawsuits’, published in April 2018 in the Journal of Accounting Research, Professor Lou and her co-authors looked at how litigation risk affects the decisions of firm managers to disclose corporate information.

Unlike many prior studies, which examined litigation risk at the firm level, this study was unique in that it focused on the personal litigation risk of firm managers, says Professor Lou.

“Ultimately, firms are run by managers. Yes, managers care about whether the firm they are running gets sued or not, but at the end of the day, it’s not their money,” she explains. “But when it comes to managers’ personal litigation risk, that’s where their reputations are really at stake.”

To carry out the study, the researchers took advantage of a series of legislative changes in the US—the adoption of universal demand laws by different US states at different points in time. By requiring plaintiffs to make a demand on the firm’s board of directors before filing a derivative lawsuit, universal demand laws essentially made it more difficult for shareholders to sue firm managers.

“This setting is unique and relatively exogenous [i.e. without confounding factors], such that we can actually make a causal inference about the relationship between managers’ personal litigation risk and their disclosure decisions,” explains Professor Lou.

The researchers found that when managers’ personal litigation risk was reduced by the passage of universal demand laws, they indeed became more forthcoming, sharing more information on earnings forecasts with the firms’ shareholders.

“Overall, it’s a win for the shareholders, because they get access to more information about the firm.”

“All else being equal, it seems beneficial for the capital markets to lower managers’ litigation risk, as that will encourage them to share more information with investors,” says Professor Lou, adding that the study has implications for regulatory policy.

Information: the linchpin of the markets

In addition to corporate disclosure, Professor Lou is also interested in how the capital markets design debt contracts—that is, what information is taken into consideration when lenders like banks extend credit to firms. In ongoing work, she is examining how lenders perceive firms with foreign institutional investors, as well as firms that count government bodies among their client base.

“The argument [in the latter case] is that because the government is a customer, it cares about the firm’s performance and thus helps to monitor it, which is considered a good thing from the lender’s perspective,” explains Professor Lou. “Lenders may be less afraid that the firm will go into default, and may therefore be more willing to lend to the firm with more lenient contract terms.”

At the end of the day, the capital markets run on financial information, which accounting researchers are well placed to understand and interpret, emphasises Professor Lou.

“Information is not only the language of business, but is also what connects the different parties in the capital market, including firms, investors, auditors, analysts and institutions like mutual funds and pension funds,” she explains.

“I think this is where accounting professionals can really make a contribution. We know how firms create accounting information, and we know how to read financial reports prepared by the firms; we therefore have an advantage in understanding the process of information production.”

Asian Scientist Magazine is a media partner of the Singapore Management University Office of Research & Tech Transfer.


Copyright: SMU Office of Research & Tech Transfer. Read the original article here; Photo: Cyril Ng/SMU.
Disclaimer: This article does not necessarily reflect the views of AsianScientist or its staff.

A premier university in Asia, the Singapore Management University is internationally recognized for its world-class research and distinguished teaching. Established in 2000, SMU’s mission is to generate leading-edge research with global impact and produce broad-based, creative and entrepreneurial leaders for the knowledge-based economy.

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