Disclosure Theory

Question 1

Five (5) theories that can explain the reporting disclosure?

Answer 1

1. Capital Market Theory
2. Proprietary Cost Theory
3. Agency Theory
4. Signalling Theory
5. Stakeholder Theory

Question 2

Explain capital market theory and how it relates to disclosure.

Answer 2

1. EMH (Efficient Market Hypothesis) - asset prices reflect all available information and, therefore, it is impossible to consistently achieve returns above the market average.
2. The efficiency of financial markets => depends on the speed and accuracy with which the information is reflected in asset prices => high disclosures help improve the efficiency of the market.
3. CAPM (Capital Asset Pricing Model) - the relationship between risk and return => investors are compensated for taking higher risk with the potential for higher returns.
4. This can be used to explain - high voluntary disclosure, investors understand better the overall picture of the company in terms of their business model, strategy, objectives etc => may be willing to accept a lower rate of return on investment in a low-risk company => translates to a lower cost of capital for firms (CAPM)

Question 3

Explain Proprietary cost theory and how it relates to disclosure.

Answer 3

1. Proprietary cost => not just the cost of preparing and disseminating information => the cost derived by disclosing the information to the competitors or other parties in a way that will harm the company.
2. based on the assumption that, in the absence of these costs, companies are incentivized to voluntarily disclose relevant information to the market in order to reduce information asymmetry.
3. Particularly relevant for segment reporting.
   => Information on profitable products, and profitable business locations.

Question 4

Explain Agency theory and how it relates to disclosure.

Answer 4

1. Explains the relationship between the principals (shareholders / owners) and the agents (the managers and executives) and the dynamic of the agency relationship => where it could create conflict interests due to information asymmetry.
2. Recognizes that one party has more information than another party => voluntary disclosure serves as a monitoring and oversight mechanism => and helps align the interests of both the managers and the shareholders.

Question 5

Explain Signalling theory and how it relates to disclosure.

Answer 5

1. focuses on how firms use financial reporting and disclosure to convey information to investors and other stakeholders
2. Lundholm and Winkle (2006) - theoretical assumptions that => no news is bad news and that it’s always better to disclose and have the truth to be revealed later.

Question 6

Explain Stakeholder theory and how it relates to disclosure.

Answer 6

1. Focuses on not just fulfilling the interest of their shareholders but rather all stakeholders’s interest that directly and indirectly have interest in an organisation.
2. Eg: employees, community, customers, suppliers, government, environment.
3. GRI’s Sustainability Reporting + Directive 2014/95/EU on non financial reporting.