Analytical Master Essay

Question

What information do investors need to decide where to invest their capital and then to judge the effectiveness of their investment decisions. To what extent can this information be provided in a world of international groups of companies and floating exchange rates?

Write an essay on the above topic. This should be 3000 words long (+/- 10%) and should be submitted via Blackboard, in accordance with the rules of the School.

The source of all quotations should be given and other references to the literature should be made in proper style.

Answer

Contents

Introduction. 2

The problem of information asymmetry. 3

The need for information on financial governance. 5

Importance of information on reported earnings, equity values, and cash flows. 6

The dynamics of information on financial statements. 8

Constraints on availability of information: Focus on international groups of companies and floating exchange rates. 10

Conclusion. 11

References. 12

 

Introduction

Organizations and institutions play a critical role in the creation of appropriate capital structures to finance large-scale business operations. In this undertaking, one of the biggest problems is asymmetric information that tends to divide the interests of corporate investors and managers (Pollard & Robertson, 1979). Over time, this asymmetry has continued to shape international arrangements in the world of finance. This is evident in the way corporate finance markets have developed in the United States and Britain.

Access to information is crucial in ensuring that the prevailing environment of international economic vibrancy is maintained. Moreover, it can greatly enable international investors make prudent investment decisions. For this to happen, the existing patterns of governance should promote transparency in the way information is provided. As Baskin & Miranti (1999) different countries operating in today’s world of floating exchange rates, including Japan and Germany, have made serious attempts to transform their local markets into centres of international capital. However, at the same time, such countries have been accused of discriminatory practices in information access with a view to ensure that local economies are not dominated by large international companies.

To succeed in their efforts, investors operating in different countries need to be aware of the information they need and how best to assess the effectiveness of all the investment decisions that they make. The aim of this paper is to investigate the information that investors need to decide where to invest and then to judge the effectiveness of their investment decisions. The paper also discusses the extent to which this information can be provided in today’s world of international groups of companies and floating exchange rates.

The problem of information asymmetry

Information asymmetry is a major concern especially for investors from outside a country (Kinney, 2002). Kinney (2002) points out that such investors tend to find it difficult to gather sufficient data to assist them in the crucial task of analyzing corporate performance. In such circumstances, accurate valuation of securities becomes difficult. Asymmetries of information used to exist even in the nineteenth-century Britain in the absence of modern systems of company regulation such as auditing (Pollard, 1983).

During the last three decades, researchers have suggested that the problem of information asymmetry is not as serious as it was during the mid-nineteenth century (Edwards, 1989; Floud & McCloskey, 1994; Jones, & Kirby, 1991). This, according to Jones & Kirby (1991), is partly because of the development of alternative arrangements. For example, in the pre-railway era, the scale of most activities was modest, meaning that on the overall, capital requirements were relatively limited (Hawke, 1970).

Investors operating in situations of information asymmetry may resort to speculation on the basis of inaccurate projections and rumours. More significantly, foreigners may be unwilling to risk their capital for fear that asymmetric access to privileged information may lead to insider trading. Church (1980) suggests that in an environment of information asymmetry, the use of partnerships as an alternative form of organization provides a flexible basis for effectiveness in industrial production.

Many large investors are also wary of discrimination in favour of large clients operating from local brokerage houses. Indeed, the problem of this type of discrimination has been experienced in the Japanese Tokyo exchange, whereby many local brokerage firms were reimbursed for trading losses. This challenge is compounded by the tendency by individual countries to introduce rules that ensure that foreigners have no corporate control over local economies. These hindrances act as a major barrier to free flow of capital in the international market. More significantly, they trigger retaliatory actions by trading partners who may previously have been embracing more liberal practices (Mann, 1988).

According to Ferguson (2009), the strands of development in the securities market in the US and the UK can create a better understanding of the implications of information asymmetry for large investors and international groups of companies. In this regard, two main spectrums may be identified. One end of this spectrum is characterized by similarity of systems adopted in both the US and the UK. Securities markets in both countries are characterized by transparency in regulatory structure and corporate affairs and freely competitive markets. The role of the regulatory structure is to ensure that investors are always protected from dishonest and incompetent agents. This is in sharp contrast with the case of Japan and Germany, where the local markets are dominated by powerful local and governmental institutions through cooperative relationships. The informal way in which these relationships are promoted increases the degree of information asymmetry. In such cases, investors have to be keen on the information that they look for. Priority should be on information that is critical to their long-term survival in these foreign markets.

One of the most advantageous attributes of Anglo-American securities markets is that investors have access to reliable information. This facilitates proper pricing of securities, such that it becomes possible for capital to be allocated efficiently by the market. Moreover, efficiency in access to information augments economic growth simply because investors have more opportunities for transacting profitably. Additionally, professional and governmental monitoring patterns complement each other. This creates an assurance of currency and reliability of corporate information.

Originally, the agencies that oversaw the task of monitoring patterns in the flow of information in the Anglo-American financial markets were limited to professionals such as direct accountants, boards of directors, investment bankers, and attorneys. For these professionals, fiduciary responsibility largely involved legal precedents in addition to being based on path-dependent processes. Later on, state-level monitoring was also introduced, thereby putting professional groups at a reinforced position.

It is ironical that this receptivity to innovation ultimately tends to have a negative impact on internal investment in the long run. Emphasis tends to be on ensuring that conglomerates and leveraged buyouts (LBOs). The negative effects when managers tend to prefer projects with a promise of short-term payoffs. In essence, long-term developments become unattractive simply because delayed are misconstrued for managerial incompetence or opportunism. The massive inflow of information compels managers to be highly selective with the capital investment projects that they venture into. This is primarily because investors exert a lot of pressure on them to achieve extraordinarily high levels of financial performance.

The need for information on financial governance

In a world of international groups of companies and floating exchange rates, information on financial governance is critical. Ordinarily, strong the vested interest exhibited by the professional groups operating in the financial markets and the investing public tends to deter change in financial governance. The public lacks the incentive to do away with institutional arrangements that safeguard transparency in all financial affairs while at the same time protecting the public against fraud and professional incompetence. Moreover, the existing structures of government are highly relied upon by a vast array of professionals to apply their skills.

Surprisingly, in the US, a most heated debate in recent times has focused not on whether regulatory regimes should exist, but rather on whether these regimes should lean towards governmental or professional agencies (Nelson, 2003; Audretsch, 2002). The debate has also focused on the setting up of regulatory and supervisory boundaries. These issues have been relied upon in the evaluation of whether corporate disclosure provides a sufficient mechanism exchange among large investors. Since corporate disclosure touches on the delicate nature of contemporary corporate affairs, it has in recent history triggered a heated debate.

Importance of information on reported earnings, equity values, and cash flows

Information on reported earnings, book equity values, and cash flows is important in evaluating the potential of a business venture in terms of profitability. Lev (2000) argues that there is a need to extend the boundaries of financial reporting to cover these areas. Lev (2000), however, is also cautious that government and professional entities with vested interests have in recent years been creating the impression that this information is increasingly becoming irrelevant. In Lev’s view, there is a need for investors to compare the available financial information with the total information that exists in the marketplace.

If a decline in demand for information on cash flows and reported earnings has been experienced in recent times, it is largely because many accounting professionals and supervisory bodies have not been keen to promote its usefulness (Myers & Myers, 2003). At the same time, investors have never appeared to relent on their quest for relevant information for use in making critical business decisions. It is not clear whether the decline in demand for information on cash flow, reported earnings, and equity values is being driven by innovation, deregulation, or competition. What is evident, however, is that the impact of market changes on the operations of firms and economic conditions is not being reflected accurately in contemporary reporting systems (Elliott & Hanna, 2000).

Today, many investors are keen on innovative approaches to wealth creation (Bedard, 2004). They are increasingly investing in intangible assets such as research and development, brands, information technology, and human resources (Hunton, 2006). These investments have radically altered the firms’ operations and products, market values, and economic conditions. According to Elliott & Elliott (2012), the greatest failure has been observed through efforts to account for intangibles.

Failure in accounting for intangibles easily creates the impression that a business enterprise is investing a disproportionately high percentage of its earnings to research and development (Gibbins, 2002).  What the individual who gets this impression may not know is that research and development may be contributing significantly to the overall rate of change in the fortunes of the enterprise (Gibbins, 2002). According to Cain & Hopkins (1993a), the situation can be arrested first and foremost by comprehensively capitalizing all intangible investments. Moreover, financial statements should be systematically restated (Cain & Hopkins, 1993a). Regarding the capitalization of intangible assets, some efforts have already been introduced. For example, many technology companies have established accounting norms for accounting for software development costs. Regarding the restatement of financial statements, no much progress has been made because the current accounting practices are yet to be subjected to radical change.

The perceptions of investors regarding the usefulness of financial information continue to change. At the same time, relationships between private sector and state have been undergoing fundamental changes. These changes continue to have significant effects on accumulation of capital by investors. According to Turner (1984) today’s investors seem to have taken a passive approach to information acquisition.

In a world of floating exchange rates, a lot of focus has been on the association between returns and earnings. According to Elliott (2002) the association between stock returns and reported earnings is rather weak. In other words, variations in stock returns are influenced to a very small extent by earnings. In this regard, a need arises for research to be carried out to determine the extent to which earnings are informative for those who invest in international groups of companies.

Information on the association between cash flows and returns is also regarded as a crucial factor that influences investment decisions. Conventionally, cash flows are considered more informative than returns. This is simply because they are less subject to manipulation by managers than accrual earnings. Moreover, they are less likely to be impacted upon by questionable rules imposed by rogue accountants.

The dynamics of information on financial statements

Financial statements continue to provide a crucial source of information for investors, particularly in their efforts to assess the effectiveness of their investment decisions. However, according to Cain & Hopkins, (1993b), some disadvantages are associated with these statements, and this may have contributed to a continued decline in their use. Nevertheless, financial statements continue to be the most sought-after sources of information for investors seeking business opportunities in international groups of companies and floating exchange rates.

Using financial statements, investors are able to ascertain the rate of change in a specific business or line of businesses. In addition to these statements, surveys of policymakers, investors, and business executives are critical. The surveys also enable the investor understand changes in business environment, which continue to occur at an ever-increasing rate. According to Wilson (1995) businesspeople with investments in incorporated businesses are particularly vulnerable to the destabilising effects of economic uncertainties in the international business environment. In efforts to form mergers and acquisitions, these investors consider consistency in financial statements as a crucial indicator of corporate strength.

At the same time, the investors may want to assess the efficiency of floating exchange rates by measuring the rate of change in business. One of the ways of measuring this change is by evaluating portfolio switches in terms of frequency and magnitude. Ine one of the approaches of assessing the viability of investment decisions, investors simply select a sample representing companies in an industry and then investigate business trends in terms of optimal business size and the ability by firms to go public. They also take note of the tendency by existing businesses to merge or go bankrupt. Financial statements play a critical role in evaluating this information. In some situations, the financial statements obtained of bankrupt firms may have been portraying a positive image all along. This may imply that the accounting professionals were either dishonest with their legal and public disclosures or that the business was brought down by factors that could not be captured through financial reporting.

It is true that not all factors affecting the business environment can be captured through traditional accounting. One of the reasons for this phenomenon is that the international business environment has been changing drastically during the last three decades yet traditional accounting practices have hardly changed. For example, during the 1980s and early 1990s, a process of deregulation was introduced in the US phone service (Foreman-Peck, 1995). Gradually, the country shifted from an environment of monopolistic tendencies to that of competitiveness.

Reactions from investors following this deregulation increased business risk in the phone service industry. The revenues that were expected to drop significantly in the former phone service companies that operated as monopolies. Yet this move towards deregulation did not have a major impact with on the way recordable events are accounted for (Foreman-Peck, 1995). For example, it took almost half a decade since the onset of deregulation for Baby Bells, a regional telephone company operating as a monopoly in the US, to write of $26 billion worth of assets (Foreman-Peck, 1995). These assets were written off because they were no longer useful for the company in the new era of deregulation.

Constraints on availability of information: Focus on international groups of companies and floating exchange rates

The history of the world economy in general and British imperialism in particular shows that investors, especially the non-professional ones, rely too much on a wide range of financial announcements. This overreliance may be hazardous for the economy in many ways. Gourvish (1980) gives the example of overreliance on announcements on pro-forma earnings by non-professional investors. With time, such investors get used to the practice of relying on pro-forma disclosures too much when making virtually all business decisions. This is disadvantageous in that it creates a fixed mindset among these investors, who find it unnecessary to search for alternative sources of financial information.

In some cases, professional agencies and government-affiliated entities tend to refrain from putting too much emphasis on a few instruments for use in decision-making by investors (Floud & McCloskey, 1994). This is mainly to avoid the risk of overreliance on a few sources of information among investors, thereby clouding their judgments and decisions (Gelos, 2005). By so doing, these entities also tend to be guarding against any disclosures that may offset the existing industry structures (Kennedy, 1987). They normally do this because it may not be in their best interest for these structures to be realigned (Kennedy, 1987). According to Kirby & & Rose (1994), these constraints have become very common in the British economy in today’s information age.

Constraints on information flow in the world of floating exchange rates are also motivated by the fact that in economics, information is potentially tradable (Baskin & Miranti, 1999). In other words, messages communicated can potentially be accorded a price in a market. In this regard, difficulties can only arise in the determination of a fair price. This creates an environment of ambiguity, whereby no single source of information is precise enough to be relied upon by all investors under all circumstances. Chiu (2003) uses the concepts of constructive ambiguity versus transparency in discussing the dynamics of constraints on availability of information for international groups of companies and floating exchange rates.

Conclusion

In conclusion, investors look for different sources of information in their quest for success in the highly dynamic world of large international companies and floating exchange rates. The investors are always faced with a choice to make decisions on which sources of information to rely on. Information on financial governance is particularly useful because of the way it brings together professional and governmental practitioners. However, numerous vested interests have led to the existence of information asymmetries. This phenomenon has continued to exist as far back as in the nineteenth-century Britain. Other crucial sources of information include equity values, reported earnings, cash flows, and financial statements.

From the analysis presented in this paper, it is evident that the goal of transparency in the supply of information to investors is virtually unattainable. This is especially the case in a world of floating exchange rates where the information provided can potentially be accorded a price in a market. The extent to which this information can be provided in a world of floating exchange rates and international companies depends on many factors, including its dynamics, constraints, legal disclosure requirements, and public disclosure standards.

 

References

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