The Committee's approach to the benefits and costs of disclosure included three key procedures: identifying the benefits and costs of decisionuseful information, identifying types of information that could provide significant benefits to business report users, and developing criteria that limit costs in cases in which costs could be significant. This approach, described in more detail below, is consistent with the longacknowledged constraints on costbenefit analysis for disclosure. There is no accepted technique of quantifying such benefits and costs.
But benefits and costs nevertheless have been considered regularly by standard setters, such as the Financial Accounting Standards Board (FASB), by regulators of corporate disclosure, such as the SEC, and by other groups considering disclosure. For example, the Advisory Committee on Corporate Disclosure, a distinguished body that reported to the SEC in 1977, frankly stated that though its charge included analyzing benefits and costs, it had been "generally unable" to reduce them to "objectively measurable terms."
Similarly, the FASB, which regularly considers the benefits and costs of its standards, says in its conceptual framework, "the benefits from financial information are usually difficult or impossible to measure objectively, and the costs often are; different persons will honestly disagree about whether the benefits of the information justify its costs." This chapter presents the main findings from the Committee's study of the benefits and costs of disclosure and explains how the Committee applied its approach to benefits and costs.
The Committee's analysis of the generic benefits and costs of informative disclosure was partly an exercise in studying longknown benefits and costs. However, the Committee also tried both to identify the full range of generic benefits and costs and to pursue their ramifications and interrelationships. The analysis focused only on informative disclosure. The term means information useful for decision making even if it involves costs that outweigh its usefulness. Informative disclosure is reliable; it is unbiased and untarnished by misleading omissions. Its usefulness, still by definition, is explicit: It provides an opportunity for a decision maker to obtain an incremental improvement in assessing the real prospects of a company.
Increased informative disclosure benefits users by reducing the likelihood that they will misallocate their capital. This is obviously a direct benefit to individual users of business reports. The disclosure reduces the risk of misallocation by enabling users to improve their assessments of a company's prospects. Although this is built into the definition of informative disclosure, it is far from a mere abstraction. It is a solid benefit long appreciated in the financial reporting community. The benefit and the process that creates it have three important ramifications.
The first is the effect on the allocation of capital countrywide and its meaning for the economy. Users that use informative disclosure to increase the likelihood and dimensions of their investment returns simultaneously are seeking out and supporting the most productive companies, the companies that can contribute most to economic growth and national competitiveness. Conversely, unwise investments are bad for economic growth and national competitiveness. Thus, an important benefit of informative disclosure is that it improves the effectiveness of the allocation of capital. This is a benefit to society as a whole.
The public interest in effective allocation of capital cannot be underestimated. It has been of concern in recent years, both because of intensified international competition and the social need to increase job formation. The concern is visible in debates over "industrial policy" and in studies on building national competitiveness. The second ramification lies in the effect of the process of providing users with informative disclosure on the liquidity of the capital markets. A more liquid market assists the effective allocation of capital by allowing users to reallocate their capital quickly. It thereby contributes to the same set of benefits. Liquidity varies according to the bidask spread.
The wider the bidask spread, the less liquidity (that is, fewer transactions take place), and the narrower the bidask spread, the greater the liquidity (that is, more transactions take place). Two principal determinants of the bidask spread are the degree of information asymmetry between the buyer and seller and the degree of uncertainty of the buyer and the seller. Both larger asymmetry and greater uncertainty widen the spread, but lower asymmetry and less uncertainty ; two products of broad, public disclosure ; diminish it, thereby increasing liquidity. The third ramification of users' improved capitalallocation decisions is their effect on the disclosing entity's cost of capital. The benefits to users are translated into lower capital prices, a benefit for companies.
This takes place across the total population of disclosing companies and is therefore a reduction in the average company's cost of capital. As the word average suggests, the benefit does not mean that every company in every situation benefits by a lower cost of capital from increased informative disclosure. The benefit must be put in perspective. Looking at the process conceptually, informative disclosure helps users understand the economic risk of a prospective investment. Without any information, the user has no way of assessing a company's prospects. Capital is unlikely to be advanced under such circumstances, but if it is, it will be at some very high price. Now consider the opposite extreme, the ideal state of total informative disclosure. In this situation, the user has all the knowledge necessary to assess a company's prospects.
The price of capital therefore would be based on a company's economic risks (as assessed with the informative disclosure) and the riskfree rate of return (in our society this is generally considered the rate on Treasury bills). Between the two extremes is the real world, where informative disclosure helps investors interpret companies' economic prospects and the interpretations result on average in a lower price for capital. This scenario appears to run counter to the wellknown situation of a company that discloses bad news and has its cost of capital rise. However, there is no contradiction when it is remembered that the scenario applies only to the average company ; that is, across the whole population of capital transactions ; and when two additional factors are considered. First, information about a company can give either positive or negative impressions of its prospects, and the combination of such types of information contributes to learning the economic risk of the business.
Thus, when the information indicates poor prospects, it means that the entity's economic risk is high, not that the increment in information is functioning to raise the price of capital. Getting a better understanding of the true economic risk would still lower the price of capital for the average company. Second, overoptimistic misinterpretations of a company's economic prospects, which would lead additional informative disclosure to correct the misinterpretation and result in a higher price for capital, should be balanced by overpessimistic misinterpretations. It is reasonable to assume that misinterpretations distribute normally between under and overestimates of companies' economic prospects, with the net result for all companies that informative disclosure reduces the average cost of capital.
It is difficult to prove empirically that the average cost of capital is lowered by informative disclosure, even though it is logically and practically impossible to assess a company's economic risk without relevant information. There is abundant evidence that prices are influenced by disclosure (efficient markets research). We also know that capital suppliers request and sometimes demand disclosures that is, they sometimes make disclosure a condition of the transaction. We also have anecdotal evidence, such as the article by Paul Sweeney in the New York Times arguing that many companies "realize that institutional investors prefer to put money into companies that provide lots of information and that good investor relations can help their stock price."
These kinds of evidence are suggestive but are not an empirical case that informative disclosure lowers the cost of capital. Apart from the fact that the disclosure selected for testing must indeed be informative, practical problems have presented obstacles to empirical study. There are, however, two such studies. Dan S. Dhaliwal's study of line of business reporting produced findings consistent with the lowercostofcapital thesis. More recently, Teresa L. Conover and Wanda A. Wallace found that greater extent of disaggregated disclosure for geographical segments correlated with higher stock prices.
To the degree that additional informative disclosure in fact leads to lower capital costs, it benefits society as a whole. Lower capital costs promote investment, which, assuming wise investment, stimulates productivity and economic growth.
One other benefit must be noted before moving on to costs ; the public benefit of consumer protection. To the degree that informative disclosure provides needed consumer protection to users, other things being equal, the public benefits. The benefit is fairness to consumers, even though the confidence such fairness promotes is also good for the economy and is part of corporate accountability to society as a whole. One of the purposes of the SEC's mandate and the statutory disclosure system it regulates is consumer protection. The longevity of this system, now three generations old, suggests that our society values its consumerprotection benefit highly.
There are three primary company costs: (1) the cost of developing and disseminating information, (2) the cost of litigation attributable to informative disclosure, and (3) the cost of competitive disadvantage attributable to disclosure. As described in the next section, the Committee developed costlimiting criteria for all three of these.
The costs of working up and delivering disclosure include the cost of gathering, processing, auditing (if the information is audited), and disseminating the information. These costs also include what is incurred to work up and deliver responses to questions about already issued disclosure. Owners alone ultimately pay all these costs, just as they ultimately bear all company costs. The cost of developing and presenting information that is also used or needed by management must be excluded from the cost of developing such information for external disclosure.
To the degree that the work has been done already or would be done for managerial purposes, there would be no need to duplicate it. Other disclosure costs (formatting, packaging, auditing, and disseminating information), however, would be unaffected by the overlap between costs incurred for managerial purposes and costs incurred for purposes of external disclosure. Potential owners obtain the benefits of disclosure without the costs. However, they would pay if they became owners in the sense that the stream of cash flows to the company would be curtailed by the cost of the disclosure the potential owner had used as a free rider.
Although litigation costs are known to arise from informative disclosure, it does not follow that all informative disclosure leads to litigation costs. Therefore, in order to assess the relationship between informative disclosure and litigation costs, cases exclusively attributable to informative disclosure must be distinguished from other cases involving disclosure. The first distinction is between cases that arise from allegations of insufficient disclosure and those arising from allegations of misleading disclosure. Only the latter are prompted by the presentation of informative disclosure.
The second distinction is between cases of genuinely misleading disclosure and cases where the accusation of misleading disclosure is false. Genuinely misleading disclosure is not informative disclosure as we have defined it, because informative disclosure is unbiased and helpful to users. Such suits are similar to those arising from allegations of insufficient disclosure in that informative disclosure is both not at issue and, if presented, might have prevented the suit. Suits whose accusation of misleading disclosure is false are meritless and should never have been brought, but informative disclosure is indubitably their subject.
The third distinction is within the population of meritless suits. A muchdiscussed characteristic of many meritless suits is that a drop in stock price triggers the suit. In these situations, informative disclosure is a cause of the suit but not the primary cause. The same disclosure without stockprice volatility presumably would not have led to litigation, and the stockprice volatility alone, in the absence of that particular disclosure, presumably would have been sufficient to cause the litigation.
In two of the categories above, informative disclosure would prevent or might have prevented the suit (allegations of insufficient and of misleading disclosure). Thus, the population of suits that add costs attributable to informative disclosure is only meritless suits. Meritless suits have been widely denounced. They have been cited in congressional hearings, and legislation has been introduced in Congress with provisions to reduce their frequency.
The costs of such suits can be very significant. Apart from the legal fees, court awards, and the costs of settlements made strictly as business decisions (the lesser of two cost evils), there is a cost in public relations and in the distraction of executives from productive activities in a company's interests. Although these are not regular costs for all companies, directors' and officers' insurance is a widespread cost that is arguably attributable in significant measure to meritless suits.
Litigation costs are a drag on sued companies and on the economy as a whole. Nevertheless, it is difficult to reach a conclusion on the overall effects of informative disclosure on litigation costs. The whole population of suits must be considered, including those in which informative disclosure could have prevented certain types of suits (allegations of insufficient and of misleading disclosure) and those where price volatility appeared to be the primary cause.
In addition, the whole population of disclosure events must be considered, not just those that lead to suits, and within that population, suits alleging fraudulent disclosure are a tiny minority, dwarfed by events of genuinely informative disclosure. Voluntary disclosures are particularly important because forwardlooking voluntary disclosures are a feared source of meritless suits. But the whole population of voluntary informative disclosures, if measured, seems likely to be far greater than the voluntary forwardlooking disclosures that lead to meritless suits. Finally, there is the likely effect of increased informative disclosure on the frequency and outcome of meritless suits.
Fuller disclosure should lead to smaller claims because the stock market would have more realistic expectations of the company's prospects. The smaller the discrepancy between the valuation implicit in the market price and the valuation based on a company's true prospects, the smaller declines in share prices from disappointed expectations. Since damages are based on the extent of the decline, the smaller declines would lead to smaller damage claims.
Defendants should have better defenses. Assume, for example, richer disclosure of company risks. Defense attorneys could point to such disclosures to argue that the plaintiffs were adequately informed of the potential decline in share prices. This would increase the proportion of cases won by defendants and reduce the settlement amounts. The more important effect is the reduction in settlement amounts, because the cost of pursuing litigation leads to the settlement of most securities class actions.
There should be fewer suits as a consequence of the two conditions just cited. A higher proportion of the shareprice declines would be too small to justify a suit. Better defenses from richer disclosure would warn classaction attorneys that they would have a more difficult time winning and would gain less in settlement. This also would be factored into classaction attorneys' decisions to bring suit.
Some believe that litigation costs increase with increased informative disclosure, and it is possible that they do. However, the analysis above indicates that considered in full context (that is, the full population of suits and the full population of disclosure events as well as the influence of informative disclosure on meritless suits), litigation costs do not increase with the extent of the disclosure. Rather, it appears from the analysis that increased informative disclosure reduces litigation costs on average. However, both points of view agree that with respect to disclosure of forwardlooking information, the potential cost is high and regulatory and statutory relief is needed.
Disclosure that would weaken a company's ability to generate future cash flows by aiding its competition is not in the interests of the company. However, looked at fully, the effect of disclosure on competitiveness is complicated and uneven, involving benefits as well as costs. Some types of information that might create competitive disadvantage are:
To the degree that disclosure adds to competition among U.S. businesses, other things being equal, it serves the public interest in greater economic efficiency and national competitiveness. The economic advantages of competition have been part of our national political ideology and law for generations (for example, the antitrust laws and the Federal Trade Commission's mandate to fight restraints on trade). Anticompetitive features in other societies are widely cited by economists to explain slow growth and difficulties in emerging from a recession. However, the United States is not a land of unfettered competition.
There are types of trade protection and subsidies that reduce the vigor of marketplace competition. In addition, there are specific devices to give monopoly advantages to companies and other economic agents. These are patents, copyrights, and trade secret law. The economic rationale for such devices is that a certain level of anticompetitive advantage is necessary to encourage innovation and risk taking. Discussions of competitive disadvantage from disclosure must consider that these devices protect competitive advantage that otherwise might be lost from disclosure, and the idea that enhanced competition from disclosure is a public benefit must be seen in light of the tempering effect of such devices on the level of competition.
International competition is an exception to the idea that enhanced competition from disclosure is a public benefit. Foreign companies selling to the U.S. market do not have in their home countries the same disclosure requirements that U.S. companies have here. It is typically more costly for U.S. companies to prepare disclosure under the U.S. requirements, a competitive disadvantage. Another competitive disadvantage is that U.S. disclosures allow foreign competitors to know more about publicly traded U.S. companies than such companies know about competitors from abroad. One mentioned remedy, assuming it were available, is the socalled level playing field, a U.S. level of disclosure identical to the levels in foreign competitors' home countries.
However, equality of disclosure by itself is not a rational approach to public interest. It ignores the quality and sufficiency of disclosure. A playing field with no disclosure, foreign or domestic, is as level as any other, but not one that is publicly beneficial. An approach that totally ignores the objectives of effective capital allocation and the interests of users cannot be considered rational. The benefits of informative disclosure obviously weigh against leveling by reducing such disclosure. Moreover, the U.S. has long had a distinction between public company and private company disclosure requirements that is inconsistent with a purely level playing field on disclosure.
There is also the question of what is meant by a playing field . A disclosure system is only part of a capitalallocation system and cannot be understood out of that context. This point is made in the study on national competitiveness by Michael Porter of Harvard Business School for the Council on Competitiveness. Porter notes that German and Japanese enterprises have fewer external reporting requirements but have closer, longterm relationships with dominant owners, who are informed by other mechanisms. In this way Porter justifies recommending more and better disclosure in the U.S. to improve capital allocation in the interest of national competitiveness.
For our purposes, the differences among national capitalallocation systems means that comparisons based on disclosure alone must be considered incomplete. Globally harmonized disclosure standards that adequately serve users' needs and meet costbenefit tests would be consistent with the premises and recommendations of the Committee and end the problem of international differences in disclosure. But that is down the road. For the present, it is important to note that U.S. companies can raise capital abroad if they choose to or engage in private placements in the U.S. Their decisions to stay in the U.S. public market suggest its advantages outweigh its disadvantages.
The advantages include low cost and liquidity that are partly attributable to disclosure. The U.S. also has an interest in attracting overseas companies to its capital markets. However, the arguments that apply to the public interest in the disclosures of domestic issuers apply to foreign issuers. It is again in the public interest, for example, that the stock of U.S. capital be allocated effectively and for the markets to be liquid. The presumable attractions to foreign issuers are lower capital costs and increased liquidity, and fuller disclosure serves those interests.
Companies bargain with suppliers and with customers, and informative disclosure could give those parties an advantage in negotiations. In such cases, the advantage would be a cost for the disclosing entity. However, the cost would be offset whenever informative disclosure was presented by both parties, each in that case receiving an advantage and a disadvantage.
Companies sometimes alter their behavior in response to disclosure requirements or the information that is disclosed, and the behavior can lead to costs or benefits. However, it is very difficult to predict the results of disclosure on company behavior. The imminent adoption of the FASB's pronouncement on contingencies in 1975 led to predictions that corporate risk and insurance management would be changed with adverse consequences. In a study performed after the Statement was issued, however, Robert C. Goshay found there were no impressive differences between the riskmanagement decisions of the companies he studied and those of a control group.
A similar story occurred with FASB's controversial first statement on foreign currency translation in 1975. A postissuance study three years later found no overall detriment to companies or society and some benefits (for example, companies became more aware of exchange risk and more sophisticated in evaluating the cost of foreign currency loan transactions). There seems no basis for concluding that the extent of the disclosure results either in net damage from company behavior or net benefits. Each case is unique. However, if new disclosure is truly informative and previously underappreciated by management, as was the case with the costs of postretirement medical benefits, there is likely to be a net economic benefit.
Although most of the examples given above cite public company disclosure situations, the benefits and costs of informative disclosure applicable to public companies also apply to private companies.
Exhibit 1 MAIN BENEFITS AND COSTS OF INFORMATIVE DISCLOSURE (To Be Understood as Described in the Text) Benefits Investors benefit from the reduced likelihood that they will misallocate their capital. The economy benefits from ; more effective allocation of capital. ; the investment effect of a lower cost of capital. ; the more liquid capital markets. ; enhanced efficiency from competition. Entities (and their owners) benefit from ; a lower average cost of capital. ; access to more liquid markets. ; reduced likelihood that they will misallocate their capital (as users of other companies' financial statements). ; avoided litigation alleging inadequate informative disclosure. ; better defenses when such suits are brought. ; competitive advantage obtained through other entities' information disclosure. ; competitive advantage obtained from their own informative disclosure. ; bargaining advantage from customers' and suppliers' informative disclosure. ; instances where new disclosure is truly informative and previously underappreciated by enterprise management. Society benefits from the consumer protection provided by informative disclosure. Costs Owners bear the cost of developing and presenting disclosure. Entities (and their owners) bear the costs of ; competitive disadvantage from their own informative disclosure. ; bargaining disadvantage from their own disclosures to suppliers and customers. ; litigation from meritless suits attributable to informative disclosure. The economy bears the costs of ; the drag on growth from meritless suits attributable to informative disclosure. ; competitive disadvantage from lower disclosure requirements in foreign competitors' home countries. ; developing, presenting, understanding, and analyzing informative disclosure.
The difference is one of degree rather than kind. For example, competitive disadvantage and litigation risk are limited by the narrower distribution of disclosure, but both are applicable. Private companies are sometimes concerned about whether a supplier that receives disclosure reveals such information to the disclosing company's competitor that is also the supplier's customer. The costs of developing disclosure are typically lower absolutely for private than for large public companies, but they can be more important relatively. Informative disclosure by private companies contributes to the social benefits of improved capital allocation and lower cost of capital. The main benefits and costs of informative disclosure discussed above are summarized in exhibit 1.
The three steps in the Committee's approach, as already noted, were identifying the benefits and costs of decisionuseful information, identifying types of information that could provide significant benefits, and developing costlimiting criteria to identify recommendations that could impose potentially significant costs. These steps were not taken in sequence, but each represents a set of actions taken by the Committee. The Committee developed its potential recommendations based on their potential benefits, identifying decisionuseful information from its study of users, as described in chapter 3. The Committee's benefit estimates relied more on users' needs data than on any other source.
This was supplemented by the study of the generic benefits of disclosure. The Committee's consideration of costs was at first based on members' experience with financial reporting and later supplemented by the study of generic costs. However, once recommendations were developed, they were tested for costeffectiveness through consultation with preparers of financial reports, who provided useful information on potential costs as well as other substantive commentary. The primary source for information on the problems that tentative recommendations might pose for private companies was accountants serving private companies, including the AICPA Private Companies Practice Section's Technical Issues Committee, a group responsible for being aware of the reporting interests of private companies. These processes yielded the following criteria on benefits and costs of candidate disclosures:
The flowchart in exhibit 2 both illustrates those criteria and gives examples of information excluded from the Committee's recommendations as a result of applying those criteria. In applying its costbenefit criteria, the Committee was aware that there is a distinction between its recommendations and draft standards. Recommendations might or might not lead to draft standards.
Moreover, since recommendations are far more general than standards, a variety of standardsetting outcomes could result from the translation of recommendations into standards, with commensurately different costs and benefits. It therefore would be impossible as well as inappropriate to treat the recommendations as draft standards. The question for the Committee was, and could only be, whether its recommendations are sufficiently costbeneficial to merit consideration by standard setters, not whether its recommendations are sufficiently costbeneficial to be implemented.
Exhibit 2
CONCLUSION
The Committee's approach to benefits and costs was conservative. First, it was based on the research evidence already described. Second, the evidence showed that there are many benefits to informative disclosure, some traditionally underappreciated, and that users have unmet information needs. Third, the approach was stringent despite the fact that any proposed standards that emerge from the Committee's recommendations will be subjected to costbenefit analysis by the standard setters. Fourth, and most important, its costlimiting criteria address directly every one of the three major costs that a disclosing company could face ; preparation and dissemination, competition, and litigation. (The Committee's criteria to limit costs are discussed in chapter 5.)
Moreover, the costlimiting criteria on competition and on litigation are arguably in tension with the findings from the analysis of generic benefits and costs. The findings on competition showed there are potential benefits to be had. Companies that suffer competitive disadvantage from disclosure could benefit from reciprocated disclosure by their competitors, and enhanced competition provides some benefits to the economy. However, the Committee decided that the risk of competitive disadvantage to the disclosing company should take priority. The findings on litigation showed that informative disclosure could be beneficial in defending and avoiding litigation. In this instance, the Committee decided that the risk of litigation from forwardlooking information should not be ignored.
The approach is conservative, finally, when one considers likely changes in benefits and costs in the future. The Committee attempted to estimate coming changes in the generic benefits and costs it identified, even though the exercise obviously involves additional uncertainties. One finding stood out ; the influence of information technology on the costs of preparing, disseminating, acquiring, and interpreting informative disclosure. Even if one postulates increasing disclosure, there would still be a costofpreparation decline in the long term.
This is quite different from the assumption in the criterion above that puts a high priority on avoiding excessive costs from preparing and disseminating disclosure. Put another way, the effect of progress in information technology would increase the optimal disclosure level for companies ; that is, the level at which they incur minimal net costs (receive maximum net benefits) from disclosure. Of course, we cannot know with any certainty what the optimal disclosure level is today for individual companies, for all companies as a group, or for society as a whole.
Some companies through voluntary disclosure may have achieved their optimal level, benefiting fully in their cost of capital. But there are no quantitative measures of how today's levels of disclosure stand with respect to optimal levels. Standard setters must make such estimates as best they can, guided by prudence, what evidence of benefits and costs can be obtained (such as data on investors' needs), awareness of the types and interrelationships of benefits and costs, and their understanding of the tradeoffs that best serve the public interest.