Theme: There is always going to be information asymmetry between the investors in the public markets and the management inside the company because if everything were out in public, the firm would lose all competitive advantages. To combat this, full and timely disclosure will reduce the adverse selection problem so that markets work better, but adverse selection will never fully disappear.

Insights: The fundamental value of a firm will always be larger than the efficient market price of a firm because there is a layer of inside information between the two values. The purpose of financial reporting is to make the publicly available information about the firm increase in order to shrink the gap between the two values. The possibility of adverse selection, insiders profiting off of their insider information at the disadvantage of outside investors, creates estimation risk for investors so they will effectively raise the cost of capital for the firm in order to compensate for this estimation risk. Since the reporting of all inside information is too costly compared to its benefits, the problem of adverse selection will continue to be present. In discussion about full disclosure, we should treat regulation like a “stick” and requires penalties to enforce it. However, the need for regulation will be reduced to the extent that “carrots”, like increased share price and lower cost of capital, begin to motivate full disclosure. These carrot and stick concepts are played out in the author’s discussion about management discussion and analysis (MD&A) that is required in the financial statements to provide a narrative explanation of company operations. Some firms go above and beyond the standard since we can say “carrots” might motivate them, while some do the bare minimum to avoid penalties from regulators. Full disclosure has two big benefits. One is that is will help investors to make better decisions and the other is to improve the ability of securities markets to direct investment to its most productive uses. These benefits can be attained at the same time because better information enables more informed buying and selling decisions, which help share price to move closer to the firm’s fundamental value. Superior disclosure in the form of MD&A signals a confident management approach that can bode well for the firm’s future performance because why else would you release the information especially if your firm’s prospects were bleak. The market price can be seen as the as the aggregation of all relevant “other” information up to the time of release of the financial statements. Still though, we can be reassured the market price is not fully informative because of the presence of noise traders and information asymmetry. Accountants still have a competitive advantage over others in the market for information by allowing for full disclosure, which helps reduce the adverse market impacts of inside information. Question: As much publicity and praise management discussion and analysis (MD&A) portions of the financial statements receive, how often are they really probed by investors and does that sort of information truly make a calculable difference in their decisions/forecasts? What is the ratio between firms that actually go above and beyond the expected reporting level for MD&A and those that just meet the bare minimum to keep regulators off their backs?