Schematic Diagram for Theoretical Framework

The theoretical structure of the study is market based to reflect the principal aim of the study of establishing the usefulness of narrative disclosures to investors. The stance adopted is that there are two markets in which information content of narratives is explained. They are the market for capital and market for information where the respective products are capital and accounting disclosures. In other words, the interaction of the markets is that there is an agency relationship between shareholders (principals) and managers (agents). Whilst the principals supply capital to the agents to manage the company, they are in quest for information about the firm from the agents. Elliott and Jacobson (1994) ideates this relationship between the two markets with the suggestion that investors are buying customers of accounting disclosures when they intend to or effectively trade based on the information.

However, as earlier discussed, the main motivation for regulation is the existence or propensity of market failures. Therefore, the market for regulation is augmented by the interaction between the two markets (that for capital and that for information) to control free market deficiencies. The inclusion of the economic theories of regulation in this thesis‟

theoretical framework recognises that the regulatory and standard-setting instruments, ASB (2005; 2006), recommend complementing and supplementing.

Diagram 4 provides a sketch of the thesis‟ theoretical setting.

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Diagram 4 Theoretical Framework for Usefulness of Complementary and Supplementary Narratives

The framework above provides an illustrative impression for the theoretical framework explaining the essence of complementary and supplementary information to investors using an economic market based approach. The first consideration is identification of the markets involved, that is, the market for capital and the market for information, distinguished above by the thick dotted line. The upper section of the structure relates to the market for capital while the lower relates to the market for information.

In the MC, the commodity traded is capital, supplied by the firm‟s shareholders and demanded by the entity‟s management. In the MI, the commodity is information, in this case complementary and supplementary disclosures, supplied by management to the shareholders.

The theories for the MC assume the mainstream economics perspective that the capital market is efficient and therefore all available information is correctly priced. Therefore, since accounting disclosures are a form of information, they are accurately reflected in the share price and have no abnormal returns. For reference, the irrelevance of accounting narrative commentaries for share pricing is explained by Fama‟s (1970) semi-strong form efficiency of

B

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EMH. Since accounting information has no value in informing share pricing, the MC theories do not have any regard for the disclosures as visualised in the diagram above with the arrow symbolised as A .

The theories for the MI reflect the heterodox economics, which consider inefficiency in markets. The MI in reference to accounting disclosures realises that there is an agency relationship between shareholders and the firm‟s management, reflecting Jensen and Meckling‟s (1976) agency theory. Therefore, for investors to make prudent investment decisions, they will require information to assess both the firm and management‟s performance. Investors will demand information which in return they will use to supply capital to the capital market. The theories under here consider that the two markets, MC and MI, interact as denoted with the arrows B. Most crucial to the study is the UIH and ORH which considers disclosure attributions and post-event price adjustments to news. Other augmenting theories include IRH, ML, signalling and incomplete contracting.

The third group of theories is the market for regulation (MR) which is based on the possibility that free economic markets may fail to equitably or efficiently operate. Regulations or standards by either government to protect the public in which markets operate or special interest to protect interests of their members are enforced on to the free economic markets.

Jensen and Meckling (1976) as well as Watts and Zimmerman (1979) opinionated that existence market failure justifies the consideration of regulations and standard setting to correct the market inefficiencies. More related to this study, complementing and supplementing as the fundamental information types of concern are a result of a regulation and standard-setting documented in ASB (2005; 2006). Arrows C above stand for the MR theories that may impact on either the functioning of the MC or the MI or their interaction. The theories under this category include the public interest and the capture theories of regulation.

6.6 Summary and Concluding Remarks

Given that the objective of the study is to investigate information content of narratives, a market-based theoretical approach is adopted since information content relates to market valuation of an event. The purpose of this chapter was to discuss the theories that explain the

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relevance of accounting disclosures to investment decision-making. The discussion related to chapter 5 where the entity concept of the firm underlines the essence of accounting disclosures for the purpose of investment decision-making through which information asymmetry may be alleviated. By way of the mainstream and heterodox economic mechanisms assumptions explained in chapter 5, the theories justifying information content of complementary and supplementary narratives are explained in this chapter. The discussion is done by classifying the theories under the market for capital (mainstream) and the markets for information and regulation (heterodox).

Under the mainstream stance, markets are efficient and the market agents have homogenous expectations as well as being rational. This would suggest that no market participant can profit from new information on the market above the market return. Concerning accounting disclosures, such a setting is reflective of the efficient market hypothesis in its semi-strong form which suggested that the information cannot be used to make abnormal profits. Hence, in the market for capital narrative commentaries accompanying financial statements have no value.

Alternatively, the heterodox mechanism recognises that there are market imperfections such as diversity in expectations and irrationality that result in market inefficiencies. With regard to the relationship between accounting disclosures and capital markets, this setting presents the market for information. Ideally, the theories under this stream intend to conjecture that accounting information affects share pricing in the market for capital. The basis for this postulate is the existence of the agency relationship between shareholders and the firm‟s management arising from the contracting of managers to run the business on behalf of the shareholders. Due to heterogeneous expectation, irrationality or other market inefficiencies, shareholders depend on information from managers to make investment decisions. Thereby, management will reduce information asymmetry in attempt to attract capital from shareholders. By providing accounting disclosures, management alleviates the risk of adverse selection on part of the shareholders. However, another stream of market for information theories, there is an argument that would compel managers to mislead investors through

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concealment and deception. In such cases, information asymmetry leads managers to beget a moral hazard scenario through accounting disclosures.

The realisation that free economic markets may not function efficiently or equitably largely due to inconsistencies between their assumptions and the real world applicability, the market for regulation theories are also considered in the theoretical milieu of the study. A further problem is that integrating two markets, that for information and capital, results in conflicting assumptions and the posture regarding relevance of accounting disclosures in the investment decision-making process. These problems may result in market failures that are presumably correctible through regulation. Further, given that complementing and supplementing was introduced in the UK accounting environment through regulative instruments (e.g. ASB 2005;

2006), it is suffice to consider the market for regulation and standard setting in the study.

There are two broad regulatory theories, the public interest and the capture theories. The public interest regulation theory in which regulation intends to control free economic markets for the good of the society. However, with criticism such as the inability to have a common good for the entire public and high costs involved in negotiating regulation for the entire public, the capture theories of regulation are fostered. The capture theories arise from special interest groups who formulate regulation or standards for the benefit of their members. The cardinal critic of capture theories in Posner (1974) is that they have no definite theoretical underpinning. Benston (1969) disregarded the broad relevancy of regulation on the ground that the presence and absence of regulation did not deter slumps in capital markets. In addition, free markets can exhibit the potential to efficiently allocate resources without government intervention.

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