The Importance of Information Asymmetry
We shall consider two major types of information asymmetry:
- Adverse Selection
Adverse selection is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, have an information advantage over other parties. Adverse selection occurs because some persons, such as firm managers and other insiders, will have better information about the current condition and future prospects of the firm than outside investors. There are various ways that managers and other insiders can exploit their information advantage at the expense of outsiders. For example, managers may behave opportunistically by biasing or otherwise managing the information released to investors, perhaps to increase the value of stock options they hold. They may delay or selectively release information early to selected investors or analysts, enabling insiders, including themselves, to benefit at the expense of ordinary investors. Such tactics are adverse (hence the term) to the interests of ordinary investors, since it reduces their ability to make good investment decisions. Then, investors’ concerns about the possibility of biased information release and favouritism will make them wary of buying firms’ securities, with the result that capital markets will not function as well as they should. We can then think of financial accounting and reporting as a mechanism to control adverse selection by timely and credible conversion of inside information into outside information.
- Moral Hazard
Moral hazard is a type of information asymmetry whereby one or more parties to a contract can observe their actions in fulfillment of the contract but other parties cannot.
Moral hazard exists in many situations. A medical doctor may give a patient a cursory examination. A trustee for a bond issue may shirk his/her duties, to the disadvantage of the bondholders. In our context, moral hazard occurs because of the separation of ownership and control that characterizes most large business entities. It is effectively impossible for shareholders and lenders to observe directly the extent and quality of top manager effort on their behalf. Then, the manager may be tempted to shirk on effort, blaming any deterioration of firm performance on factors beyond his/her control, or biasing reported earnings to cover up. Obviously, if this happens, there are serious implications both for the contracting parties and for the efficient working of the economy. We can then view accounting net income as a measure of managerial performance. This helps to control moral hazard in two complementary ways. First, net income can serve as an input into executive compensation contracts to motivate manager performance. Second, net income can inform the managerial labour market, so that a manager who shirks will suffer a decline in income, reputation, and personal market value in the longer run.
Note that both adverse selection and moral hazard result from information asymmetry. The difference is that adverse selection involves inside information about matters affecting future firm performance and resulting security returns. Moral hazard involves manager effort—the manager knows how hard he/she is working but investors do not.
- Scott, W. R. (2015). Financial Accounting Theory 7th Pearson Canada Inc. ISBN 978-0-13-298466-9
- Google Image (2021).