Latin American Capital Markets

216 PIETRO MASCI AND IVAN SOTOMAYORclusively, on accounting as an instrument to compile and comprehend informationand can yield satisfactory rewards in an inefficient market Financial statements andquarterly reports are inadequate, on a stand-alone basis, to anticipate the firm'sexpected revenues and therefore the prediction of future earnings. Informationembedded in prices cannot be understood without the input of additional forwardlookingconsiderations, which are the prerogative of the research analyst and of themarket in general. At the same time, one of the basic principles of accounting, thatis, the revenue recognition principle, makes financial statements unlikely to providetimely indicators of market value, which only valuation models can offerRecent events, from Enron to Tyco to WorldCom, that have shaken U.S. capitalmarkets and investors' confidence, further confirm the limitations of capital marketsand demonstrate how the misuse of accounting has a significant impact on stockprices and valuation. However, these events also illustrate that accounting is an instrumentfor organizing information according to certain rules; accounting is not, per se,responsible for financial disclosure. The crucial issue remains corporate governanceand management selection and oversight. According to Jensen and Heckling (1976)and Watts and Zimmerman (1978, 1979, 1983, 1986), accounting and auditing, in additionto helping to perform the valuation function, contribute to enhancing corporategovernance by improving the accuracy of management disclosure, monitoring its behavior;and reducing corruption and agency costs. In dealing with an organization,agency problems exist, that is, the relationship is a contract under which one or morepersons, the principals, engage another person, the agent, to perform some serviceon their behalf that involves delegation of some decisionmaking authority. Therefore,shareholders may want to link managerial compensation to shareholders' value as expressedby the stock price. However; shareholders also need to monitor management,which could manipulate accounting values, policies, and procedures to influence stockprice performance. 3 As the market is not perfectly efficient and accounting manipulationcan affect the stock price, the proper functioning of accounting and auditing isessential to ensure that representations are not fraudulent, deceptive, or likely tocompromise the health of the firm.Accurate and transparent financial statements provide a practical form ofcontract verification among managers, owners, and lenders. Disclosure and accountinginformation as well as auditing are expected to ensure that asymmetric informationbetween managers, owners, and investors is eliminated so that research analystsand investors have adequate information to monitor the performance of managers3 For instance, bonus plans in favor of management increase the probability of selecting corporate accounting proceduresthat shift accounting earnings from the future to the current period.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub