A Re-Examination of the Cost of Capital Benefits from Higher-Quality Disclosures

Abstract

Prior research suggests a negative relation between disclosure and costs of capital, but Francis, Nanda, and Olsson (2008; hereafter FNO) find the relation weakens considerably or disappears after controlling for earnings quality. Their results suggest that prior research may incorrectly attribute the capital market benefits of earnings quality to disclosure quality. FNO utilize a self-constructed disclosure measure similar to Botosan (1997), while considerable cost of capital research relies on Association for Investment Management and Research (AIMR) disclosure ratings. We posit that AIMR ratings can capture elements of disclosure quality that affect capital costs even in the presence of earnings quality. We introduce earnings quality into the designs of three prominent studies documenting capital market benefits from higher AIMR-rated disclosures. We find that inferences from prior research suggesting that better disclosure quality is associated with lower costs of equity, bid-ask spreads, and costs of debt are robust to conditioning on earnings quality. Further, the economic significance of disclosure quality and earnings quality for costs of capital are roughly equivalent. Additional analyses using non-AIMR disclosure measures suggest that differences between the AIMR ratings and the FNO disclosure measure, rather than differences in sample period, likely explain the disparity in our and FNO's results. We conclude earnings quality does not generally subsume disclosure quality in explaining costs of capital. Data Availability: Data are available from sources identified in the paper.

Voluntary disclosure, mandatory disclosure and the cost of capital

“…Heflin et al. () replicate this analysis using a subset of the Botosan & Plumlee sample and document similar results. Sengupta () and Heflin et al.…”

“…Sengupta () and Heflin et al. () document a negative association between the cost of debt and AIMR scores. In addition, Botosan () and Francis et al.…”

“…Results from prior empirical studies that examine the relationship between voluntary disclosures and the cost of capital generally support a negative association, although this is not always the case. Several studies examine the link between voluntary disclosures based on AIMR scores and the cost of capital – both equity and debt (e.g., Botosan & Plumlee, ; Heflin et al., ; Sengupta, ; Welker, ). Botosan and Plumlee () regress the implied cost of equity on total AIMR scores and three related AIMR component scores that capture three aspects of a firm's disclosures (annual report, other publications, and investor relations).…”

“…() and Heflin et al. (). We find that even though periodic mandatory disclosures and event‐driven mandatory disclosures are correlated with voluntary disclosures and with the cost of capital, the documented association between voluntary disclosure and the cost of capital is generally unaffected by including them in the analysis.…”

“…The concern is that, while an empirical link between voluntary disclosure and the cost of capital is established, the true relationship is between the underlying aspects of the reporting environment that are correlated with voluntary disclosure. For example, several empirical studies focus on how the inclusion of earnings quality in the analysis impacts the association between voluntary disclosure and the cost of capital (e.g., Bhattacharya, Ecker, Olsson, & Schipper, ; Francis et al., ; Heflin, Moon, & Wallace, ) . Further, Segal and Segal's () findings, which show that firms strategically bundle voluntary and event‐driven mandatory disclosure, suggest that the effects of voluntary disclosure may not be fully understood without considering the effect of event‐driven mandatory disclosure.…”