Accounting Information, Disclosure, and the Cost of Capital

Abstract

In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the Capital Asset Pricing Model and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures affect the firm's assessed covariances with other firms' cash flows, which is nondiversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline in the cost of capital. AbstractIn this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the CAPM and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures reduce the firm's assessed covariances with other firms' cash flows, which is non-diversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline the cost of capital.JEL classification: G12, G14, G31, M41

Consequences of financial reporting quality on corporate performance: Evidence at the international level

“…Numerous advantages of providing high-quality information have been cited: FRQ reduces information risk and liquidity (Lambert et al, 2007), prevents managers from using discretionary powers for their own benefit and helps them make efficient investment decisions (Chen et al, 2010). Lambert et al (2007) obtained empirical evidence that the quality of accounting information can influence the cost of capital, both directly, by affecting market participants' perceptions about the distribution of future cash flows, and indirectly, by affecting real decisions that alter the distribution of future cash flows.…”

“…Lambert et al (2007) obtained empirical evidence that the quality of accounting information can influence the cost of capital, both directly, by affecting market participants' perceptions about the distribution of future cash flows, and indirectly, by affecting real decisions that alter the distribution of future cash flows. Chen et al (2010) found that FRQ positively affects the investment efficiency of private firms in emerging markets and this effect enhances bank financing and decreases incentives to minimise earnings for tax avoidance purposes.…”

“…Numerous advantages of providing high-quality information have been cited: FRQ reduces information risk and liquidity (Lambert et al, 2007), prevents managers from using discretionary power for their own benefit and helps them make efficient investment decisions (Chen et al, 2011). Specifically, one of the main benefits of better FRQ is based on the minimisation of asymmetric information problems that arise from conflicting agency (Rajgopal and Venkatachalam, 2011).…”

“…Companies that report higher quality financial information give to the various markets' agents better information on it, allowing them to act in the market with better conditions and a higher level of information (Jo and Kim, 2007). Lambert et al (2007) obtained empirical evidence that the quality of accounting information can influence the cost of capital, both directly, by affecting market participants' perceptions about the distribution of future cash flows, and indirectly, by affecting real decisions that alter the distribution of future cash flows. Chen et al (2011) found that FRQ positively affects private firms investment efficiency in emerging markets and that this effect enhances bank financing and decreases incentives to minimise earnings for tax avoidance purposes.…”

“…FRQ has been studied in different areas, and several authors have referred to its advantages, such as its positive effects from the financial point of view, by contributing to reducing information risk and enhancing liquidity (Lambert et al, 2007). On the other hand, information in financial statements is particularly fundamental in debt contracting (Costello and Wittenberg-Moerman, 2011).…”