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

59 Pages Posted: 24 Oct 2014 Last revised: 4 Sep 2015

See all articles by Frank Heflin

Frank Heflin

University of Georgia - J.M. Tull School of Accounting

James Moon

Georgia Institute of Technology - Scheller College of Business

Dana Wallace

University of Central Florida - School of Accounting

Date Written: September 1, 2015

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 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 subsume disclosure quality in explaining costs of capital.

Keywords: disclosure, cost of equity, cost of debt, bid-ask spread

JEL Classification: M41, G10

Suggested Citation

Heflin, Frank and Moon, James and Wallace, Dana, A Re-Examination of the Cost of Capital Benefits from Higher Quality Disclosures (September 1, 2015). Available at SSRN: https://ssrn.com/abstract=2513577 or http://dx.doi.org/10.2139/ssrn.2513577

Frank Heflin (Contact Author)

University of Georgia - J.M. Tull School of Accounting ( email )

Athens, GA 30602
United States
706-542-1616 (Phone)
706-542-3630 (Fax)

James Moon

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

Dana Wallace

University of Central Florida - School of Accounting ( email )

Kenneth G. Dixon School of Accounting
P.O. Box 161400
Orlando, FL 32316-1400
United States

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