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Accounting Information, Disclosure, and the Cost of Capital

Wharton Financial Institutions Center Working Paper Series #06-20

47 Pages Posted: 12 Oct 2005  

Richard A. Lambert

University of Pennsylvania - Accounting Department

Christian Leuz

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania - Wharton Financial Institutions Center; CESifo Research Network

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Multiple version iconThere are 3 versions of this paper

Date Written: March 2006

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 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.

Keywords: Cost of capital, disclosure, information risk, asset pricing

JEL Classification: G12, G14, G31, M41, M45

Suggested Citation

Lambert, Richard A. and Leuz, Christian and Verrecchia, Robert E., Accounting Information, Disclosure, and the Cost of Capital (March 2006). Available at SSRN: https://ssrn.com/abstract=823504 or http://dx.doi.org/10.2139/ssrn.823504

Richard Lambert (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-7782 (Phone)
215-573-5463 (Fax)

Christian Leuz

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-834-1996 (Phone)

HOME PAGE: http://faculty.chicagobooth.edu/christian.leuz/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

HOME PAGE: http://www.nber.org

European Corporate Governance Institute (ECGI)

Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Center for Financial Studies (CFS) ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

University of Pennsylvania - Wharton Financial Institutions Center

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

CESifo Research Network

Poschinger Str. 5
Munich, DE-81679
Germany

Robert E. Verrecchia

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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