Richard Lambert* The Wharton School University of Pennsylvania Christian Leuz The Wharton School University of Pennsylvania Robert E. Verrecchia The Wharton School University of Pennsylvania
September 2005 Revised, March 2006 Abstract In this paper we examine whether and how accounting information about a firm manifests in its costof 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 assessedcovariances 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 underwhich an increase in information quality leads to an unambiguous decline the cost of capital. JEL classification: Key Words: G12, G14, G31, M41
Cost of capital, Disclosure, Information risk, Asset pricing
*Corresponding Author. We thank the seminar participants at Ohio State University and an anonymous referee for their helpful comments.
Introduction The link between accountinginformation and the cost of capital of firms is one of the
most fundamental issues in accounting. Standard setters frequently refer to it. For example, Arthur Levitt (1998), the former chairman of the Securities and Exchange Commission, suggests that “high quality accounting standards […] reduce capital costs.” Similarly, Neel Foster (2003), a former member of the Financial Accounting StandardsBoard (FASB) claims that “More information always equates to less uncertainty, and […] people pay more for certainty. In the context of financial information, the end result is that better disclosure results in a lower cost of capital.” While these claims have intuitive appeal, there is surprisingly little theoretical work on the hypothesized link. In particular, it is unclear to what extentaccounting information or firm disclosures reduce non-diversifiable risks in economies with multiple securities. Asset pricing models, such as the Capital Asset Pricing Model (CAPM), and portfolio theory emphasize the importance of distinguishing between risks that are diversifiable and those that are not. Thus, the challenge for accounting researchers is to demonstrate whether and how firms’ accountinginformation manifests in their cost of capital, despite the forces of diversification. This paper explores both of these questions. We define the cost of capital as the expected return on a firm’s stock. This definition is consistent with standard asset pricing models in finance (e.g., Fama and Miller, 1972, p. 303), as well as numerous studies in accounting that use discounted cash flow orabnormal earnings models to infer firms’ cost of capital (e.g., Botosan, 1997; Gebhardt et al., 2001).1 In our model, we explicitly allow for multiple firms whose cash flows are correlated. In contrast, most analytical models in accounting examine the role of
We also discuss the impact of information on price, as the latter is sometimes used as a measure of cost of capital. See, e.g., Easley andO’Hara (2004) and Hughes et al. (2005).
information in single-firm settings (see Verrecchia, 2001, for a survey). While this literature yields many useful insights, its applicability to cost of capital issues is limited. In single-firm settings, firm-specific variance is priced because there are no alternative securities that allow investors to diversify idiosyncratic risks. We begin with...