Disclosure,conservatism and the cost of equity capital: A review of the foundation literature

In this review piece, we survey the literature on the cost of equity capital implications of corporate disclosure and conservative accounting policy choice decisions with the principle objective of providing insights into the design and methodological issues, which underlie the empirical investigations. We begin with a review of the analytical studies most typically cited in the empirical research as providing a theoretical foundation. We then turn to consider literature that offers insights into the selection of proxies for each of our points of interest, cost of equity capital, disclosure quality and accounting conservatism. As a final step, we review selected empirical studies to illustrate the relevant evidence found within the literature. Based on our review, we interpret the literature as providing the researcher with only limited direct guidance on the appropriate choice of measure for each of the constructs of interest. Further, we view the literature as raising questions about both the interpretation of empirical findings in the face of measurement concerns and the suitability of certain theoretical arguments to the research setting. Overall, perhaps the message which is most clear is that one of the most controversial and fundamental issues underlying the literature is the issue of the diversifiability or nondiversifiability of information effects.     

Multiple large shareholders, control contests, and implied cost of equity

In this paper, we examine whether the presence of multiple large shareholders alleviates a firm's agency costs and information asymmetry manifested in the cost of equity financing. Using data for 1165 corporations from 8 East Asian and 13 Western European countries, we find evidence that the implied cost of equity decreases with the presence, number, and voting size of large shareholders beyond the controlling owner. We also find that the identity of the second largest shareholder is important in determining the risk of corporate expropriation in family-controlled firms. Our regional analysis reveals that, mainly in East Asian firms, multiple large shareholders structures exert an internal governance role in curbing private benefits and reducing information asymmetry, perhaps to sidestep deficiencies in the external institutional environment.     

Financial development,corporate governance and cost of equity capital

Existing research suggests that external governance is more relevant than internal governance in affecting a firm’s value. We contribute to the literature by explicitly examining the interactive role played by country-level financial development and legal institutions in influencing the impact of firm-level governance on the cost of equity capital. Using a comprehensive sample of 7380 firm years drawn from 22 developed countries, we show that firm-level corporate governance attributes affect the cost of equity capital primarily in the Common Law countries with high levels of financial development. Our study is the first to highlight the complementary effects of legal origin, financial development and firm-level governance attributes in influencing the cost of equity capital.     

The implied cost of equity capital,corporate investment and chief executive officer turnover

This study investigates how the cost of equity capital, along with corporate investment, affects chief executive officer (CEO) turnover decisions. We hypothesize that the cost of equity conveys information about firm performance uncertainty that is informative of CEO talent. Consistently, our empirical results show that the likelihood of CEO turnover is positively associated with the implied cost of equity, after controlling for earnings and stock performance measures and risk factors. Additional analysis of reverse causality supports the causal effect of the high cost of equity on CEO dismissals. We also find that the positive association is more pronounced for firms that are more likely to suffer from underinvestment problems. These results suggest that the cost of equity plays a more important role in assessing CEO performance when the firm needs more external equity capital to pursue investment opportunities.     

The effect of increased disclosure on cost of capital: Evidence from China

This study examined the relationship between disclosure and the cost of capital. Prior studies empirically testing this relationship provided mixed findings, and also raised several concerns, such as the endogeneity of disclosure, the information disclosure environment, and the sample size. This study investigated this relationship based on data from the Chinese capital market where a unique institutional arrangement makes the disclosure exogenous. This unique characteristic, in conjunction with a less stringent information environment and a big sample size, helped address these concerns. Our findings confirmed the negative relationship between disclosure and cost of capital.     

Social disclosure, financial disclosure and the cost of equity capital

We test the relation between financial and social disclosure and the cost of equity capital for a sample of Canadian firms with year-ends in 1990, 1991 and 1992. We find that, consistent with prior research, the quantity and quality of financial disclosure is negatively related to the cost of equity capital for firms with low analyst following. Contrary to expectations, there is a significant positive relation between social disclosures and the cost of equity capital. This positive relationship is mitigated among firms with better financial performance. We consider some biases in social disclosures that may explain this result. We also note that social disclosures may benefit the firm through its effect on organizational stakeholders other than equity investors.     

Religious atmosphere and the cost of equity capital: Evidence from China

The cost of equity capital (ICC) is a crucial component of investment decisions and corporate performance evaluations. This study explores the effect of a region’s religious atmosphere on ICC and finds that ICC tends to be lower when stronger religious atmosphere is created. We further use the mediation effect method to clarify the specific channel through which religious atmosphere reduces ICC, and find that earnings quality, corporate investment efficiency and corporate social responsibility partially mediate the effect of religious atmosphere on ICC. Moreover, the relationship between religious atmosphere and ICC is more pronounced in firms with stronger external law environments and higher audit quality, indicating that formal institutions and religious tradition complement each other.     

The effect of management earnings forecast characteristics on cost of equity capital

This study uses a framework presented in Hirst, Koonce, and Venkataraman (2008) to assess how differences in management earnings forecast characteristics influence a firm's cost of equity capital. I find that less specific forecasts, pessimistic forecasts, and forecasts that predict a loss for the period are associated with higher cost of equity capital levels and more timely forecasts and forecasts with more information content are associated with lower cost of equity capital levels. Analysis interacting control variables and forecast antecedents with forecast characteristics indicates that the effects forecast characteristics have on cost of equity capital are either enhanced or moderated depending on firm beta, firm size, firm book-to-market ratios, analyst following, prior forecast bias, and earnings quality. The results highlight the importance of interacting key variables when interpreting the market effect of management earnings forecasts.     

Compliance with goodwill-related mandatory disclosure requirements and the cost of equity capital

Theory suggests that increased levels of corporate disclosure lead to a decrease in cost of equity via the reduction of estimation risk. We examine compliance levels with International Financial Reporting Standard 3 Business Combinations and International Accounting Standard 36 Impairments of Assets mandated goodwill-related disclosure and their association with firms’ implied cost of equity capital (ICC). Using a sample of European firms for the period 2008–2011, we find a median compliance level of about 83% and significant differences in compliance levels across firms and time. Non-compliance relates mostly to proprietary information and information that reveals managers’ judgement and expectations. Overall, we find a statistically significant negative relationship between the ICC and compliance with mandated goodwill-related disclosure. Further, we split the sample between firms meeting (or not) market expectations about the recognition of a goodwill impairment loss in a given year to study whether variation in compliance levels mainly plays a confirmatory or a mediatory role. We find the latter: higher compliance levels matter only for the sub-sample of firms that do not meet market expectations regarding goodwill impairment. Finally, our results hold only in countries where enforcement is strong.     

Disclosure and the cost of equity in international cross-listing

In this paper, we examine the relationship between disclosure level and the cost of equity capital for a sample of international firms cross-listing on the New York Stock Exchange. Increased disclosure has the potential to reduce information asymmetry, reduce the cost of financing and increase analyst following. Using an international asset pricing model, we find that listing firms experience a decrease in both disclosure risk and systematic risk while matching firms do not. Further, we find that the magnitude of the decrease is related to three types of disclosure: accounting standards; analyst following; and exchange/regulatory investor protection. Our results suggest that increased disclosure through accounting standards is beneficial to investors and that disclosure can be accomplished through information intermediaries, e.g., analyst following. For firms with the lowest levels of disclosure prior to cross-listing, all three types of disclosure appear to be valuable.