Accounting Information, Disclosure, and the Cost of Capital

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.     

Investor recognition and stock returns

It is well established that investment fundamentals, such as earnings and cash flows, can explain only a small proportion of the variation in stock returns. We find that investor recognition of a firm’s stock can explain relatively more of the variation in stock returns. Consistent with Merton’s (J Finance 42(3):483–510, 1987) theoretical analysis, we show that (i) contemporaneous stock returns are positively related to changes in investor recognition, (ii) future stock returns are negatively related to changes in investor recognition, (iii) the above relations are stronger for stocks with greater idiosyncratic risk and (iv) corporate investment and financing activities are both positively related to changes in investor recognition. Our research suggests that investors and managers who are concerned with firm valuation should consider investor recognition in addition to accounting information and related investment fundamentals.     

Discussion of “Using accounting information for consumption planning and equity valuation”

This paper discusses Yee (2007), who investigates the role of accounting information for consumption planning and equity valuation. Higher earnings quality increases investor welfare and ex ante stock prices as well as the weight on earnings in valuation equations based on both cash flows and earnings. The former is due to improved consumption smoothing through more informed production choices, while the latter is due to the impact on the relative information content of current cash flows versus earnings about future cash flows.     

Information disclosure,firm growth,and the cost of capital

We study how information disclosure affects the cost of equity capital and investor welfare in a dynamic setting. We show that a firm’s cost of capital decreases (increases) in the precision of public disclosure if the firm’s growth rate is below (above) a certain threshold. The threshold growth rate is higher when the firm’s cash flows are more persistent, or when other firms in the economy are growing at low rates. While current shareholders always prefer maximum public disclosure, future shareholders’ welfare decreases (increases) in the precision of public disclosure if the firm’s growth rate is below (above) the threshold.     

Economic determinants of price informativeness about future earnings

This study investigates how the value-creation process affects the extent to which stock prices incorporate value-relevant information about future earnings. In contrast to previous studies focusing on the value-reporting process, this paper shows that strong product market power accelerates the incorporation of future earnings into current equity prices due to less uncertainty about future cash flows and that intensive long-term investment deters such incorporation because of greater uncertainty regarding future cash flows. The results suggest that firm fundamentals shaped by product market competition and long-term investment explain the price informativeness about future earnings beyond the impact of management’s reporting discretion.     

Types of investor uncertainty and the cost of equity capital

We jointly test the effects of two types of investor uncertainty, one related to future firm performance and unrelated to accruals (cash flow uncertainty) and one directly related to accrual estimation errors (accounting quality uncertainty). Distinct from prior studies, our uncertainty estimates are based on a matched‐firm design that minimizes the mechanical relationship between the two uncertainty variables. We find a strong negative relationship between cash flow uncertainty and multiple estimates of the cost of equity capital. With respect to accounting quality uncertainty, we find a strong positive association with both expected stock returns and implied costs of equity, but only in settings that control for cash flow uncertainty. Collectively, our results suggest the need to consider different types of investor uncertainty when examining how investor uncertainty affects the cost of equity capital.     

Is Investor Attention for Sale? The Role of Advertising in Financial Markets

Prior research documents capital market benefits of increased investor attention to accounting disclosures and media coverage; however, little is known about how investors and markets respond to attention‐grabbing events that reveal little nonpublic information. We use daily firm advertising data to test how advertisements, which are designed to attract consumers' attention, influence investors' attention and financial markets (i.e., spillover effects). Exploiting the fact that firms often advertise at weekly intervals, we use an instrumental variables approach to provide evidence that print ads, especially in business publications, trigger temporary spikes in investor attention. We further find that trading volume and quoted dollar depths increase on days with ads in a business publication. We contribute to research on how management choices influence firms' information environments, determinants and consequences of investor attention, and consequences of advertising for financial markets.     

The term structures of equity and interest rates

This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market, and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis, and the poor performance of the capital asset pricing model.     

Accounting and Valuation: How Helpful Are Recent Accounting Rule Changes?

The longstanding debate over the proper definition of “earnings”—whether investors when setting stock prices focus primarily on GAAP earnings or other measures like operating cash flow—is both misguided and theoretically unresolvable. The biggest problem faced by investors in evaluating earnings reports is not their inability to understand the effects of the different accounting methods companies use when aggregating accounting line items into reported net income. More challenging, and more critical to the investment process, is getting complete and reliable information about the line items themselves. The authors' underlying premise is that investors, when provided sufficient information about these “components” of earnings, can combine or reconfigure them in whatever way they find most useful. But without sufficient and reliable information about the individual line items, investors will find it difficult to understand how earnings are generated and thus to produce the forecast of future earnings necessary to value a company. In the past few years, there have been significant rule changes in accounting for employee options, derivatives, and special purposes entities. The authors evaluate the extent to which the new rules encourage disclosures that are helpful from a valuation perspective. Although there has been some progress, financial reporting in each of the three areas continues to fall well short of providing the complete, disaggregated data required to value a firm with confidence.     

How Firms Make Capital Expenditure Decisions: Financial Signals, Internal Cash Flows, Income Taxes and the Tax Reform Act of 1986

This paper empirically assesses the determinants of future net capital expenditures for a broad cross-section of COMPUSTAT firms from 1973 to 1989. We explore three general categories of factors expected to affect investment: (1) external equity financing, (2) internally generated accounting information, and (3) tax incentives. We find that external financing and information plays a role in that both positive stock returns and equity issuances indicate future increases in investment. The results suggest that high stock prices not only lower the cost of capital, but also signal good investment opportunities. Accounting information about internal sources and uses of funds are also important in the investment decision. In particular, net income and depreciation are positive indicators of future investment while there is a tradeoff between the payment of dividends and investment. Further, positive changes in available cash liquidity also motivate future investment. While taxes are not important in the investment decision on average, we find that firms with previously higher income taxes invested substantially more in 1985 and 1986. This coincides with the repeal of the investment tax credit and the accelerated depreciation schedules in the Tax Reform Act of 1986. We view this as evidence that federal tax policy in the 1980's induced firms with high income tax obligations to accelerate capital expenditures just before the favorable tax treatment of capital expenditures was eliminated.     

Accounting Treatment of Inherent versus Incentive Uncertainties and the Capital Structure of the Firm

This paper studies the accounting treatment of uncertainty and how it affects a firm's capital structure. We distinguish two sources of uncertainty that raise reliability concerns: inherent uncertainty and incentive uncertainty. By inherent uncertainty, we refer to uncertainty about the quality of raw information regarding future cash flows. By incentive uncertainty, we refer to uncertainty about the quality of accounting numbers conveying the raw information. We explore features of accounting that can effectively deal with these two types of uncertainties in order to aid in the debt‐equity decision of the firm. To handle inherent uncertainty, preferable accounting involves flexible revenue/expense recognition rules that recognize more profit when the uncertainty level is low. To deal with incentive uncertainty, a stringent revenue/expense recognition rule may be desirable to fend off management's opportunistic reporting behavior. Inflexible accounting rules cause a firm's financing choices to deviate from what would hold with complete information. Given any accounting rule, an information environment with a lower (higher) uncertainty regarding future cash inflows leads to higher (lower) expected debt financing. This is because assessed default risk is increasing in the uncertainty of future cash inflows, holding the uncertainty of the outflows constant.     

The usefulness of firm risk disclosures under different firm riskiness,investor-interest,and market conditions: New evidence from Finland

To date, there is only meager research evidence on the usefulness of mandatory annual report risk disclosures to investors. Although it has been argued that corporate disclosure decreases information asymmetry between management and shareholders, we do not know whether investors benefit from high-quality risk reporting in a highly regulated risk disclosure environment. In this paper, we performed association tests to examine whether the quality of firms' mandatory risk disclosures relate to information asymmetry in the Finnish stock markets. In addition, we analyzed whether the usefulness of risk disclosures depends on contingency factors such as firm riskiness, investor interest, and market condition. We demonstrate that the quality of risk disclosure has a direct negative influence on information asymmetry. We also document that risk disclosures are more useful if they are provided by small firms, high tech firms, and firms with low analyst coverage. We also found that momentum in stock markets affects the relevance of firms' risk reports.     

Intangible Assets and Corporate Signaling

Research and development (R&D) and advertising expenditures often result in patents, technologies and brand names which are difficult to accurately value. Under current generally accepted accounting principles (GAAP) these intangible assets are generally not recognized in the financial statements, but instead are expensed in the period that they occur. Prior studies note that the market-to-book ratios of firms with significant levels of R&D and advertising expenditures suggest that investors, at least partially, value these assets. Researchers and practitioners argue that current GAAP, by not recognizing these intangible assets, reduces the usefulness and relevance of accounting reports.We investigate whether companies with significant levels of intangible assets are more likely to emphasize dividend increases and stock repurchases (which are generally perceived as signaling favorable investment opportunities), instead of traditional accounting disclosures, as a means of overcoming adverse selection. Because these assets are difficult to measure, cash distributions may be viewed as a more credible means of signaling firm value to investors. Using analysts' ratings of firms' accounting disclosures, we find that companies with higher levels of R&D and advertising expenditures are less likely to provide extensive accounting disclosures and instead tend to employ dividend and stock repurchase signals. We obtain these results even after controlling for other firm attributes, such as size, stock returns performance, leverage, liquidity and investors' expectations of growth opportunities. We also find that the market reaction to dividend increase and stock repurchase announcements is greater for firms with higher levels of R&D and advertising expenditures, indicating that these announcements are more informative for such firms.     

Earnings vs. stock-price based incentives in managerial compensation contracts

We develop a theory of stock-price-based incentives even when the stock price does not contain information unknown to the firm. In our model, a manager must search for and decide on new investment projects when the market may have a difference of opinion about the quality of the firm’s investment opportunities. The firm optimally provides incentives based solely on realized earnings, leading to an efficient investment policy, when the market has congruent or pessimistic beliefs; however, the firm optimally introduces stock-price-based incentives, leading to an inefficient investment policy, when the market has optimistic beliefs. If the firm can raise equity capital on favorable terms, negative NPV projects from the perspective of the firm may be positive NPV projects from the perspective of current shareholders. The firm motivates the manager to take such projects by basing some compensation on the current stock price.     

Detecting news in aggregate accounting earnings: implications for stock market valuation

How much news is there in aggregate accounting earnings? I provide evidence that earnings changes at the stock market level are correlated with new information about not only expected future cash flows but also discount rates. A comprehensive investigation of the link to discount rates reveals that aggregate earnings changes are tied to news about all components of the expected future stock market return, i.e., the real riskless rate, expected inflation, and the expected equity risk premium. Over the sample period studied, cash flow news and discount rate news in aggregate earnings changes covary positively and have offsetting impacts on stock market prices. As a result, stock market prices appear to be insensitive to aggregate earnings changes. The findings highlight the importance of separating cash flow news from discount rate news when evaluating the information content of accounting earnings at the stock market level. Overall, my study sheds new light on the informativeness and relevance of accounting earnings for valuation at the stock market level.     

The stock price effects of changes in dispersion of investor beliefs during earnings announcements

Existing research provides competing theories about how dispersion of investor beliefs might affect stock prices. We measure changes in dispersion of investor beliefs around earnings announcements using changes in the dispersion of individual analysts’ forecasts. We find that the 3-day market response to earnings announcements is negatively associated with changes in dispersion, consistent with the cost of capital hypothesis. The results hold after controlling for the current earnings surprise, forecast revisions of future earnings, and reported earnings relative to various earnings thresholds. Our study provides new insight about the information contained in earnings announcements that is incremental to the magnitude and timing of cash flows.     

Accounting comparability and relative performance evaluation by capital markets

This paper examines how accounting comparability affects the monitoring role and the risk allocation role of capital markets. We develop the statistical and informational properties of accounting reports under varying degrees of comparability. A perfectly comparable accounting information system enables investors to perfectly infer the difference between any two firms' future cash flows although investors remain uncertain about either firm's cash flow. Comparability alleviates entrepreneurs' moral hazard problem by strengthening the price response to the relative accounting performance, but can induce excessive price risk as well as residual systematic cash flow risk. Unlike the investors (users) who earn their surplus by bearing the residual systematic risk, the entrepreneurs (preparers) do not find perfect comparability desirable. Hence, a standard setter would mandate higher comparability than preferred by preparers, but not perfect comparability.     

Financial Reporting Practices of China's Listed Firms

The long‐term success of financial markets depends on the widespread availability of reasonably detailed and reliable financial information. Individual investors depend critically upon companies' regulatory filings and voluntary disclosures to assess their long‐run risks, payoffs, and, ultimately, their intrinsic values. However, a recent string of accounting frauds involving Chinese firms listed on overseas markets has drawn attention to the accounting and governance risks associated with investing in Chinese firms. This article provides a brief overview of the information environment of Chinese capital markets and the primary forces that affect the incentives of Chinese listed companies to provide timely and accurate financial reports. The evidence reviewed here indicates that the adoption of world‐class standards and regulation, although necessary, is not sufficient to generate incentives for transparency. The long‐term health of China's capital markets will also depend upon other reforms that are designed to accomplish the following: (1) improve the protection of investor rights through an effective, independent judiciary court system that promotes civil lawsuits, and through credible regulatory enforcement; (2) strengthen market development activity, especially with respect to foreign investors; and (3) limit political rent‐seeking behavior and deter politicized business decisions, especially in China's state‐owned enterprises. Together, such reforms have the potential to improve corporate governance in China and better align the incentives of the state and majority shareholders with those of minority shareholders, while increasing the ability of accounting to serve a contracting function and the demand for timely information for valuation purposes.     

Why Do Managers Voluntarily Issue Cash Flow Forecasts?

We study a relatively recent change in voluntary disclosure practices by management, namely, the issuance of cash flow forecasts. We predict and find that management issues cash flow forecasts to signal good news in cash flow, to meet investor demand for cash flow information, and to precommit to a certain composition of earnings in terms of cash flow versus accruals, thus reducing the degree of freedom in earnings management. Our results also suggest that management discloses good news in cash flow to mitigate the negative impact of bad news in earnings, to lend credibility to good news in earnings, and to signal economic viability when the firm is young. Our finding that management cash flow forecasts primarily convey good news is in contrast to the generally negative nature of management earnings guidance and suggests that different incentives drive firms' disclosure of different financial information.