Disclosure Level and Cost of Equity: Evidence from Consumer Goods and Services Industries

Credit & Financial Management Review, First Quarter 2009 by Khlif, Hichem, Souissi, Mohsen

Abstract

In this study, we test the relation between the cost of equity and disclosure of annual reports for a sample of eighty firms listed on the NYSE for 2006 fiscal year end. The results provide evidence that the relationship between these variables is not necessarily significant. The absence of non-financial disclosure is not always conducive to higher cost of equity. The accounting policy choices do not have a significant impact on the association between disclosure and cost of equity. We consider some empirical biases related to disclosure index and accounting policy index to explain this finding. Besides, the lack of significant impact of disclosure on the cost of equity is reflective of the strict disclosure environment in which U.S. firms operate.

Introduction

According to Levitt (2000), the ''quality information is the lifeblood of strong, vibrant markets. Without it, liquidity dries up. Fair and efficient markets cease to exisf . Given the crucial role of corporate reporting policy, an increasing number of studies have focused on this issue. These studies attempt to identify the policy effects on investors' decisions by examining the relationship between the level of disclosure and cost of equity. The theoretical literature suggests that increased disclosure results in the reduction of cost of equity through its impact on market liquidity (Diamond and Verrichia, 1991), estimation risk (Handa and Linn, 1993) and misalignment risk (Easly and O'Hara, 2004). Several empirical studies have attempted to test the significance of this relationship (Botosan, 1997; Hail, 2002; Botosan and Plumlee, 2002 ..).

The present paper constitutes an attempt to address various empirical issues. The contributions of this paper to the literature are three-fold. First, the significance of the association between disclosure and firm's cost of capital is tested with respect of a sample of companies that has not been the subject of research in earlier studies. Second, the focus is also made on non financial disclosure by examining the issue of whether such type of disclosure affects the level of required returns. Finally, this study provides new evidence on the possible interaction between disclosure, accounting choices and cost of equity.

These empirical issues are examined using the residual-income valuation approach (Gebhardt et al., 2001) and price earnings growth (Easton, 2004). The classical approach to measuring the firm's transparency is implemented through the construction of a disclosure index. The proxy for accounting choices is based on the recent index developed by Astami and Tower (2006), which is adapted to U.S. GAAP standards. Applying this methodology to a cross-sectional sample of eighty firms listed on the NYSE stock exchange under the consumer goods and services (retail) sectors. There is no evidence from multivariate analysis of a significant association between cost of equity and disclosure level. However, it is noted that the univariate tests reveal a signification correlation between non-financial disclosure and cost of equity. This study contributes to the existing literature by testing for new relations and extending the sample of U.S. companies in the consumer goods and services industries.

The remainder of the paper is organized as follows. Section 2 provides a brief review of the literature on disclosure and cost of equity. Section 3 describes the testing methodology. Section 4 discusses the empirical evidence while Section 5 concludes the paper.

Literature Review and Empirical Issues

Disclosure and cost of equity

A variety of theoretical models were developed to demonstrate that greater disclosure is conducive to a reduction in the cost of equity. This literature has developed along three main avenues, providing evidence on the impact of disclosure on the estimation risk encountered in the determination of return distribution, liquidity risk and misalignment risk (Daske, 2006). The first stream of research suggests that greater disclosure level allows investor to estimate more accurately the distributional moments of asset return distributions. Therefore, firms with increased disclosure are likely to be associated with lower risk in the estimation of returns. The model developed by Handa and Linn (1993) suggests that investors attribute less systematic risk for equities with higher information quality.

The second stream of theoretical research argues that higher disclosure ameliorates stock liquidity, which in turn may reduce the cost of equity through greater demand for firms' equities and lower transaction costs (Amihud and Mendelson, 1986). Also, Diamond and Verrichia (1991) show that greater disclosure, by making private information publicly available, has the effect of reducing information asymmetry and improving liquidity. Increased disclosure has also the potential to attract stronger demand for the firm's securities and thereby decrease its cost of equity. The association between the disclosure level and liquidity is also examined in many empirical studies such as Welker (1995), who provides evidence of a positive link between disclosure and bid-ask spread, which proxies for the degree of liquidity.