Accounting Information, Disclosure, and the Cost of Capital
Source: Lambert, R., Leuz, C. & Verrecchia, R. E. (2007) · Journal of Accounting Research 45(2), 385–420
TL;DR
A CAPM-consistent, multi-security model recast in terms of cash flows rather than returns, used to show whether and how the quality of accounting information/disclosure manifests in a firm's cost of capital despite diversification. The key insight: better disclosure has a direct effect that lowers a firm's assessed covariance with other firms' cash flows — a non-diversifiable component — so information quality is priced even in a large economy.
The question
Standard setters routinely assert that "high quality accounting standards reduce capital costs" (Levitt 1998), but there was little theory. Portfolio theory says firm-specific (idiosyncratic) information should wash out via diversification. So: can a firm's own disclosure quality affect its cost of capital despite the forces of diversification, in an economy with many correlated securities?
The model
A multi-security economy consistent with the CAPM, but the CAPM is rewritten in terms of expected end-of-period cash flows and their covariances rather than returns. The firm's cost of capital is defined as the expected return on its stock.
Eqn. (1): the only firm-specific parameter in the cost of capital is its beta — the covariance of its future cash flow with the sum of all firms' cash flows (the market), a forward-looking quantity based on participants' information. The ratio of expected future cash flow to that covariance is the key determinant.
Accounting information and disclosure enter as noisy signals about future cash flows, operating through two channels:
- Direct effect — information does not change cash flows themselves, only participants' assessed distribution.
- Indirect effect — information changes the firm's real decisions, altering the actual expected-cash-flow-to-covariance ratio.
Key predictions
Higher-quality information reduces the assessed variance of a firm's own cash flows — but this effect is diversifiable in a properly defined "large economy" (large requires the number of firms and investors to grow appropriately, not just N→∞).
More surprisingly, higher-quality disclosure has a direct effect on the firm's assessed covariances with other firms' cash flows, lowering them — this is not diversifiable and moves the firm's cost of capital toward the risk-free rate. This extends the "estimation risk" literature (Barry–Brown 1985; Coles et al. 1995) to a single firm's own disclosure.
The indirect (real-decision) effect can go in either direction; the paper derives conditions under which higher information quality unambiguously lowers the cost of capital.
All effects are captured by a fully-specified forward-looking beta; with such a beta there is no role for a separate "information risk" factor outside the one-factor CAPM. Historical-return betas will not capture this, which is what justifies information proxies empirically.
Empirical status
A theory paper with no estimation of its own. It provides the analytical underpinning for the disclosure / information-risk cost-of-capital literature (Botosan 1997; Francis et al. 2005) and is positioned against contemporaneous work — notably Easley–O'Hara (2004) and Hughes et al. (2005), the latter of which finds no cross-sectional information effect under a different (price-based) definition of cost of capital.
Limitations
A stylized one-period model; mapping abstract "information quality" to observable disclosure measures is hard.
Empirically separating the diversifiable direct effect, the non-diversifiable direct effect, and the indirect effect is challenging.
The non-diversifiable result depends on the specific definition of cost of capital (expected return); under alternative definitions cross-sectional effects can vanish or differ.
Key references
Easley, D. & O'Hara, M. (2004) — Information and the Cost of Capital — Journal of Finance
Hughes, J., Liu, J. & Liu, J. (2005) — Information, Diversification, and Cost of Capital
Francis, J., LaFond, R., Olsson, P. & Schipper, K. (2005) — The Market Pricing of Accruals Quality — Journal of Accounting and Economics
Barry, C. & Brown, S. (1985) — Differential Information and Security Market Equilibrium
Provenance: verified/generated from the paper's full text.
