Disclosure Quality, Earnings Quality, and the Cost of Capital: A Re-Examination

• In Event: Earnings Quality and Cost of Capital

Abstract

Francis, Nanda, and Olsson (2008) conclude that the cost of capital benefits arising from higher voluntary disclosure quality arise from a more primitive construct—earnings quality. Specifically, they show that, after controlling for earnings quality, the negative relation between disclosure and the cost of capital, suggested by prior research, weakens and sometimes disappears. Their arguments and results raise the possibility that much prior research on capital market benefits of higher quality disclosures suffer from an omitted correlated variables problem. However, much of the prior research on disclosure quality uses ratings from the Association for Investment Management Research (AIMR), while Francis et al. (2008) use a self-constructed disclosure measure. We re-examine three prominent prior studies utilizing AIMR disclosure ratings to address the relation between disclosure and the cost of equity, the cost of debt, and bid-ask spreads. However, we add earnings quality as a control. We find that inferences from prior research suggesting that better disclosure quality (i.e. better ratings from AIMR) is associated with lower costs of equity, lower bid-ask spreads, and lower costs of debt are generally robust to conditioning on earnings quality, although the relation between disclosure quality and the cost of equity is specification-sensitive, even without controlling for earnings quality.

Authors

• Frank Heflin, Florida State University

• James Robert Moon, Florida State University

• Dana Marie Wallace, Florida State University