The Associations among Earnings Quality, Voluntary Disclosure, Information Asymmetry, and Cost of Equity Capital: A Structural Equation Modeling Approach

• In Event: Valuation, cost of equity, and expected returns
  In Paper Session: EValuation, Cost of Equity, and expected Returns

Abstract

Using structural equation modeling, we examine the direct and indirect paths from earnings quality and voluntary disclosure quality to cost of equity capital. Our analyses are motivated by theoretical studies that debate the mechanism linking disclosure to cost of capital and by empirical studies that debate the incremental effect of voluntary disclosure on cost of capital after controlling for earnings quality. We use common factor analysis to create latent variables for earnings quality, voluntary disclosure, information asymmetry, and cost of equity capital. We find that higher earnings and voluntary disclosure quality are negatively associated with cost of capital both directly and indirectly through information asymmetry. Further, the negative association between voluntary disclosure and cost of capital continues to hold after the inclusion of earnings quality in the model. The results suggest that mandatory and voluntary disclosures reduce cost of capital by decreasing both information risk and information asymmetry and that the reduction in cost of capital associated with voluntary disclosure is incremental to the reduction associated with high quality earnings.

Authors

• Lisa A. Hinson, The University of Georgia

• Steve Utke, The University of Georgia