Disclosure and the Cost of Capital

This post is by Christian Leuz of the University of Chicago.

In our paper Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock, which was recently updated after I presented it at the Law, Economics and Organizations seminar here at Harvard Law School, my co-author Catherine Schrand and I exploit the Enron debacle as an exogenous shock for other U.S. firms and relate cost of capital shocks to subsequent disclosure responses in an attempt to understand the critical link between disclosure and cost of capital. This approach is different from existing research, which has examined the relation cross-sectionally , relating disclosure levels to the cost of capital. Even though this research has found that firms with more extensive voluntary disclosure exhibit less information asymmetry and have a lower cost of capital, a causal interpretation of such findings has proved problematic due to endogeneity concerns for which valid instruments are very difficult to find. Our approach tackles the endogeneity concern in a different way, exploiting the Enron collapse acts as a natural experiment. In addition, there are a number of features of the Enron collapse that make this a powerful setting to address the broad question of the relation between disclosure and cost of capital. First, the shock led to investor concerns about a systematic lack of transparency in financial reporting. Hence, it seems reasonable to expect firms to consider disclosure responses. Second, the shock occurred during a relatively short window. Finally, it occurred during the fourth quarter of 2001. Thus, firms had the opportunity to respond in their annual financial reporting.

Our sample comprises 1,868 U.S. firms with December fiscal-year ends and the required financial data from 1999 to 2001. Using this sample, we document that the cost of capital shocks are associated with an increase in the firms’ disclosures in their subsequent annual 10-K filings. Firms extend the number of pages in their 10-K filings, notably the sections containing the management discussion & analysis, related-party transactions, financial statements and footnotes. This link between cost of capital shocks and 10-K disclosure responses is robust to a broad set of alternative specifications. The increase in disclosure is particularly pronounced for firms that experience positive beta shocks and are likely to be more sensitive to their cost of capital because they have larger external financing needs and more growth opportunities. We also find that Arthur Anderson clients increase their 10-K pages and the section on related-party transactions more than firms that have other auditors, consistent with the idea that the disclosures are a response to the transparency concerns created by the Enron scandal.

We do not find a significant relation between the beta shocks and changes in the length of firms’ annual earnings announcements. However, an analysis of firms’ interim disclosures after the shock suggests that firms increase the number of 8-K filings in response to the crisis. We show that the 8-K disclosures mitigate the effects of the shock but such interim disclosures do not eliminate the relation between the cost of capital shocks and disclosure in the 10-K, consistent with the idea that firms’ 10-K filings and interim disclosures are complementary activities to reduce the transparency problems during this time period. The latter finding is important because it suggests that the annual 10-K filing contains relevant information that can alleviate investor concerns, despite its lack of timeliness. Finally, we show that firms’ disclosure responses subsequently reduce firms’ costs of capital and hence mitigate the impact of the transparency crisis.

The full paper is available for download here.

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