The Expected Costs of Increased Disclosure. Firm- and Industry-specific Forces

Contents

Contents

List of Abbreviations

1. Introduction

2. The Capital Market Effects of Increased Disclosure
2.1. Ambiguous Predictions about the Capital Market Effects: Information Asymmetry as Link between Public Disclosure and Capital Market Outcomes
2.1.1. The Effect of Increased Disclosure on Information Asymmetry: A Complementary versus Substitutive Relationship between Private and Public Information
2.1.2. The Effect of Information Asymmetry on Capital Market Outcomes
2.2. Empirical Evidence on the Capital Market Effects
2.2.1. Reduction of Information Asymmetry through Increased Disclosure
2.2.2. Capital Market Benefits through Voluntary Disclosure
2.2.3. Conflicting Evidence and Reservations about Empirical Studies Implying Capital Market Benefits

3. The Ambiguity of Expected Cost of Disclosure
3.1. Litigation Costs: Dependence on Disclosure Horizon and Tone
3.1.1. Theoretical Predictions: Preemption Effect versus Chilling Effect
3.1.2. Preemption Effect: Reduction of Litigation Costs through Increased Disclosure
3.1.3. Chilling Effect: Rise of Litigation Costs through Increased Disclosure
3.2. Proprietary Costs: Dependence on the Nature of Competition
3.2.1. Limitations of Studies Utilizing Industry Concentration-based Measures
3.2.2. Linking the Nature of Competition to Proprietary Costs
3.2.2.1. Competition from Market Incumbents versus Competition from New Entrants
3.2.2.2. Difficulties Identifying the Nature of Competition
3.2.2.3. Establishing a Link between the Nature of Competition and Proprietary Costs
3.2.3. Additional Forces Impeding a Distinct Link between Disclosure and Proprietary Costs

4. Conclusion

References

Statutory Declaration (in German Language)

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

A series of financial crises and corporate scandals gave rise to increasing concerns about prevailing models of corporate governance and disclosure and stimulated financial disclosure and reporting regulation (Leuz and Wysocki 2016). As a result, there has been considerably more interest in documenting the benefits of increased disclosure than its costs. Accordingly, numerous papers purport to provide evidence of capital market benefits through incremental disclosure (Christensen, de la Rosa and Feltham 2010; Lang and Sul 2014).

At the same time, firms refrain from voluntarily committing to increased disclosure, implying that there must be a trade-off between associated benefits and costs (Christensen 2012). Consequently, critics contend that the capital market benefits are inconclusive. Instead, increased disclosure may result in adverse capital market effects through increasing information asymmetry (e.g., Kim and Verrecchia 1994). Moreover, critics predict that increased disclosure imposes further costs on the firm (e.g., Leuz and Verrecchia 2016).

The purpose of this seminar thesis is to review existing literature on these expected costs of increased disclosure. Thereby, I focus on controversies regarding the heavily debated capital market effects as well as on specific forces that determine proprietary and litigation costs associated with increased disclosure.¹ While a firm's disclosure choices likely are a joint outcome of market forces and incentives provided by regulation (Leuz and Wysocki 2016), the seminar thesis is limited to voluntary disclosure choices as a starting point for possible disclosure regulation.

The remainder of the seminar thesis is structured as follows. Section 2 reviews the literature on the capital market effects of voluntary disclosure through its impact on information asymmetry. Section 3 discusses the ambiguous impact of voluntary disclosure on litigation and proprietary costs. Section 4 concludes the seminar thesis.

2. The Capital Market Effects of Increased Disclosure

2.1. Ambiguous Predictions about the Capital Market Effects: Information Asymmetry as Link between Public Disclosure and Capital Market Outcomes

2.1.1. The Effect of Increased Disclosure on Information Asymmetry: A Complementary versus Substitutive Relationship between Private and Public Information

If one or more investors possess private information about a firm's value while other uninformed investors only have access to public information, information asymmetry arises (Brown and Hillegeist 2007). A great portion of studies assume that increased disclosure leads to a decline in information asymmetry through the dissemination of public information (e.g., Diamond and Verrecchia 1991; Leuz and Verrecchia 2000; Botosan and Harris 2000; Zhang 2001). However, Bushman et al. (1997) argue that the impact of disclosure on information asymmetries in capital markets depends on the relationship between public and private information. A complement relationship implies that private information is created by analysts through the examination of public information. Therefore, increasing disclosure of public information, such as earnings announcements, leads to more private information acquisition and, hence, to greater information asymmetry. If public and private information, on the other hand, are seen as substitutes, more public information leads to less private information gathering and, therefore, less information asymmetry (Bushman et al. 1997). Kim and Verrecchia (1994) support the complement relationship and contend that public disclosure can lead to more information asymmetry at the time of the announcement if the ability of individual traders to evaluate the information is superior to the judgment of other traders.

2.1.2. The Effect of Information Asymmetry on Capital Market Outcomes

Leuz and Verrecchia (2000) argue that information asymmetries cause costs by introducing adverse selection into stock transactions. Accordingly, the majority of analytical studies predict that decreasing information asymmetry reduces the cost of capital of a firm. Specifically, reduced information asymmetry increases the demand of previously less-informed investors and thereby increases stock liquidity. Increased stock liquidity, in turn, attracts investors with higher future cash flow needs. Finally, this process reduces the cost of capital of the firm (e.g., Glosten and Milgrom 1985; Diamond and Verrecchia 1991; Baiman and Verrecchia 1996). Consistent with that idea, Easley and O'Hara (2004) argue that investors demand a higher return with increasing private information acquisition. Moreover, by reducing the uncertainly about the firm's future cash flows, public disclosure reduces the firm's risk premium and, hence, its cost of capital (Christensen, de la Rosa, and Feltham 2010).

On the other hand, Diamond and Verrecchia (1991) contend that there are situations in which decreasing information asymmetry has a detrimental effect on a firm's cost of capital because it results in market makers leaving the market due to reduced trading incentives. Accordingly, if the disclosure level is endogenously chosen by the firm, Zhang (2001) predicts that the equilibrium association between the firm's disclosure level and its cost of capital can be either positive or negative and depends on exogenous factors such as earnings volatility, variability of aggregated liquidity shocks, and the cost of private information production. Additionally, Christensen, de la Rosa and Feltham (2012) argue that there is no effect on the ex-ante cost of capital because the ex-post-reduction of the cost of capital is offset by an equal increase preceding the disclosure.

Further, in the case of increased information asymmetry due to increased disclosure, Kim and Verrecchia (1994) predict that an increase of the information asymmetry causes an increase of the bid-ask spread. Nevertheless, they contend that the trading incentives of informed investors may still result in higher trading volume despite the increased bid-ask spread.

2.2. Empirical Evidence on the Capital Market Effects

2.2.1. Reduction of Information Asymmetry through Increased Disclosure

The majority of empirical studies provide evidence of a reduction of information asymmetry through increased disclosure². For example, Brown and Hillegeist (2007) document a negative relation between disclosure quality and information asymmetry³, implying a substitute relationship. Yet, controversially, their findings document a positive association between the quality of quarterly reports and information asymmetry. They conclude that disclosure quality reduces information asymmetry by reducing the probability that investors discover and trade on private information (Brown and Hillegeist 2007). Balakrishnan et al. (2014) exploit the closure of research operations of 43 brokers between 2000 and 2008 as an exogenous shock to information asymmetry in order to investigate the firms' responses. They document that firms react to the loss of public information by providing timelier and more informative earnings guidance. Therefore, Balakrishnan et al. (2014) show that managers anticipate a substitute relationship between public and private information and try to close the information gap by more public information.

Further, Berger and Harm (2003) provide evidence that indicates a reduction of information asymmetry between the firm and market participants through increased disclosure. They investigate how mandated segment disaggregation following the introduction of SFAS 131⁴ affects the expectation of analysts and investors. On the one hand, new segment information is associated with analyst forecasts, suggesting that analysts knew at least some of the new information prior to its disclosure. On the other hand, analyst forecasts errors are significantly reduced after the introduction of SFAS 131, implying that analysts were unaware of a significant share of the new data. Additionally, Berger and Harm (2003) document that market prices did not fully incorporate the newly disclosed information, indicating that not only analysts were unaware of the newly disclosed information, but the aggregate market was as well.

2.2.2. Capital Market Benefits through Voluntary Disclosure

Several empirical studies provide evidence that is suggestive of capital market benefits through increased disclosure.⁵ First, Botosan and Harris (2000) find evidence that multisegmented firms associated with declining share turnover and increasing information asymmetry, measured as analyst consensus, increasingly engage in voluntary disclosure by providing quarterly segment reports. The firms' increasing engagement in voluntary disclosure suggests that managers consider voluntary disclosure as a means to reduce their capital market deficits. Second, empirical studies provide evidence of favorable capital market-related effects through increased disclosure. Healy, Hutton, and Palepu (1999) find that firms in their sample associated with increased disclosure ratings experience increases in stock returns and reduced bid-ask spreads. However, Leuz and Verrecchia (2004) note that ratings only reflect analysts' perceptions of voluntary disclosure. Further, Leuz and Verrecchia (2000) provide evidence that German firms that commit themselves to increased levels of disclosure through the voluntary adoption of an international reporting regime (i.e., IAS or U.S. GAAP) experience lower bid-ask spreads and higher share turnover, but they cannot confirm a reduction in volatility. Third, Verrecchia and Weber (2006) find that firms that reduce their disclosure by requesting the SEC to withhold information from its investors in its material contract filings experience an increase of their stock's bid-ask spread and a decrease of share turnover.

Lastly, studies examining exogenous shocks document positive capital market consequences. Utilizing the Enron scandal in Fall 2001 as an exogenous cost of capital shock, Leuz and Schrand (2009) investigate the firms' disclosure responses to this shock. By reversing the test using an exogenous shock to the firms' cost of capital, Leuz and Schrand (2009) respond to increasing concerns about omitted variables in traditional cross-sectional disclosure studies. They find that firms react to the exogenous rise in cost of capital by increasing their disclosure through the expansion of their annual 10-K filings and provision of additional interim disclosure. Finally, they show that the increased disclosure led to a reduction in the firms' cost of capital.

Additionally, the study of Balakrishnan et al. (2014) documents that incremental disclosure of earnings guidance following the loss of public information increased the firms' stock liquidity⁶ and enhanced their enterprise value, suggesting a reduction of the cost of capital. Consistently, Shroff et al. (2013) find that a quasi-exogenous increase in voluntary disclosure through the relaxation of restrictions on firms' disclosure reduced information asymmetry and the cost of raising equity capital.⁷

2.2.3. Conflicting Evidence and Reservations about Empirical Studies Implying Capital Market Benefits

While the aforementioned studies provide evidence of positive capital market consequences, Botosan and Plumlee (2002) find mixed evidence on the impact of voluntary disclosure on the firms' cost of capital⁸. Although the firms' costs of capital are negatively associated with the disclosure level of annual reports, they are positively associated with the disclosure level of quarterly reports and unrelated to investors relations' activities (Botosan and Plumlee 2002). This latter finding is reminiscent of the positive association between quarterly report disclosure quality and information asymmetry documented in Brown and Hillegeist (2007). Additionally, Rogers, Skinner and Van Buskirk (2009) document that management forecasts conveying negative news are associated with increased stock return volatilities.

Healy and Palepu (2001) attribute mixed evidence to the difficulty of isolating the impact of disclosure. They contend that empirical studies are limited by endogeneity because disclosure ratings are positively associated with the firms' performance. Therefore, capital market benefits may be driven by performance instead of the firms' disclosure. As a result, drawing clear conclusions about the direction of causality is difficult (Healy and Palepu 2001). Accordingly, Francis, Nanda, and Olsson (2008) challenge empirical findings of capital market benefits and investigate the impact of earnings quality on the relationship between voluntary disclosure.⁹ They find that earnings quality and voluntary disclosure complement each other, implying that firms are more likely to voluntarily disclose if the earnings quality is high. Moreover, their results show that a negative association between voluntary disclosure and the firms' cost of capital significantly decreases or disappears once the research design is conditioned on the firms' earnings quality.

Finally, Leuz and Wysocki (2016) conclude in their review of empirical studies, that empirical findings on the cost of capital suffer from a selection problem resulting in difficulties separating the attributes of disclosure from the firms' underlying economics. Hence, it is possible that these studies do not capture the disclosure quality but the differences in firms' operating and economic risks (Leuz and Wysocki 2016). However, they state that empirical studies exploiting exogenous shocks (i.e., Balakrishnan et al. 2014, Leuz and Schrand 2009, Shroff et al. 2013) are a step forward to strengthen the evidence of a causal link.

3. The Ambiguity of Expected Cost of Disclosure

3.1. Litigation Costs: Dependence on Disclosure Horizon and Tone

3.1.1. Theoretical Predictions: Preemption Effect versus Chilling Effect

After a significant drop of a firm's stock price, its managers face a litigation thread if investors argue that they failed to disclose relevant information faithfully and timely (e.g., Lowry 2009). Therefore, on the one hand, pre-emptive voluntary disclosure weakens the claim that the firm did not disclose adverse information on time, thereby reducing the contingent loss of a lawsuit. The reduction of the plaintiffs potential financial gain, in turn, reduces the incentive to file a lawsuit. Consequently, the firm can reduce the likelihood of class action lawsuits. By reducing the firm's litigation cost, voluntary disclosure can also diminish the extent of its shares' price drop following the release of unfavorable information. This effect is referred to as the preemption effect (Field, Lowry, and Shu 2005). The chilling effect, on the other hand, refers to the effect of litigation costs that reduces managers' incentives to voluntarily disclose forward-looking and optimistic information given the possibility that the firm does not meet the forecasts (Huang, Hui, and Li 2019).

A survey among managers confirms that managers consider bad-news disclosure very differently from good-news disclosure. While 46 percent of the managers agree that they limit the disclosure to avoid lawsuits, 77 percent state that they disclose bad news earlier than good news to reduce litigation risk (Graham, Harvey, and Rajgopal 2005).

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¹ The seminar thesis does not cover research on direct costs of disclosure such as preparation and certification (Leuz and Verrecchia 2016), agency costs (e.g., Baiman and Verrecchia 1996), or detrimental effects on firm and industry innovation (Almazan, Suarez, and Titman 2009).

² For further examples see Bowen, David and Matsumoto (2002), Brown and Hillegeist (2004) or Welker (1995).

³ The probability of informed trade (PIN), a measure based on the imbalance between buy and sell orders among investors, serves as the proxy of their study. Analysts' evaluation of the firms' disclosure activities compiled by the Association for Investment Management and Research (AUVTR) is used as proxy for disclosure quality (Brown and Hillegeist 2007).

⁴ SFAS 131 follows the analysts' demand that financial statement data must be disaggregated to a much greater degree. SFAS 131 requires that disaggregated information must be presented based on the management's internal business unit performance evaluation (Berger and Harm 2003).

⁵ This study does not cover cost of capital effects through factors unrelated to information asymmetry. For studies revealing a diversification/conglomerate discount following public disclosure, see Lang and Stulz (1994), Berger and Ofek (1995), and Berger and Harm (2003).

⁶ Illiquidity was estimated using Amihud's (2002) illiquidity measure.

⁷ In 2005, the SEC introduced the Securities Offering Reform, which relaxes restrictions on firms' disclosure prior to equity offerings (Shroff et al. 2013). Bid-ask spreads, market depths and forecasting accuracy are used as proxy for information asymmetry. The costs of raising equity capital are measured by examining SEO announcement returns.

⁸ While the AIMR score serves as proxy for a firm's disclosure level, Botosan and Plumee (2002) estimate the cost of capital using the classic dividend discount model.

⁹ Voluntary disclosure is proxied by a self-constructed index of coded items from the firms' annual reports and 10-K filings.