Accounting Information, Disclosure, and the Cost of Capital

TLDR

The study investigates how accounting information influences a firm's cost of capital amid diversification pressures. A CAPM‑consistent model incorporating multiple correlated securities is developed. Higher quality accounting disclosures lower the cost of capital directly by reducing perceived covariances and can also affect it indirectly through firm decisions, with conditions identified under which improved information unambiguously reduces the cost of capital.

Abstract

In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the CAPM and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures reduce the firm's assessed covariances with other firms' cash flows, which is non-diversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline the cost of capital.