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Accounting Information, Disclosure, and the Cost of Capital

Richard Lambert* The Wharton School University of Pennsylvania Christian Leuz The Wharton School University of Pennsylvania Robert E. Verrecchia The Wharton School University of Pennsylvania

September 2005 Revised, March 2006 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. JEL classification: Key Words: G12, G14, G31, M41

Cost of capital, Disclosure, Information risk, Asset pricing

*Corresponding Author. We thank the seminar participants at Ohio State University and an anonymous referee for their helpful comments.

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Introduction The link between accounting information and the cost of capital of firms is one of the

most fundamental issues in accounting. Standard setters frequently refer to it. For example, Arthur Levitt (1998), the former chairman of the Securities and Exchange Commission, suggests that “high quality accounting standards […] reduce capital costs.” Similarly, Neel Foster (2003), a former member of the Financial Accounting Standards