A Re-Examination of the Cost of Capital Benefits from Higher Quality Disclosures

Prior research suggests a negative relation between disclosure and costs of capital, but Francis, Nanda, and Olsson (2008; hereafter, FNO) find the relation weakens considerably or disappears after controlling for earnings quality. Their results suggest that prior research may incorrectly attribute the capital market benefits of earnings quality to disclosure quality. FNO utilize a self-constructed disclosure measure similar to Botosan (1997), while considerable cost of capital research relies on AIMR disclosure ratings. We posit that AIMR ratings can capture elements of disclosure quality that affect capital costs even in the presence of earnings quality. We introduce earnings quality into the designs of three prominent studies documenting capital market benefits from higher AIMR-rated disclosures. We find that inferences from prior research suggesting that better disclosure quality is associated with lower costs of equity, bid-ask spreads, and costs of debt are robust to conditioning on earnings quality. Further, the economic significance of disclosure quality and earnings quality for costs of capital are roughly equivalent. Additional analyses using non-AIMR disclosure measures suggest that differences between the AIMR ratings and the FNO disclosure measure, rather than differences in sample period, likely explain the disparity in our and FNO's results. We conclude earnings quality does not subsume disclosure quality in explaining costs of capital