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Disclosure and the cost of capital: A discussion
Journal of Accounting and Economics 26 (1999) 271—283
Disclosure and the cost of capital: A discussion Robert E. Verrecchia* The Wharton School, University of Pennsylvania, 2400 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6365, USA Received 1 November 1998
Abstract In this discussion I comment on the contribution of two papers toward our understanding of how disclosure affects the cost of capital. Specifically, in the context of these papers, I comment on whether disclosure ameliorates or exacerbates the cost of capital that arises from the existence of information asymmetries in capital markets. This is a notion that should be of fundamental interest in that it provides an economic basis for evaluating the costs and benefits of accounting information. 1999 Elsevier Science B.V. All rights reserved. JEL classification: D8; M4 Keywords: Capital markets; Disclosure; Cost of capital
1. Introduction In this paper I discuss two related papers, ‘International Accounting Harmonization and Global Equity Markets’, by Mary E. Barth, Greg Clinch, and Toshi Shibano (henceforth BCS), and ‘Disclosure Requirements and Stock Exchange Listing Choice in an International Context’, by Steven Huddart, John S. Hughes, and Markus Brunnermeier (henceforth HHB). The challenge of discussing multiple papers is to offer a way to think about them, as well as similar-type studies, in the context of a single economic construct or idea. Consequently, before introducing BCS and HHB, I digress briefly into a * Corresponding author. Tel.: #1 215 898 6976; fax: #1 215 573 2054; e-mail: verrecchia @wharton.upenn.edu 0165-4101/99/$ — see front matter 1999 Elsevier Science B.V. All rights reserved PII: S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 4 1 - X
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discussion of the economic idea that unifies both papers, namely, the relation between disclosure and the cost of capital. Then I offer comments on each paper, attempting in each case to fit the paper into my construct. This approach does considerable disservice to both papers in two ways. First, it requires that one reduce each paper to only those elements that fit neatly into the construct, and ignore other features that contribute to a paper’s texture and complexity. Second, it forces both analyses through the disclosure-and-cost-of-capital prism, and this inevitably distorts each paper’s overall contribution. The advantage of my approach, however, is that it assists a reader in making sense of a literature that, of necessity, involves complex analyses. The economic idea that unifies both papers is the relation between public disclosure and the cost of capital — specifically, whether public disclosure reduces or increases the cost of capital. This is a notion that should be of fundamental interest to accounting researchers in that it provides an economic basis for evaluating the costs and benefits of accounting information. The conventional wisdom is that more public disclosure reduces the cost of capital. However, there may be important reasons why this relation does not hold. This provides the rationale for this research. To understand better the relation between disclosure and the cost of capital, let me suggest an ‘economic time line’ that endogenizes many of the important elements of this relation. The economic time line is illustrated in Fig. 1, and is motivated by the discussion in Baiman and Verrecchia (1996). To begin, imagine that there exists an entrepreneur who has sole ownership over some production process, which I refer to as ‘the firm’. To implement the production process, the entrepreneur must acquire $K of capital and hire a manager. The percentage of the firm sold to outside interests to achieve a fixed amount of capital $K represents the firm’s cost of capital to the entrepreneur. At time 1 the entrepreneur commits to a level of financial disclosure anticipating all subsequent events. Interpretations of an entrepreneur’s commitment to a level of disclosure include: a commitment to a level of disclosure that achieves a particular quality of earnings under the auspices of a broad set of choices as allowed under generally accepted accounting principles (GAAP); a commitment to a level of voluntary disclosure that is above and beyond the mandated level; or a commitment to list on a particular market or exchange, where different markets and/or exchanges have different fixed disclosure requirements. The commitment by the entrepreneur to a fixed level of disclosure is the firm’s endogenous disclosure choice. Having committed to a level of disclosure, at time 2 potential equity holders price the value of equity in the firm and the entrepreneur issues that percentage of firm shares that raises $K of capital. As the percentage of the firm that is sold to raise $K of capital increases (decreases), the entrepreneur’s cost of capital increases (decreases). In deciding what percentage of the firm they demand for a fixed amount of capital $K, potential equity holders also anticipate all future
Fig. 1. A time line of potential endogenous elements of the relation between disclosure and the cost of capital.
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events. In particular, they anticipate the possibility that they will receive a liquidity shock that requires them to sell their equity interest, or purchase a greater interest, at some future market price. The decision by potential equity holders as to what percentage of the firm to demand represents the firm’s endogenous cost of capital. The important feature of time 1 and time 2 is that allowing potential equity holders the opportunity to price the firm based on the entrepreneur’s disclosure commitment links disclosure to the cost of capital. In the absence of this link, disclosure cannot affect the cost of capital and vice versa. At time 3 the entrepreneur commences production. Production could be characterized in a variety of ways. However, for purposes of this discussion, I interpret production as the entrepreneur designing a compensation contract and hiring a manager. For example, in the context of contracting, production is represented by the manager expending effort that stochastically affects the firm’s cash flow, and any moral hazard problems attendant with her actions. Incorporating contracting into the discussion has the advantage that it allows us to consider moral hazard generally, and insider trading specifically, which is a central feature of HHB. At time 4 production ceases and the manager exclusively observes firm cash flow. The manager is then obligated to disseminate a public report of this value. The accuracy or faithfulness of the report to actual cash flow must be consistent with the disclosure level to which the entrepreneur originally committed at time 1. At time 5, all market participants are allowed to trade in a market for firm shares. Market participants may include: the manager, who, if she trades, presumably trades on inside information; privately informed traders, who may be either endogenous or exogenous; and uninformed traders, who bear the sobriquet ‘uninformed’ because their demand orders are independent of the public or private information about firm cash flow. The manager’s participation in trading can be made endogenous by allowing the entrepreneur to anticipate this action, and thereby treating it as a contracting problem (at time 3). Privately informed traders’ participation can be made endogenous by assuming that they only acquire their private information at some cost. Uninformed traders’ can be made endogenous by assuming that they can choose those firms or exchanges where their liquidity motivated trades are executed. However, to make disclosure commitments at time 1 affect the firm’s cost of capital, it is necessary to assume that there is some positive probability that uninformed traders include some original firm shareholders: that is, some traders who acquired their equity in the firm at time 2. At time 6 all trades are executed at a market equilibrium price of some sort. Finally, at time 7, the firm liquidates, contracts are settled, and all parties consume their asset holdings.
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This economic construct treats as endogenous a number of elements: (i) the entrepreneur’s choice of a level of disclosure (at time 1); (ii) the cost of capital (at time 2); (iii) firm production/contracting (at time 3); and trading and equilibrium market pricing (at times 5 and 6). Most importantly, it links disclosure and the cost of capital through the behavior of the entrepreneur and potential equity holders at times 1 and 2. In an economic model in which most of the major elements are assumed to be endogenous, and there are no obvious frictions, transaction costs, or other discontinuities, the conventional wisdom is that more disclosure results in more liquid markets at time 5. Consequently, a commitment to greater disclosure at time 1 should lead to a lower cost of capital at time 2. This, in turn, implies that the entrepreneur chooses the corner solution of full disclosure at time 1, so as to achieve the lowest cost of capital. Because a positive relation between disclosure and the cost of capital is compelling, the interesting research question is the following. Is it ever the case that the corner solution of full disclosure does not hold in equilibrium? In other words, are there pathologies to more disclosure that advocates of this policy need to be aware of in determining appropriate disclosure standards? With regard to evaluating the contribution of individual papers, the compelling nature of the corner as an equilibrium solution (i.e., full disclosure) suggests the following. If a paper demonstrates that the corner solution of full disclosure holds, then while its underlying economic message is sound, the result itself suffers from the fact that it is not very provocative. If, alternatively, a paper demonstrates that an entrepreneur does not choose full disclosure in equilibrium (i.e., an interior solution holds), the question then is whether the underlying economic force that achieves that result is likely to be descriptive and produce descriptive implications. For example, proprietary costs seem to offer a very compelling economic rationale for why a firm would not fully disclose, and are also descriptive of how decisions are made to disclose or withhold information in real market settings. Alternatively, arriving at a less-than-full-disclosure equilibrium by assuming that the firm only exists as a vehicle for owners/ managers to earn insider trading profits (which is the idea underlying HHB) seems less credible given the implications of this assumption on the cost of raising capital in equity markets. In the course of reviewing BCS and HHB, I revisit this issue.
For example, to allude briefly to other papers in this literature, in Bushman et al. (1996) the corner solution of full disclosure results. In Diamond and Verrecchia (1991) an interior solution results because original firm equity holders are uncertain as to whether they will be informed or uninformed traders in the future. In Baiman and Verrecchia (1996) an interior solution results because more disclosure makes price-based compensation less efficient, thereby increasing agency problems.
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2. International accounting harmonization and global equity markets Using the above economic construct as a backdrop, I now discuss BCS. To begin, it is important to distinguish those elements that BCS treat as endogenous versus those they treat as exogenous, or simply ignore. This is illustrated in Fig. 2. Note that one should not interpret pejoratively the fact that some elements are ignored. It is unrealistic to expect one model to incorporate every nuance and feature represented in Fig. 1. As currently conceived, both BCS and HHB are already very complex models. Briefly reviewing Fig. 2, BCS ignore the production process, contracting issues, and issues related to insider trading. Alternatively, as is common throughout this literature, BCS implicitly regard the disclosure choice, and explicitly treat the price at which firm shares are traded, as endogenous. Significantly, BCS also treat as endogenous private information acquisition. They do this by considering the proportion of informed traders who migrate to trade on the exchange where the firm is listed, where the cost of becoming informed is a function of a trader’s familiarity with the disclosure requirements on that exchange. Finally, BCS attempt to address cost-of-capital concerns: in effect, to treat the cost of capital as endogenous. This turns out, however, to be a very complex task (see, for example, the discussion in Section 5.3 of their paper). The fundamental point of BCS is that if one increases public disclosure, and increased public disclosure has the collateral effect of making private information acquisition less costly, then more disclosure can make markets more or less liquid. More (less) liquidity, in turn, implies a lower (higher) cost of capital. The reason for this result is clear. The direct effect of more disclosure is that generally it makes markets more liquid. However, when acquiring private information is costly, the proportion of informed investors is endogenous. If a collateral effect of public disclosure is to make private information acquisition cheaper, then it is conceivable that more disclosure results in more private information acquisition, which, in turn, may result in less liquid markets. In other words, the contribution of BCS is to suggest that one possible reason for an interior disclosure choice in the presence of cost-of-capital considerations is that the benefit of more public disclosure must be weighed against the cost of cheaper private information acquisition. Consider the descriptive power of this rationale for less than full disclosure. Supplying complex and highly detailed information, like the information required in the recent FASB Statement No. 133 on accounting for derivative instruments and hedging activities, could have the unintended effect of temporarily subsidizing those investors who are already better informed than the market as a whole (e.g., investors familiar with derivative instruments), while offering no benefit to the ‘average’ investor, who might find this information unfathomable. Over time, however, one would expect this subsidy to be bid
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Fig. 2. A representation of key elements of Barth et al. (1998).
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away as investors have a financial incentive to become more familiar with derivative transactions. In other words, this unintended subsidy may not offer a compelling rationale for less than full disclosure over an extended period. In reading BCS, two possible areas of future work come to mind. First, the model of rational trade employed in BCS is one of perfect competition. In Section 5.3, BCS suggest a clever adaptation of their perfect competition model to discuss cost-of-capital concerns. Any adaptation, however, is awkward in that perfect competition implies perfectly liquid markets, and perfect liquidity implies that there is no cost of capital arising from information asymmetries between well-informed and less well-informed market participants. Consequently, it would be interesting to reinterpret the results of BCS in a model of rational trade in which there is an explicit cost of capital that arises from the existence of information asymmetries. Here, it may be useful to read the discussion in Verrecchia (1996). Note that in their analysis, BCS discuss in detail various measures of price efficiency, and in general price efficiency is a useful proxy for liquidity and/or the cost of capital. The reason for this is that as price efficiency increases, more information is transmitted from the informed to the uninformed. Price efficiency is not, however, a perfect proxy. To appreciate this, note that as public disclosure increases, ceteris paribus prices become more efficient and markets become more liquid. In other words, in discussing exclusively public disclosure, price efficiency and liquidity are reliably linked: that is, they move in the same direction. However, as private information increases, ceteris paribus prices become more efficient but markets become less liquid. In effect, more private information means that prices transmit more information about a firm’s true economic value, but more private information also means that markets are less liquid. In other words, in discussing exclusively private information, price efficiency and market liquidity are less reliably linked: they move in opposite directions. In short, an interesting extension of BCS would be to reinterpret their results in the context of a model in which the cost-of-capital is incorporated explicitly, and perhaps with greater facility. Second, I am curious as to whether the result that more disclosure makes markets less liquid is robust under different characterizations of the cost of becoming an expert in another country’s GAAP. For example, in a model where all functional forms are continuous (in particular, functional forms involving private information acquisition costs), my intuition suggests that the indirect, negative effect of more public disclosure on cost-of-capital is always dominated by the primary, positive effect (in equilibrium). That is, I would expect more
For example, the cost function in BCS is not continuous in that it includes a positive, fixed cost f . G
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disclosure to result in a lower cost of capital despite the fact that it makes private information acquisition cheaper. This having been said, there is no doubt that discontinuous, private information acquisition cost functions of the type employed in BCS result in situations where the indirect effect of more public disclosure overwhelms the primary effect. To put these possible extensions in perspective, none of them is likely to change the basic intuition underlying BCS. More harmonization can have a negative effect on cost-of-capital considerations if it makes costly private information acquisition cheaper. This is a useful insight for policy makers in general, and advocates of greater harmonization in particular.
3. Disclosure requirements and stock exchange listing choice in an international context I now turn to HHB. How the analysis in HHB fits into my economic construct is illustrated in Fig. 3. As one would expect in a paper about disclosure choice, HHB treat as endogenous a firm’s choice of disclosure requirements by allowing firms to list on different exchanges. (For texture these exchanges are assumed to represent the different disclosure requirements of different countries). In addition, as in BCS and throughout this literature, HHB treat as endogenous the price at which firm shares are traded. The controversial feature of HHB is that it treats the firm production process/contracting as exogenous, and only partially endogenizes the cost of capital. This is problematic in that HHB also assume that the raison d’eL tre of the firm is to provide the entrepreneur and/or manager with insider trading profits. To the extent to which an entrepreneur engages in insider trading, when the cost of capital is not fully endogenous, an entrepreneur’s choice of disclosure requirements is motivated primarily by his ability to generate insider trading profits. Similarly, to the extent to which managers engage in insider trading, when firm contracting is treated as exogenous there is an unresolved moral hazard problem that cannot be addressed in the context of the model. I return to these issues later. The key insight in HHB is that if an exchange has sufficient liquidity (for whatever reason), firm insiders will choose to list on that exchange even though disclosure standards are high and firm insiders’ sole objective is to maximize profits that arise from trading on their inside information. In effect, greater liquidity implies that prices are less sensitive to insiders’ trades. If the reduction in sensitivity is sufficiently high, it offsets higher disclosure standards, thereby leading to greater insider trading profits despite higher standards. This allows HHB to promulgate the potentially provocative thesis that disclosure requirements lead to a ‘race to the top’. That is, even in the absence of regulation,
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Fig. 3. A representation of key elements of Huddart et al. (1998).
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firm incentives will result in firms gravitating toward the highest disclosure standards. As in BCS, the basic intuition underlying HHB is not controversial; in fact, it is immediate. Nor, for that matter, should a ‘race-to-the-top’ be all that surprising in general terms. As discussed previously, when the cost of capital is endogenous, there is a natural gravitation toward the highest disclosure standards. The notion that firms or exchanges choose the corner solution of full disclosure to reduce the cost of capital is a cornerstone of research in this area. What is unusual about HHB is how they arrive at that insight. The assumption in HHB is that an entrepreneur and/or managers are motivated solely by a desire to earn insider-trading profits. By ignoring contracting and only partially endogenizing the cost of capital, the presumption is that an entrepreneur will choose the lowest disclosure standards. In this context, a ‘race to the top’ may seem provocative. But it is only provocative because HHB fail to endogenize fully key elements of the problem. Consider specifically the cost of capital. HHB attempt to endogenize the cost of capital by allowing uninformed traders to choose exchanges where they trade. As these traders are uninformed, uninformed traders choose exchanges where they can execute liquidity shocks at the smallest liquidity premium. If a sufficient number of uninformed traders choose a high disclosure exchange, their number may create sufficient market depth to attract firms whose sole motivation is to earn insider-trading profits for their entrepreneurs and managers. The reason for this is that with regard to maximizing insider-trading profits, the benefit of greater market depth outweighs the cost of more disclosure. Fair enough. One should not, however, mistake the notion of letting uninformed traders choose an exchange with endogenizing fully the cost of capital. Through the requirement captured in equation (3) of their model, HHB require that firm equity be held by someone, regardless of the obvious agency problem that results from insider trading. In other words, regardless of their disdain for the behavior of firm insiders, uninformed traders must participate as equity holders. The requirement that they hold firm shares implies that they earn negative expected returns in the model, regardless of which firms’ shares they hold and/or which exchanges they use. If, alternatively, liquidity traders could earn a zero return holding risk-free bonds, why would they ever participate in
To digress briefly, anecdotal evidence supports this notion. One observation consistent with that is that German accounting standards are widely regarded as less transparent than US GAAP. Despite this, German firms lobbied the Securities and Exchange Commission (SEC) to allow exclusively German financial statements when firms applied for listing on the New York Stock Exchange (NYSE). The SEC held firm, and ultimately Daimler—Benz broke ranks by restating its results under US GAAP and listing itself on the NYSE. In other words, Daimler—Benz chose higher disclosure standards in return for access to markets with more liquidity, i.e., market depth overcame higher disclosure requirements.
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these markets (except for the fact that equation (3) requires them to do so)? In other words, in an economy in which the cost of capital is fully endogenous, we would expect firms to ‘race-to-the-top’; otherwise they may be denied access to capital. Furthermore, even in the event that less than full disclosure results in the HHB analysis, consider the descriptive power of its underlying economic force. It arises from the fact that the entrepreneur and managers are concerned exclusively with earning insider trading profits, and ignore completely cost-ofcapital considerations. This does not strike me as descriptive of the behavior of entrepreneurs and managers in real markets settings. At the risk of appearing uncharitable, it is difficult to understand the contribution of HHB. If the intention of HHB was to consider the relation among disclosure, insider trading, and the cost of capital, this was done previously in Baiman and Verrecchia (1996). If the intention was to consider the role of liquidity, then HHB should have endogenized fully the cost of capital by allowing potential equity holders the opportunity to resolve any potential moral hazard problems with the entrepreneur at a time 2, or the entrepreneur with the manager at time 3 (see Fig. 1). For all the controversial features of HHB, it is somewhat ironic that the paper largely confirms the notion that firms will select the corner solution of full disclosure.
4. Conclusion In the absence of compelling reasons to the contrary, the conventional wisdom is that more disclosure results in more liquid markets. Consequently, an initial commitment by a firm to the greatest disclosure should lead to the lowest cost of capital. This implies that in a model of disclosure choice that is governed by cost-of-capital considerations, one expects the corner solution of full disclosure to be chosen so as to achieve the lowest cost of capital. Broadly stated, the insight underlying BCS is that if the effect of public disclosure is to make private information acquisition cheaper, then it is conceivable that more disclosure results in more private information acquisition. This, in turn, may result in less liquid markets. Therefore, greater harmonization of accounting standards may have the unintended effect of making markets less liquid. Alternatively, one could suggest that HHB’s insight is that the choice of the corner solution of full disclosure is robust even in the absence of cost-ofcapital considerations. That is, full disclosure may result even in the presence of an entrepreneur/managers of the firm who exploit shareholders through unrestricted insider trading, because it is likely to achieve the greatest market depth. It is true that in adverse-selection trading models, uninformed traders generically earn negative expected returns. But the role of uninformed traders in these models is simply to proxy for noise.
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In fairness to BCS and HHB, it should be emphasized that this discussion is not a traditional summary or review of each paper’s analysis and contribution. Rather, it is an attempt to codify what we know about disclosure choice and the cost of capital using their work as salient points of reference. While this may have some unsatisfying aspects, hopefully it offers a general understanding of the role of these papers in the literature, and points out interesting avenues for future work on this topic.
References Baiman, S., Verrecchia, R.E., 1996. The relation among capital markets, financial disclosure, production efficiency, and insider trading. Journal of Accounting Research 34, 1—22. Barth, M.E., Clinch, G., Shibano, T., 1998. International accounting harmonization and global equity markets. Journal of Accounting and Economics, this issue. Bushman, R.M., Gigler, F., Indjejikian, R., 1996. A model of two-tiered financial reporting. Journal of Accounting Research 34 (Supplement), 51—74. Diamond, D.W., Verrecchia, R.E., 1991. Disclosure, liquidity, and the cost of capital. Journal of Finance 46 (4), 1325—1359. Huddart, S., Hughes, J.S., Brunnermeier, M., 1998. Disclosure requirements and stock exchange listing choice in an international context. Journal of Accounting and Economics, this issue. Verrecchia, R.E., 1996. Discussion of a model of two-tiered financial reporting. Journal of Accounting Research 34 (Supplement), 75—82.
Disclosure and the cost of capital: A discussion Robert E. Verrecchia* The Wharton School, University of Pennsylvania, 2400 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6365, USA Received 1 November 1998
Abstract In this discussion I comment on the contribution of two papers toward our understanding of how disclosure affects the cost of capital. Specifically, in the context of these papers, I comment on whether disclosure ameliorates or exacerbates the cost of capital that arises from the existence of information asymmetries in capital markets. This is a notion that should be of fundamental interest in that it provides an economic basis for evaluating the costs and benefits of accounting information. 1999 Elsevier Science B.V. All rights reserved. JEL classification: D8; M4 Keywords: Capital markets; Disclosure; Cost of capital
1. Introduction In this paper I discuss two related papers, ‘International Accounting Harmonization and Global Equity Markets’, by Mary E. Barth, Greg Clinch, and Toshi Shibano (henceforth BCS), and ‘Disclosure Requirements and Stock Exchange Listing Choice in an International Context’, by Steven Huddart, John S. Hughes, and Markus Brunnermeier (henceforth HHB). The challenge of discussing multiple papers is to offer a way to think about them, as well as similar-type studies, in the context of a single economic construct or idea. Consequently, before introducing BCS and HHB, I digress briefly into a * Corresponding author. Tel.: #1 215 898 6976; fax: #1 215 573 2054; e-mail: verrecchia @wharton.upenn.edu 0165-4101/99/$ — see front matter 1999 Elsevier Science B.V. All rights reserved PII: S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 4 1 - X
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discussion of the economic idea that unifies both papers, namely, the relation between disclosure and the cost of capital. Then I offer comments on each paper, attempting in each case to fit the paper into my construct. This approach does considerable disservice to both papers in two ways. First, it requires that one reduce each paper to only those elements that fit neatly into the construct, and ignore other features that contribute to a paper’s texture and complexity. Second, it forces both analyses through the disclosure-and-cost-of-capital prism, and this inevitably distorts each paper’s overall contribution. The advantage of my approach, however, is that it assists a reader in making sense of a literature that, of necessity, involves complex analyses. The economic idea that unifies both papers is the relation between public disclosure and the cost of capital — specifically, whether public disclosure reduces or increases the cost of capital. This is a notion that should be of fundamental interest to accounting researchers in that it provides an economic basis for evaluating the costs and benefits of accounting information. The conventional wisdom is that more public disclosure reduces the cost of capital. However, there may be important reasons why this relation does not hold. This provides the rationale for this research. To understand better the relation between disclosure and the cost of capital, let me suggest an ‘economic time line’ that endogenizes many of the important elements of this relation. The economic time line is illustrated in Fig. 1, and is motivated by the discussion in Baiman and Verrecchia (1996). To begin, imagine that there exists an entrepreneur who has sole ownership over some production process, which I refer to as ‘the firm’. To implement the production process, the entrepreneur must acquire $K of capital and hire a manager. The percentage of the firm sold to outside interests to achieve a fixed amount of capital $K represents the firm’s cost of capital to the entrepreneur. At time 1 the entrepreneur commits to a level of financial disclosure anticipating all subsequent events. Interpretations of an entrepreneur’s commitment to a level of disclosure include: a commitment to a level of disclosure that achieves a particular quality of earnings under the auspices of a broad set of choices as allowed under generally accepted accounting principles (GAAP); a commitment to a level of voluntary disclosure that is above and beyond the mandated level; or a commitment to list on a particular market or exchange, where different markets and/or exchanges have different fixed disclosure requirements. The commitment by the entrepreneur to a fixed level of disclosure is the firm’s endogenous disclosure choice. Having committed to a level of disclosure, at time 2 potential equity holders price the value of equity in the firm and the entrepreneur issues that percentage of firm shares that raises $K of capital. As the percentage of the firm that is sold to raise $K of capital increases (decreases), the entrepreneur’s cost of capital increases (decreases). In deciding what percentage of the firm they demand for a fixed amount of capital $K, potential equity holders also anticipate all future
Fig. 1. A time line of potential endogenous elements of the relation between disclosure and the cost of capital.
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events. In particular, they anticipate the possibility that they will receive a liquidity shock that requires them to sell their equity interest, or purchase a greater interest, at some future market price. The decision by potential equity holders as to what percentage of the firm to demand represents the firm’s endogenous cost of capital. The important feature of time 1 and time 2 is that allowing potential equity holders the opportunity to price the firm based on the entrepreneur’s disclosure commitment links disclosure to the cost of capital. In the absence of this link, disclosure cannot affect the cost of capital and vice versa. At time 3 the entrepreneur commences production. Production could be characterized in a variety of ways. However, for purposes of this discussion, I interpret production as the entrepreneur designing a compensation contract and hiring a manager. For example, in the context of contracting, production is represented by the manager expending effort that stochastically affects the firm’s cash flow, and any moral hazard problems attendant with her actions. Incorporating contracting into the discussion has the advantage that it allows us to consider moral hazard generally, and insider trading specifically, which is a central feature of HHB. At time 4 production ceases and the manager exclusively observes firm cash flow. The manager is then obligated to disseminate a public report of this value. The accuracy or faithfulness of the report to actual cash flow must be consistent with the disclosure level to which the entrepreneur originally committed at time 1. At time 5, all market participants are allowed to trade in a market for firm shares. Market participants may include: the manager, who, if she trades, presumably trades on inside information; privately informed traders, who may be either endogenous or exogenous; and uninformed traders, who bear the sobriquet ‘uninformed’ because their demand orders are independent of the public or private information about firm cash flow. The manager’s participation in trading can be made endogenous by allowing the entrepreneur to anticipate this action, and thereby treating it as a contracting problem (at time 3). Privately informed traders’ participation can be made endogenous by assuming that they only acquire their private information at some cost. Uninformed traders’ can be made endogenous by assuming that they can choose those firms or exchanges where their liquidity motivated trades are executed. However, to make disclosure commitments at time 1 affect the firm’s cost of capital, it is necessary to assume that there is some positive probability that uninformed traders include some original firm shareholders: that is, some traders who acquired their equity in the firm at time 2. At time 6 all trades are executed at a market equilibrium price of some sort. Finally, at time 7, the firm liquidates, contracts are settled, and all parties consume their asset holdings.
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This economic construct treats as endogenous a number of elements: (i) the entrepreneur’s choice of a level of disclosure (at time 1); (ii) the cost of capital (at time 2); (iii) firm production/contracting (at time 3); and trading and equilibrium market pricing (at times 5 and 6). Most importantly, it links disclosure and the cost of capital through the behavior of the entrepreneur and potential equity holders at times 1 and 2. In an economic model in which most of the major elements are assumed to be endogenous, and there are no obvious frictions, transaction costs, or other discontinuities, the conventional wisdom is that more disclosure results in more liquid markets at time 5. Consequently, a commitment to greater disclosure at time 1 should lead to a lower cost of capital at time 2. This, in turn, implies that the entrepreneur chooses the corner solution of full disclosure at time 1, so as to achieve the lowest cost of capital. Because a positive relation between disclosure and the cost of capital is compelling, the interesting research question is the following. Is it ever the case that the corner solution of full disclosure does not hold in equilibrium? In other words, are there pathologies to more disclosure that advocates of this policy need to be aware of in determining appropriate disclosure standards? With regard to evaluating the contribution of individual papers, the compelling nature of the corner as an equilibrium solution (i.e., full disclosure) suggests the following. If a paper demonstrates that the corner solution of full disclosure holds, then while its underlying economic message is sound, the result itself suffers from the fact that it is not very provocative. If, alternatively, a paper demonstrates that an entrepreneur does not choose full disclosure in equilibrium (i.e., an interior solution holds), the question then is whether the underlying economic force that achieves that result is likely to be descriptive and produce descriptive implications. For example, proprietary costs seem to offer a very compelling economic rationale for why a firm would not fully disclose, and are also descriptive of how decisions are made to disclose or withhold information in real market settings. Alternatively, arriving at a less-than-full-disclosure equilibrium by assuming that the firm only exists as a vehicle for owners/ managers to earn insider trading profits (which is the idea underlying HHB) seems less credible given the implications of this assumption on the cost of raising capital in equity markets. In the course of reviewing BCS and HHB, I revisit this issue.
For example, to allude briefly to other papers in this literature, in Bushman et al. (1996) the corner solution of full disclosure results. In Diamond and Verrecchia (1991) an interior solution results because original firm equity holders are uncertain as to whether they will be informed or uninformed traders in the future. In Baiman and Verrecchia (1996) an interior solution results because more disclosure makes price-based compensation less efficient, thereby increasing agency problems.
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2. International accounting harmonization and global equity markets Using the above economic construct as a backdrop, I now discuss BCS. To begin, it is important to distinguish those elements that BCS treat as endogenous versus those they treat as exogenous, or simply ignore. This is illustrated in Fig. 2. Note that one should not interpret pejoratively the fact that some elements are ignored. It is unrealistic to expect one model to incorporate every nuance and feature represented in Fig. 1. As currently conceived, both BCS and HHB are already very complex models. Briefly reviewing Fig. 2, BCS ignore the production process, contracting issues, and issues related to insider trading. Alternatively, as is common throughout this literature, BCS implicitly regard the disclosure choice, and explicitly treat the price at which firm shares are traded, as endogenous. Significantly, BCS also treat as endogenous private information acquisition. They do this by considering the proportion of informed traders who migrate to trade on the exchange where the firm is listed, where the cost of becoming informed is a function of a trader’s familiarity with the disclosure requirements on that exchange. Finally, BCS attempt to address cost-of-capital concerns: in effect, to treat the cost of capital as endogenous. This turns out, however, to be a very complex task (see, for example, the discussion in Section 5.3 of their paper). The fundamental point of BCS is that if one increases public disclosure, and increased public disclosure has the collateral effect of making private information acquisition less costly, then more disclosure can make markets more or less liquid. More (less) liquidity, in turn, implies a lower (higher) cost of capital. The reason for this result is clear. The direct effect of more disclosure is that generally it makes markets more liquid. However, when acquiring private information is costly, the proportion of informed investors is endogenous. If a collateral effect of public disclosure is to make private information acquisition cheaper, then it is conceivable that more disclosure results in more private information acquisition, which, in turn, may result in less liquid markets. In other words, the contribution of BCS is to suggest that one possible reason for an interior disclosure choice in the presence of cost-of-capital considerations is that the benefit of more public disclosure must be weighed against the cost of cheaper private information acquisition. Consider the descriptive power of this rationale for less than full disclosure. Supplying complex and highly detailed information, like the information required in the recent FASB Statement No. 133 on accounting for derivative instruments and hedging activities, could have the unintended effect of temporarily subsidizing those investors who are already better informed than the market as a whole (e.g., investors familiar with derivative instruments), while offering no benefit to the ‘average’ investor, who might find this information unfathomable. Over time, however, one would expect this subsidy to be bid
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Fig. 2. A representation of key elements of Barth et al. (1998).
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away as investors have a financial incentive to become more familiar with derivative transactions. In other words, this unintended subsidy may not offer a compelling rationale for less than full disclosure over an extended period. In reading BCS, two possible areas of future work come to mind. First, the model of rational trade employed in BCS is one of perfect competition. In Section 5.3, BCS suggest a clever adaptation of their perfect competition model to discuss cost-of-capital concerns. Any adaptation, however, is awkward in that perfect competition implies perfectly liquid markets, and perfect liquidity implies that there is no cost of capital arising from information asymmetries between well-informed and less well-informed market participants. Consequently, it would be interesting to reinterpret the results of BCS in a model of rational trade in which there is an explicit cost of capital that arises from the existence of information asymmetries. Here, it may be useful to read the discussion in Verrecchia (1996). Note that in their analysis, BCS discuss in detail various measures of price efficiency, and in general price efficiency is a useful proxy for liquidity and/or the cost of capital. The reason for this is that as price efficiency increases, more information is transmitted from the informed to the uninformed. Price efficiency is not, however, a perfect proxy. To appreciate this, note that as public disclosure increases, ceteris paribus prices become more efficient and markets become more liquid. In other words, in discussing exclusively public disclosure, price efficiency and liquidity are reliably linked: that is, they move in the same direction. However, as private information increases, ceteris paribus prices become more efficient but markets become less liquid. In effect, more private information means that prices transmit more information about a firm’s true economic value, but more private information also means that markets are less liquid. In other words, in discussing exclusively private information, price efficiency and market liquidity are less reliably linked: they move in opposite directions. In short, an interesting extension of BCS would be to reinterpret their results in the context of a model in which the cost-of-capital is incorporated explicitly, and perhaps with greater facility. Second, I am curious as to whether the result that more disclosure makes markets less liquid is robust under different characterizations of the cost of becoming an expert in another country’s GAAP. For example, in a model where all functional forms are continuous (in particular, functional forms involving private information acquisition costs), my intuition suggests that the indirect, negative effect of more public disclosure on cost-of-capital is always dominated by the primary, positive effect (in equilibrium). That is, I would expect more
For example, the cost function in BCS is not continuous in that it includes a positive, fixed cost f . G
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disclosure to result in a lower cost of capital despite the fact that it makes private information acquisition cheaper. This having been said, there is no doubt that discontinuous, private information acquisition cost functions of the type employed in BCS result in situations where the indirect effect of more public disclosure overwhelms the primary effect. To put these possible extensions in perspective, none of them is likely to change the basic intuition underlying BCS. More harmonization can have a negative effect on cost-of-capital considerations if it makes costly private information acquisition cheaper. This is a useful insight for policy makers in general, and advocates of greater harmonization in particular.
3. Disclosure requirements and stock exchange listing choice in an international context I now turn to HHB. How the analysis in HHB fits into my economic construct is illustrated in Fig. 3. As one would expect in a paper about disclosure choice, HHB treat as endogenous a firm’s choice of disclosure requirements by allowing firms to list on different exchanges. (For texture these exchanges are assumed to represent the different disclosure requirements of different countries). In addition, as in BCS and throughout this literature, HHB treat as endogenous the price at which firm shares are traded. The controversial feature of HHB is that it treats the firm production process/contracting as exogenous, and only partially endogenizes the cost of capital. This is problematic in that HHB also assume that the raison d’eL tre of the firm is to provide the entrepreneur and/or manager with insider trading profits. To the extent to which an entrepreneur engages in insider trading, when the cost of capital is not fully endogenous, an entrepreneur’s choice of disclosure requirements is motivated primarily by his ability to generate insider trading profits. Similarly, to the extent to which managers engage in insider trading, when firm contracting is treated as exogenous there is an unresolved moral hazard problem that cannot be addressed in the context of the model. I return to these issues later. The key insight in HHB is that if an exchange has sufficient liquidity (for whatever reason), firm insiders will choose to list on that exchange even though disclosure standards are high and firm insiders’ sole objective is to maximize profits that arise from trading on their inside information. In effect, greater liquidity implies that prices are less sensitive to insiders’ trades. If the reduction in sensitivity is sufficiently high, it offsets higher disclosure standards, thereby leading to greater insider trading profits despite higher standards. This allows HHB to promulgate the potentially provocative thesis that disclosure requirements lead to a ‘race to the top’. That is, even in the absence of regulation,
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Fig. 3. A representation of key elements of Huddart et al. (1998).
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firm incentives will result in firms gravitating toward the highest disclosure standards. As in BCS, the basic intuition underlying HHB is not controversial; in fact, it is immediate. Nor, for that matter, should a ‘race-to-the-top’ be all that surprising in general terms. As discussed previously, when the cost of capital is endogenous, there is a natural gravitation toward the highest disclosure standards. The notion that firms or exchanges choose the corner solution of full disclosure to reduce the cost of capital is a cornerstone of research in this area. What is unusual about HHB is how they arrive at that insight. The assumption in HHB is that an entrepreneur and/or managers are motivated solely by a desire to earn insider-trading profits. By ignoring contracting and only partially endogenizing the cost of capital, the presumption is that an entrepreneur will choose the lowest disclosure standards. In this context, a ‘race to the top’ may seem provocative. But it is only provocative because HHB fail to endogenize fully key elements of the problem. Consider specifically the cost of capital. HHB attempt to endogenize the cost of capital by allowing uninformed traders to choose exchanges where they trade. As these traders are uninformed, uninformed traders choose exchanges where they can execute liquidity shocks at the smallest liquidity premium. If a sufficient number of uninformed traders choose a high disclosure exchange, their number may create sufficient market depth to attract firms whose sole motivation is to earn insider-trading profits for their entrepreneurs and managers. The reason for this is that with regard to maximizing insider-trading profits, the benefit of greater market depth outweighs the cost of more disclosure. Fair enough. One should not, however, mistake the notion of letting uninformed traders choose an exchange with endogenizing fully the cost of capital. Through the requirement captured in equation (3) of their model, HHB require that firm equity be held by someone, regardless of the obvious agency problem that results from insider trading. In other words, regardless of their disdain for the behavior of firm insiders, uninformed traders must participate as equity holders. The requirement that they hold firm shares implies that they earn negative expected returns in the model, regardless of which firms’ shares they hold and/or which exchanges they use. If, alternatively, liquidity traders could earn a zero return holding risk-free bonds, why would they ever participate in
To digress briefly, anecdotal evidence supports this notion. One observation consistent with that is that German accounting standards are widely regarded as less transparent than US GAAP. Despite this, German firms lobbied the Securities and Exchange Commission (SEC) to allow exclusively German financial statements when firms applied for listing on the New York Stock Exchange (NYSE). The SEC held firm, and ultimately Daimler—Benz broke ranks by restating its results under US GAAP and listing itself on the NYSE. In other words, Daimler—Benz chose higher disclosure standards in return for access to markets with more liquidity, i.e., market depth overcame higher disclosure requirements.
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these markets (except for the fact that equation (3) requires them to do so)? In other words, in an economy in which the cost of capital is fully endogenous, we would expect firms to ‘race-to-the-top’; otherwise they may be denied access to capital. Furthermore, even in the event that less than full disclosure results in the HHB analysis, consider the descriptive power of its underlying economic force. It arises from the fact that the entrepreneur and managers are concerned exclusively with earning insider trading profits, and ignore completely cost-ofcapital considerations. This does not strike me as descriptive of the behavior of entrepreneurs and managers in real markets settings. At the risk of appearing uncharitable, it is difficult to understand the contribution of HHB. If the intention of HHB was to consider the relation among disclosure, insider trading, and the cost of capital, this was done previously in Baiman and Verrecchia (1996). If the intention was to consider the role of liquidity, then HHB should have endogenized fully the cost of capital by allowing potential equity holders the opportunity to resolve any potential moral hazard problems with the entrepreneur at a time 2, or the entrepreneur with the manager at time 3 (see Fig. 1). For all the controversial features of HHB, it is somewhat ironic that the paper largely confirms the notion that firms will select the corner solution of full disclosure.
4. Conclusion In the absence of compelling reasons to the contrary, the conventional wisdom is that more disclosure results in more liquid markets. Consequently, an initial commitment by a firm to the greatest disclosure should lead to the lowest cost of capital. This implies that in a model of disclosure choice that is governed by cost-of-capital considerations, one expects the corner solution of full disclosure to be chosen so as to achieve the lowest cost of capital. Broadly stated, the insight underlying BCS is that if the effect of public disclosure is to make private information acquisition cheaper, then it is conceivable that more disclosure results in more private information acquisition. This, in turn, may result in less liquid markets. Therefore, greater harmonization of accounting standards may have the unintended effect of making markets less liquid. Alternatively, one could suggest that HHB’s insight is that the choice of the corner solution of full disclosure is robust even in the absence of cost-ofcapital considerations. That is, full disclosure may result even in the presence of an entrepreneur/managers of the firm who exploit shareholders through unrestricted insider trading, because it is likely to achieve the greatest market depth. It is true that in adverse-selection trading models, uninformed traders generically earn negative expected returns. But the role of uninformed traders in these models is simply to proxy for noise.
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In fairness to BCS and HHB, it should be emphasized that this discussion is not a traditional summary or review of each paper’s analysis and contribution. Rather, it is an attempt to codify what we know about disclosure choice and the cost of capital using their work as salient points of reference. While this may have some unsatisfying aspects, hopefully it offers a general understanding of the role of these papers in the literature, and points out interesting avenues for future work on this topic.
References Baiman, S., Verrecchia, R.E., 1996. The relation among capital markets, financial disclosure, production efficiency, and insider trading. Journal of Accounting Research 34, 1—22. Barth, M.E., Clinch, G., Shibano, T., 1998. International accounting harmonization and global equity markets. Journal of Accounting and Economics, this issue. Bushman, R.M., Gigler, F., Indjejikian, R., 1996. A model of two-tiered financial reporting. Journal of Accounting Research 34 (Supplement), 51—74. Diamond, D.W., Verrecchia, R.E., 1991. Disclosure, liquidity, and the cost of capital. Journal of Finance 46 (4), 1325—1359. Huddart, S., Hughes, J.S., Brunnermeier, M., 1998. Disclosure requirements and stock exchange listing choice in an international context. Journal of Accounting and Economics, this issue. Verrecchia, R.E., 1996. Discussion of a model of two-tiered financial reporting. Journal of Accounting Research 34 (Supplement), 75—82.