Segment Disclosure and Cost of Capital

• Published date: 01 April 2015
• Author: Belen Blanco,Juan M. Garcia Lara,Josep A. Tribo
• Date: 01 April 2015
• DOI: http://doi.org/10.1111/jbfa.12106

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(3) & (4), 367–411, April/May 2015, 0306-686X

doi: 10.1111/jbfa.12106

Segment Disclosure and Cost

of Capital

BELEN BLANCO,JUAN M. GARCIA LARA AND JOSEP A. TRIBO∗

Abstract: We investigate whether segment disclosure influences cost of capital. Improved

segment reporting is expected to decrease cost of capital by reducing estimation risk. However,

in a competitive environment segment disclosure may also generate uncertainties about future

prospects and lead to a larger cost of capital. Asset-pricing tests confirm that segment disclosure

is a priced risk factor. Also, segment disclosure reduces ex-ante estimates of cost of equity capital

and other measures connected to risk. These results suggest a negative relation between segment

disclosure and cost of capital. Our results also show that competition reduces, but does not

eliminate, the previous relationship.

Keywords: segment disclosure, earnings quality, forecast error, cost of capital

1. INTRODUCTION

There is an ongoing debate as to whether and how accounting quality decreases

the cost of capital. One stream of the literature suggests that accounting quality

reduces information asymmetries, which, in turn, decreases the cost of capital (Easley

and O’Hara, 2004). More recently, several studies demonstrate that information

differences across investors affect a firm’s cost of capital through information precision

(Hughes et al., 2007; Lambert et al., 2007, 2012). Standard setters (SFAS 131) and

practitioners (e.g., Ernst and Young, 2004) hold the view that segment reporting is

key to improving information precision, permitting a better evaluation of firm future

∗The first author is from the University of Melbourne. The second and third authors are from the Univer-

sidad Carlos III de Madrid. We appreciate the comments and suggestions contributed by an anonymous

reviewer, Peter Pope (the editor), Alicia Barroso, Daniel Cohen, Beatriz Garcia Osma, Joachim Gassen,

Miles Gietzmann, Javier Gil Bazo, Bego˜

na Giner, Paul Healy,Araceli Mora, Per Olsson, Fernando Pe ˜

nalva,

Rosa Rodriguez, David Smith, Jeroen Suijs, Laurence Van Lent, Steve Young and seminar participants at

the 2014 JBFA Capital Markets Conference, 2010 AAA Financial Accounting and Reporting Section Mid-

Year Meeting, the 2009 American Accounting Association annual meeting, the 2009 annual congress of the

European Accounting Association, the 2009 European Accounting Association Doctoral Colloquium, the

V Symposium for accounting academics (2009, Leeds Business School), the VII Workshop on Empirical

Research in Financial Accounting (2010, Universidad Polit´

ecnica de Cartagena), Universidad Carlos III

de Madrid, Universidad de Valencia, Universidad de Navarra, Universitat Pompeu Fabra de Barcelona,

Universitat Aut`

onoma de Barcelona, Tilburg University, The University of Melbourne and IE University.We

acknowledge financial assistance from the Spanish Ministry of Economy and Competitiveness (ECO2013–

48328-C3–3-P, ECO2010–19314, ECO2009–10796 and, ECO2012–36559), the European Commission IN-

TACCT Research Training Network (MRTN-CT-2006–035850), the Fundaci´

on Ram´

on Areces, and the

government of the Autonomous Community of Madrid (Grant # 2008/00037/001).

Address for correspondence: Belen Blanco, University of Melbourne, Department of Accounting, Level 7,

198 Berkeley Street, Building 110, Carlton 3010, VIC, Australia. E-mail: belen.blanco@unimelb.edu.au.

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368 BLANCO, GARCIA LARA AND TRIBO

prospects. These views of regulators and practitioners are also supported by prior

research, as there is plenty of evidence that a commitment to provide comprehen-

sive segment disclosure leads to a rich information environment characterized by:

(1) better predictive ability and increased precision of accounting numbers (e.g.,

Kinney, 1971; Collins, 1976; Silhan, 1983; Baldwin, 1984; Balakrishnan et al., 1990;

Swaminathan, 1991; Berger and Hann, 2003; and Ettredge et al., 2005), (2) reduced

information asymmetries (Greenstein and Sami, 1994), and (3) improved monitoring

ability over managerial decision making (Bens and Monahan, 2004; Berger and Hann,

2007; and Hope and Thomas, 2008). All of these effects of segment disclosure are

expected to make capital markets more efficient (Collins, 1975) and to facilitate firms

the access to external financing (Ettredge et al., 2006).1

However, the effect of segment information on cost of capital is not obvious. While

segment information improves the information environment, decreasing estimation

risk, it is likely that it also favors competitors, creating uncertainties about future

earnings and cash flows (Hayes and Lundholm, 1996; Stanford Harris, 1998). For

example, Bugeja et al. (2015) find evidence consistent with firms being reluctant to

provide segment information whenever most of their segments are profitable. Several

studies provide evidence consistent with increased competition leading to increased

uncertainty about future profitability that in turn leads to increases in the costs of

financing (Gaspar and Massa, 2006; Valta, 2012). Given these two expected opposite

effects of improved segment disclosure on cost of capital, we expect that the benefits

of segment disclosure, in terms of lower cost of capital, will be less pronounced and

might even disappear for firms subject to tougher competition.

To test our main hypothesis, that is, that segment disclosure leads to lower cost

of capital and that this effect is bound to be less pronounced or even disappear for

firms subject to competitive pressures, we construct a proxy for voluntary segment

disclosures based on the counting of the number of items of segment reporting

disclosed on a voluntary basis. In our proxy for voluntary segment disclosures we

control, following Clinch and Verrecchia (2013), for exogenous factors that affect

segment disclosure and also cost of equity capital. In particular, we take the residual

of a specification explaining the number of voluntarily disclosed items in terms of

these exogenous factors. That is, our segment disclosure score captures whether the

firm discloses more or less than what one would predict given its characteristics

(diversification, different types of risks, growth, etc.). We posit that firms that disclose

more than analysts expect ex-ante given their characteristics will be rewarded with

a lower cost of capital. This approach of using the residual of an estimation of

the number of voluntarily disclosed items on the determinants of the disclosure

decision tackles endogeneity issues related to spurious correlations among common

determinants of the cost of capital and voluntary disclosure. For example, Hann

et al. (2006) show that more diversified firms have a lower cost of capital. Given

that diversified firms will provide more segment disclosures, it is crucial that in our

segment disclosure proxy we control for diversification. Similarly, Gietzmann and

Ostaszewski (2014) show that firms for which estimating future earnings is more

difficult, which arguably will affect the cost of capital, disclose more. Our segment

1 Most prior literature assumes that increased disclosure increases the overall amount of information

available in the economy. However,in an analytical study, Tang(2014) shows that increased disclosure could

also discourage private information production and might also lead to a decreased amount of information

overall. While theoretically sound, prior empirical evidence does not support this argument.

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disclosure proxy also controls for the determinants of the difficulty in estimating

future earnings. Also, from the findings in Johnstone (2013), one could argue that

improved disclosure could lead to higher cost of capital because of the unveiling of

certain operational or financial risks. Again, we define our segment disclosure score

to control for different types of risk. Once we control for the previous variables in

the construction of our proxy for voluntary disclosure, we expect, first, the score

generated to be a sticky variable that captures a pre-specified disclosure policy.2Firms

with a higher score are firms for which estimating future profitability measures (like

earnings or cash flows) is easier. Second, our segment disclosure score controls for

the main determinants of the decision to disclose segment information: business and

geographic diversification, information asymmetries, operating risk, growth options,

performance, etc. Therefore, our results capture information effects of segment

disclosure, and not any of the effects that the aforementioned variables could have

on the cost of capital that may generate endogeneity problems of spurious correlation

between cost of capital and voluntary segment disclosure.

Using a sample of non-regulated and non-financial firms for the period 2001–2006,

and our proxy for voluntary segment disclosure, we show that firms providing better

segment disclosure enjoy lower costs of equity capital. We find, however, that such

decrease in the cost of equity capital is less pronounced in the presence of larger

competitive pressures. These results are robust to the use of tests based on asset pricing

and implied cost of equity capital. In addition, we provide empirical evidence that

segment disclosure improves investors’ ability to estimate the firm’s future earnings

by showing that better segment disclosure reduces analysts’ forecast errors. Finally, we

show that the provision of better segment information leads to a reduction in the firm’s

covariance with other firms’ returns, which is also consistent with improved segment

disclosure reducing estimation risk.

In all of our tests we control for the effects of earnings (accruals) quality on cost

of capital. It is noteworthy that in the asset pricing tests we find that accruals quality

is not a priced factor. This finding is in line with the results reported by Core et al.

(2008). We do not interpret our results, though, as segment reporting being as or

more important than accruals quality. On the contrary, a more plausible explanation

is that segment disclosures arise from an attempt at improving financial reporting in

all of its dimensions.

We provide robust results that add to prior research on the links between voluntary

disclosure and cost of capital (Botosan, 1997; Botosan and Plumlee, 2002; Gietzmann

and Ireland, 2005; Francis et al., 2008; and Dhaliwal et al., 2011). These studies offer

mixed evidence on the impact of voluntary disclosure on cost of capital. These mixed

results could be, in part, explained by the types of voluntary disclosures studied in

these prior papers. Our study differs from this prior research in that we use a type of

disclosure, segment reporting, with a clear predictive ability over future earnings and

cash flows (i.e., Kinney, 1971; Collins, 1976; Silhan, 1983; Baldwin, 1984; Balakrishnan

et al., 1990; Swaminathan, 1991; Berger and Hann, 2003; and Ettredge et al., 2005),

while prior studies have either used very wide and aggregate proxies for disclosure

(like AIMR scores in Botosan and Plumlee, 2002) or relatively softer information

2 Prior research shows that firms commit to disclosure strategies and that there is little variation in

disclosure quality across time. In particular, Leung and Verriest (2015) show that firms do not alter their

geographic segment disclosures in response to the passage of IFRS 8, which reduced substantially the

required disclosures on geographic segments.

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