Voluntary disclosure, mandatory disclosure and the cost of capital

• Author: He Wen,Jing He,Marlene A. Plumlee
• Published date: 01 March 2019
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jbfa.12368

DOI: 10.1111/jbfa.12368

Voluntary disclosure, mandatory disclosure

and the cost of capital

Jing He1MarleneA.Plumlee

2He Wen3

1Department of Accounting & MIS, University

of Delaware

2DavidEccles School of Business, University

of Utah

3Department of Accounting, University of

Missouri-St. Louis

Correspondence

MarleneA. Plumlee, Professor of Accounting,

DavidEccles School of Business, University

ofUtah, 1655 Campus Center Drive, Salt Lake

City,Utah 84112.

Email:marlene.plumlee@eccles.utah.edu

Abstract

We examine the association between a firm's cost of capital and

its voluntary and mandatory disclosures. We include two types of

mandatory disclosure: those that are a function of periodic reports

thatare realizations of ex -ante reporting systems and those that arise

due to specific corporate events. Tocapture a firm's voluntary and

event-driven mandatory disclosures, we use information the firm

provides via 8K filings. To capture periodic mandatory disclosures,

we use earnings quality measures derived from the literature. Con-

sistent with endogenous relations predicted by theory, we find that

voluntarydisclosure and both types of mandatory disclosure are cor-

related, although only event-driven mandatory disclosures are sig-

nificant in models that explainvoluntary disclosure. We also find that

the cost of capital is generally influenced by each of these disclosure

types. Wealso find that controlling for periodic mandatory disclosure

does not affect the relationship between voluntary disclosure and

the cost of capital, while controlling for event-driven mandatory

disclosure sometimes affects the relationship depending on the

measures used. Our study suggests that a firm's disclosure environ-

ment includes the three types of disclosure examined, although the

inclusion of mandatory disclosures does not affect the measured

association between voluntary disclosure and the cost of capital.

KEYWORDS

cost of capital, earnings quality, event-drivenmandatory disclosure,

mandatory disclosure, periodic mandatory disclosure, voluntary

disclosure

1INTRODUCTION

We examine the association between voluntary and mandatory disclosure, and the conditional and unconditional

pricing effects of voluntary disclosure, given these associations. Our analysis includes voluntary disclosure and two

types of mandatory disclosure: periodic mandatory reports produced by a firm'sex-ante reporting system (periodic

mandatory disclosures) and event-driven mandatory filings required when specific firm events occur (event-driven

mandatory disclosures). We measure mandatory disclosures related to periodic mandatory reports as the common

J Bus Fin Acc. 2019;46:307–335. wileyonlinelibrary.com/journal/jbfa c

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308 HE ET AL.

factor generated by factor analysis performed on three commonly used earnings quality measures. Wefollow Francis,

Nanda, and Olsson (2008) in constructing this measure and concur with their view of earnings quality as capturing

‘the precision of the earnings signal emanating from the firm's financial reporting system’ (p. 54), although we include

it as a measure of one type of mandatory disclosure. We draw our proxies for voluntary disclosure and event-driven

mandatory disclosure from Cooper, He, and Plumlee (2018) (CHP hereafter), who use 8K data to develop their

measures. Wealso capture voluntary disclosure using a measure based on management forecasts (Franciset al., 2008).

Whether mandatory and voluntary disclosures are complements or substitutes is ongoing issue in the analytical

disclosure literature. For example, some authors show that the association between voluntary and mandatory

disclosure depends on (1) whether the disclosure has financial or real externalities (Dye, 1990), (2) the purpose of the

mandatory disclosure (Gigler & Hemmer,1998), or (3) the features of the mandatory disclosure environment (Einhorn,

2005). Other studies consider settings where the structure of the mandatory disclosure system is endogenously

determined, based on expectations around subsequent receipt of a private signal (e.g., Freidman,Hughes, & Michaeli,

2018a; Stocken & Verrecchia, 2004). These differing conclusions from the analytical studies lead to conflicting

empirical expectations about the expected relationship between voluntary and mandatory disclosure, due in part

to assumptions regarding endogeneity of the mandated disclosures. We use these studies to motivate our first two

hypotheses: one that speaks to the association between voluntary disclosure and periodic mandatory disclosure and

the other to the association between voluntary disclosure and event-driven mandatory disclosure. We also consider a

related issue – the link between disclosure and a firm's cost of capital. Many theoretical and empirical studies examine

the association between a firm's cost of capital and the quality of its disclosure.1The analytical and empirical findings

from these literatures are also somewhat mixed; much of the empirical work focuses on the role that voluntary

disclosure plays and is generally consistent with voluntary disclosure being inversely related to the cost of capital.

These findings motivate our second and third hypotheses.

An unresolved issue in the literature is whether studies that provide evidence of the link between voluntary

disclosure and the cost of capital capture the impact of voluntary disclosure or whether the voluntary disclosure

measures capture more primitive aspects of firms’ reporting environment. The concern is that, while an empirical link

between voluntary disclosure and the cost of capital is established, the true relationship is between the underlying

aspects of the reporting environment that are correlated with voluntary disclosure. For example, several empirical

studies focus on how the inclusion of earnings quality in the analysis impacts the association between voluntary

disclosure and the cost of capital (e.g., Bhattacharya, Ecker, Olsson, & Schipper, 2012; Francis et al., 2008; Heflin,

Moon, & Wallace, 2016).2Further, Segal and Segal's (2016) findings, which show that firms strategically bundle

voluntary and event-driven mandatory disclosure, suggest that the effects of voluntary disclosure may not be fully

understood without considering the effect of event-driven mandatory disclosure. Thus, we expand the literature by

explicitly considering a firm's mandatory disclosure as arising from two sources (periodic reporting and corporate

events) and then document the association between both types of mandatory disclosure and its voluntary disclosure.

Finally,we consider how incorporating both periodic and event-driven mandatory disclosure in the analysis affects the

documented link between voluntary disclosure and the cost of capital.

Our empirical analysis begins with an explorationof the associations between voluntary disclosure and mandatory

disclosure – periodic and event-driven. We document positive correlations between voluntary disclosure and both

types of mandatory disclosure. After controlling for firm characteristics expected to predict voluntary disclosure,

however,the link between periodic mandatory disclosure and voluntary disclosure becomes insignificant. Throughout,

event-driven mandatory disclosure continues to provide significant explanatory power. In contrast to Francis et al.

(2008), we find that voluntary disclosures are unrelated to a firm's periodic mandatory disclosure (Franciset al.’s earn-

ings quality). Instead, consistent with Segal and Segal (2016), they appear to be responses to event-driven mandatory

1Forexample, the theoretical literature includes Bertomeu, Beyer, and Dye (2011), Cheynel (2013), Clinch and Verrecchia (2015), Diamond and Verrecchia

(1991), Kim and Verrecchia (1994), Zhang (2001). Empirical studiesin this literature include Baginski and Rakow (2012), Bhattacharya, Ecker, Olsson, and

Schipper(2012), Botosanand Plumlee (2002), Francis, Nanda, and Olsson (2008), Gietzmann and Ireland (2005), Hail and Leuz (2006). This is, of course, only

apartial list.

2Inthese studies, earnings quality is a proxy for the information environment.