NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Disclosure and the Cost of Capital


...after Enron, firms expanded the number of pages of their annual 10-K filings, notably the sections containing the financial statements and footnotes.

In a new NBER Working Paper, Christian Leuz and Catherine Schrand study how firms’ disclosure choices are related to their cost of capital by examining firms’ adjusted disclosure policies in response to the Enron scandal in fall 2001. Their paper, Disclosure and the Cost of Capital: Evidence from Firms’ Responses to the Enron Shock (NBER Working Paper No. 14897), concludes that firms successfully attempted to mitigate transparency concerns by expanding their financial statements. The firms’ disclosure responses reduced their costs of capital and hence the impact of the transparency crisis.

The news about Enron's losses and subsequent accounting irregularities created widespread worry about the quality of corporate reporting in the United States. Leuz and Schrand argue that the sudden and unpredictable nature of Enron's collapse mitigates concerns that any observed changes in disclosures after the debacle were driven by other factors. The timing of this natural experiment is also fortunate because firms had a chance to respond to the shock in their end-of-year financial statements.

The authors use financial statements for 1,868 public companies, which end their fiscal year in December and have reported financial data in each year from 1999-2001. Their sample excludes firms that have been significantly affected by the events of September 11, 2001, including insurance companies and airlines. The extent of corporate disclosure is measured by the total page count as well as page counts for the main sections of firms' annual 10-K filings to the Securities and Exchange Commission (SEC).

Leuz and Schrand find that after Enron, firms expanded the number of pages of their annual 10-K filings, notably the sections containing the financial statements and footnotes. The increase in disclosure was particularly pronounced for firms that have positive cost of capital shocks and larger financing needs. Firms also respond with additional interim disclosures (for example, 8-K filings) and these disclosures are complementary to the 10-K disclosures. Corporate disclosure itself has a significant effect on investors' evaluation of firm risk and subsequent market reaction: the authors estimate that a median increase in the length of a 10-K filing was associated with a 5 percent decline in a firm's systematic risk as measured in March 2002.

Although this analysis suggests that a firm may effectively reduce the cost of capital in a transparency crisis by providing additional disclosure, the authors stress that the “results should not be used to justify additional disclosure requirements as firms that voluntarily responded more to the cost of capital shock were those with greatest hypothesized benefits.”

-- Alex Teytelboym


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