JOHANN WOLFGANG GOETHE-UNIVERSITÄT
FRANKFURT AM MAIN
FACHBEREICH WIRTSCHAFTSWISSENSCHAFTEN
WORKING PAPER SERIES: FINANCE & ACCOUNTING
Christian Leuz/Robert E. Verrecchia
The Economic Consequences of Increased Disclosure
No.41
June 2000
Christian Leuz/Robert E. Verrecchia
The Economic Consequences of Increased Disclosure
*
No.41
June 2000
First draft: April 1999
Revised: June 2000
ISSN 1434-3401
Christian Leuz
Department of Business and Economics
Johann Wolfgang Goethe University
60054 Frankfurt – Germany
leuz@wiwi.uni-frankfurt.de
and
Robert E. Verrecchia
The Wharton School
2400 Steinberg Hall – Dietrich Hall
University of Pennsylvania
Philadelphia, PA 19104-6365
verrecchia@wharton.upenn.edu
* We gratefully acknowledge helpful comments from Phil Berger, John Core, Joachim Grammig, Robert
Holthausen, Frank Schorfheide, Erik Theissen, and an anonymous referee, as well as workshop participants
at the
Journal of Accounting Research
Conference, University of Chicago, EIASM Symposium in
Copenhagen, JWG-University of Frankfurt, University of Magdeburg, University of Vienna, and the Wharton
School. Christian Leuz thanks the Wharton School for its generous support during his visi t.
The Economic Consequences of Increased Disclosure
June 2000
Abstract
Economic theory suggests that a commitment by a firm to increased levels of disclosure should
lower the information asymmetry component of the firm’s cost of capital. But whi le the theory
is compelling, so far empirical results relating increased levels of disclosure to measurable
economic benefits have been mixed. One explanation for the mixed results among studies using
data from firms publicly registered in the US is that, under current US reporting standards, the
disclosure environment is already rich. In this paper, we study German firms that have
switched from the German to an international reporting regime (IAS or US -GAAP), thereby
committing themselves to increased le vels of disclosure. We show that proxies for the
information asymmetry component of the cost of capital for the switching firms, namely the
bid-ask spread and trading volume, behave in the predicted direction compared to firms
employing the German reporti ng regime.
Keywords: Disclosure, Cost of Capital, International Accounting, IAS, US GAAP
JEL-Classification: D8, G3, M4
1. Introduction
A major link between economic theory and contemporary accounting thought is the notion
that a firm’s commitment to gr eater disclosure should lower costs of capital that arise from
information asymmetries. A brief sketch of the economic theory is as follows. Information
asymmetries create costs by introducing adverse selection into transactions between buyers and
sellers of firm shares. In real institutional settings, adverse selection is typically manifest in
reduced levels of liquidity for firm shares (e.g., Copeland and Galai, 1983; Kyle, 1985; Glosten
and Milgrom, 1985). To overcome the reluctance of potential inves tors to hold firm shares in
illiquid markets, firms must issue capital at a discount. Discounting results in fewer proceeds to
the firm and hence higher costs of capital.
A commitment to increased levels of disclosure reduces the possibility of informat ion
asymmetries arising either between the firm and its shareholders, or among potential buyers and
sellers of firm shares.
1
This, in turn, should reduce the discount at which firm shares are sold,
and hence lower the costs of issuing capital (e.g., Diamo nd and Verrecchia, 1991; Baiman and
Verrecchia, 1996).
While the theory that relates the level of disclosure and the firm’s cost of capital is
compelling, so far the empirical results have been mixed. Aside from the difficulties of
measuring the cost of capital directly and estimating this relation, one potential explanation for
the mixed empirical results among studies using data from firms publicly registered in the US is
1
Note that the theory is sufficiently broad as to allow the notion of “increased levels of disclosure” to be
interpreted as either an increase in the
quantity
of disclosure or an increase in the
quality
of disclosure (or
both). Our use the expression “increased levels” is primarily for exposit ional convenience, and should not be
interpreted as exclusively the former (i.e., an increase in quantity). In addition, the theory makes no
distinction as to how the information asymmetries arise (e.g., between a firm and its shareholders, among
potential buyers and sellers of firm shares, etc.). The only requirement is that the information asymmetries
manifest themselves as a liquidity premium in the price at which trades are executed.
2
that, under current US Generally Accepted Accounting Principles (US -GAAP), the disclosure
environment is already rich. Consequently, commitments to increased levels of disclosure in
the US are largely incremental, thereby leading to economic consequences that are difficult to
substantiate empirically.
In contrast, the disclosure level s in the Germany under current German GAAP have been
criticized as being relatively low. Responding to this criticism, several German firms have
adopted “internationally accepted reporting strategies,” i.e., they now use either International
Accounting Standards (IAS) or US-GAAP as opposed to German standards for their financial
reporting to the capital markets. Due to the different disclosure requirements under the various
reporting regimes, a switch from German GAAP to either IAS or US -GAAP is thought to
represent a substantial increase in a firm’s commitment to greater disclosure. This, in turn,
suggests that firms electing either IAS or US -GAAP should evidence measurable economic
benefits in the form of a lower information asymmetry component of the cos t of capital.
This paper attempts to document these economic benefits empirically. We focus on proxies
for the information asymmetry component: namely, the bid -ask spread, trading volume, and
share price volatility.
2
We find in a cross-sectional analysis that firms that commit to either IAS
or US-GAAP exhibit lower percentage bid -ask spreads and higher share turnover than firms
using German GAAP. These differences are economically and statistically significant
controlling for various firm characteristics, a s well as self-selection bias. A subsequent analysis
of the bid-ask spread and trading volume around the switch to international reporting produces
corroborating results. However, we are unable to document a reduction in share price volatility.
2
Several extant studies suggest that information asymmetry and ill iquidity is compensated in stock returns.
See e.g., Amihud and Mendelson (1986, 1989), Brennan and Subrahmanyam (1996).
