Social disclosure, financial disclosure by AyikFuad

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									                                    Accounting, Organizations and Society 26 (2001) 597–616
                                                                                                   www.elsevier.com/locate/aos




                          Social disclosure, financial disclosure
                             and the cost of equity capital
                                  Alan J. Richardson*, Michael Welker
                                School of Business, Queen’s University, Kingston, Canada K7L 3N6




Abstract
  We test the relation between financial and social disclosure and the cost of equity capital for a sample of
Canadian firms with year-ends in 1990, 1991 and 1992. We find that, consistent with prior research, the quantity
and quality of financial disclosure is negatively related to the cost of equity capital for firms with low analyst
following. Contrary to expectations, there is a significant positive relation between social disclosures and the cost
of equity capital. This positive relationship is mitigated among firms with better financial performance. We consider
some biases in social disclosures that may explain this result. We also note that social disclosures may benefit the
firm through its effect on organizational stakeholders other than equity investors. # 2001 Published by Elsevier
Science Ltd.




   Regulators have argued that equity markets                         In spite of the regulatory and theoretical sup-
require comprehensive and transparent disclosures                  port for increased disclosure by firms, direct evi-
of value-relevant information by firms in order to                  dence of a negative empirical relation between
function efficiently (e.g. Levitt, 1999). Theoreti-                  disclosure levels and the cost of capital is limited
cally, adopting such a ‘‘disclosure position’’ (Gib-               (e.g. Botosan, 1997; Botosan & Plumlee, 2000, on
bins, Richardson, & Waterhouse, 1990) should                       the cost of equity capital, and Sengupta, 1998 on
benefit firms through lower cost of capital for at                   the cost of debt). In part, the lack of strong
least two reasons. First, increased disclosure by                  empirical findings on the relationship between
firms reduces transaction costs for investors                       disclosure and cost of capital may be an artifact of
resulting in greater liquidity of the market and                   the markets and information set that are used in
greater demand for the firm’s securities (e.g. Dia-                 empirical tests. If there is little variation in the
mond & Verrecchia, 1991). Second, increased dis-                   information disclosed due to effective regulatory
closure reduces the estimation risk or uncertainty                 interventions, or if analysts routinely generate
regarding the distribution of returns (Clarkson,                   information independently of the firms’ own dis-
Guedes, & Thompson, 1996).                                         closures, then the power of empirical tests will be
                                                                   significantly reduced. For example, Botosan
                                                                   (1997) documents a statistically significant nega-
                                                                   tive relation between the level of financial dis-
  * Corresponding author.                                          closure and cost of equity capital for her sample of
                                                                   USA manufacturing firms, but this relation holds
0361-3682/01/$ - see front matter # 2001 Published by Elsevier Science Ltd.
PII: S0361-3682(01)00025-3
598                    A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

only for the subset of her sample characterized by                  well. Past empirical examinations of the relation
limited analyst following.                                          between social performance, or social disclosure,
   A stronger test of the relationship between cor-                 and equity market measures such as realized
porate information disclosures and the cost of                      equity returns have generally been poorly speci-
equity capital is possible by choosing markets and                  fied, leading to results that are difficult to inter-
information sets where, ex ante, corporate dis-                     pret. RWH provide an extensive review of this
closures play a larger role in market valuations. In                literature and present a comprehensive model
this paper we test this relationship in Canadian                    outlining the ways that social performance and
markets and with both financial and social dis-                      disclosure about that performance might influence
closures. Both of these extensions to the literature                equity market measures. Their analysis focuses on
should improve the power of statistical tests as                    three distinct ways in which social performance
explained later.                                                    and disclosure could affect the cost of capital.
   First, we examine a set of Canadian firms, pro-                   Social disclosure could play a role similar to
viding an assessment of the benefits of expanded                     financial disclosure and reduce the cost of equity
disclosure in an environment other than the Uni-                    capital by reducing transaction costs and/or
ted States of America (US). Since the US equity                     reducing estimation error. In addition to these
markets are claimed to be among the most                            two effects, social disclosure could influence the
sophisticated in the world (e.g. Levitt, 1999),                     cost of equity capital directly through investor
including some of the most stringent disclosure                     preference effects if investors are willing to
standards in the world, this extension is poten-                    accept a lower expected return on investments
tially important. The generally less comprehensive                  that also fulfill social objectives. The relationship
required disclosures in Canada create an environ-                   between the cost of capital and social disclosures/
ment where variation in voluntary disclosure                        performance is one of the issues identified by
could be very important.1                                           Epstein (2000) for future research in his review of
   Second, we examine the relation between both                     the field.
social and financial disclosures and cost of equity                     Consistent with the past literature, we find a
capital estimates. The past literature has only                     significant negative relationship between the cost
examined the relation between financial disclosure                   of equity capital and financial disclosure for those
and cost of capital. As summarized in Botosan,                      firms with a small financial analyst following.
past literature suggests that financial disclosures                  Contrary to expectations, we find a significant
could influence the cost of capital because the dis-                 positive relationship between social disclosure
closures reduce information asymmetry and/or                        and the cost of equity capital. The cost of
estimation error. As Richardson, Welker, and                        equity penalty for firms with extensive social
Hutchinson (RWH, 1999) discuss, there are a                         disclosure is mitigated by higher financial
number of reasons to suspect a relation between                     performance.
the cost of equity capital and social disclosure as

                                                                    1. Hypothesis development
   1
      The view that US disclosure practices provide more infor-        The relation between financial disclosure and
mation than Canadian practices is apparently widely held.
Nearly 90% of the Canadian analysts surveyed between
                                                                    the cost of equity capital has been extensively
November 1994 and January 1995 on behalf of the Toronto             developed in the past literature (Clarkson et al.,
Stock Exchange’s Committee on Corporate Disclosure respon-          1996; Diamond & Verrecchia, 1991). Botosan
ded that disclosure was better in the USA. None of the analysts     (1997), for example, argues that financial dis-
felt that disclosure was better in Canada. Reasons provided for     closure could result in decreased cost of capital
the belief that disclosure is better in the USA included: more
stringent regulation, greater volume of information and more
                                                                    because expanded disclosure reduces estimation
detailed segmentation of information (Committee on Corpo-           risk, decreasing the total risk in owning the
rate Disclosure, 1995).                                             equity security, or reduces risk by decreasing
                         A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616             599

information asymmetries and, hence, adverse                             ‘‘vote’’ with their dollars and may (rationally)
selection risk. In either case, an inverse relation                     choose to pay more to both acquire a product or
between financial disclosure and cost of equity                          service and support a social cause for which they
capital is predicted.                                                   have an affinity. The extension of this literature to
   Richardson et al. (1999) argue that there are at                     the capital market is straightforward if investment
least three reasons to expect a similar relation                        decisions are recognized as decisions to forego
between social disclosure and the cost of equity                        current consumption in favor of future consump-
capital.2 They conclude that there may be a direct                      tion. There is also considerable anecdotal evidence
influence of social disclosure on the cost of equity                     suggesting a link between investor preferences and
capital either through investor preference effects,                      social reporting. For example, Downing (1997)
or through reduced information asymmetry or                             reports that managers of the Canadian Pension
estimation risk. The effects stemming from                               Plan’s $100 billion fund, among other investors,
reduced information asymmetry and/or estimation                         might be attracted by the information provided by
risk follow directly from the literature on financial                    social reporting.
disclosure. If information about social activities is                      Our empirical examination does not attempt
relevant to assessing the firm’s prospects, then                         to discriminate between these potential effects,
enhanced disclosure of social activities has the                        but does stand in marked contrast to the past
same effect as enhanced disclosure of other finan-                        literature examining the equity market con-
cial activities.                                                        sequences of social disclosure that has tended to
   Investor preference effects arise if investors are                    focus on the relation between social performance,
willing to accept a lower rate of return on invest-                     social disclosure and ex-post measures of financial
ments by an organization that supports a social                         performance. Ours is the first empirical examina-
cause for which some investors have an affinity.3                         tion of social disclosure practices to explicitly
This suggestion is consistent with the emergence of                     examine the cost of equity capital and the first to
Green Funds and Ethical Investing (e.g. Reyes &                         jointly examine the effects of both financial and
Grieb, 1998). It also has a direct relationship to                      social disclosure. The specific hypotheses we
the literature in organizational behavior, manage-                      examine are outlined later, each stated in alter-
ment, and marketing that suggests that advertising                      native form.
with a social dimension can be employed to legit-                          The past literature has suggested that increased
imate the firm in the eyes of consumers and con-                         financial disclosure reduces information asym-
tribute to the firms’ product/service market                             metry and/or estimation risk. This literature also
success (e.g. Garrett, 1987; Menon & Menon,                             suggests that enhanced financial disclosures reduce
1997). This literature suggests that consumers                          the cost of equity capital.

                                                                          H1a: There is an inverse relation between the
                                                                          level of financial disclosure and the cost of
  2
     RWH also argue that disclosure about social activities               equity capital.
undertaken by the firms could provide investors with informa-
tion about future cash flows, or in terms consistent with the               The arguments presented earlier suggest that
model presented later, future abnormal earnings. This link
                                                                        similar relations exist between the level of social
might exist, for example, if social activities decrease expected
future regulatory costs, influence consumers to acquire the              disclosure and information asymmetry, estimation
firm’s products/services thereby increasing the firm’s contribu-          risk and the cost of equity capital. Also, if, as has
tion margins or market share, or reduce the costs of implicit or        often been assumed in the past literature, there is a
explicit contracting. In short, if social activities have net present   perceived positive relation between the level of
value consequences, then information about social performance
                                                                        social disclosure of the firm and the firm’s social
should influence investors’ assessments of the abnormal earn-
ings the firm can earn in the future (see Scaltegger & Figge,            performance, increased social disclosure may
1998).                                                                  reduce the cost of capital through investor pref-
   3
     This linkage is more thoroughly discussed in RWH (1999).           erence effects.
600                A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

  H2a: There is an inverse relation between the                 greater for larger firms (Watts & Zimmerman,
  level of social disclosure and the cost of equity             1986). The number of analysts following a firm
  capital.                                                      tends to be correlated with firm size (e.g. see
                                                                Table 1), thus the importance of social disclosure
   Finally, we consider the interaction between                 and the independent information available from
firms’ own disclosures about their activities and                analysts will increase in parallel. We, therefore,
the information available from third parties. We                predict no interaction effect between social dis-
hypothesize that the relationship will differ for                closure and the number of analysts following the
financial disclosure and social disclosure. The                  firm.
literature on financial disclosure suggests that the
benefits of financial disclosure may be greater                      H3a(ii): The relation between social disclosure
for firms with little analyst following (Botosan,                   levels and the cost of equity capital is not
1997). This assumes that stakeholders are                          mediated by the level of analyst following.
concerned with a firm’s financial performance but
that the richness of the information set available
to them varies depending on the number of                       2. Empirical measures of disclosure levels and
analysts preparing independent reports on the                   cost of equity capital
firm. In the absence of information about the
firm from analysts, the firm’s own disclosures are                2.1. Disclosure proxy
the key source of information. The benefits of
better financial disclosure are primarily realized                 Our empirical measures of financial and social
when other information sources are absent.                      performance are drawn from the joint Society of
Therefore we predict a negative relationship                    Management Accountants of Canada (SMAC)/
between the cost of capital financial disclosure                 University of Quebec at Montreal (UQAM)
where there is a small number of analysts follow-               sponsored assessments of the annual reports of
ing a firm.                                                      a broad cross-section of Canadian companies.
                                                                These assessments were conducted and publicly
  H3a(i): The relation between financial dis-                    reported based on 1990, 1991 and 1992 annual
  closure levels and the cost of equity capital is              reports, thus providing a limited time-series of
  mediated by the level of analyst following.                   disclosure scores. To our knowledge, these data
                                                                are unique in North America because the
   The effect of social disclosure is expected to                scores contain a ranking of firms on both the
follow the same pattern to the extent that social               quality and level of financial disclosure and
disclosures inform stakeholders’ expectations of                social disclosure contained in annual reports.
the firm’s financial performance. The importance                  This provides a significant advantage over
of social performance to stakeholders, however,                 other North American rankings such as the
has been theorized to increase with the size of the             Association for Investment Management and
organization. Stinchcombe (1965), for example,                  Research (AIMR) rankings of US companies.4
has argued that as a firm grows it develops a                    However, the AIMR rankings are prepared
structural position (i.e. ties within a network of              by professional analysts and represent the
resource providers) that contributes to its success.            rankings of several analysts, while the Canadian
This structural position changes the demands of
the environment from a demand for short-run
economic efficiency to a demand for long-run
                                                                   4
                                                                     The AIMR rankings are compiled annually by the Asso-
economic and social efficiency/legitimacy (see
                                                                ciation for Investment Management and Research. These dis-
Hannan, 1998; Oliver, 1991). This prediction is                 closure rankings have been used in empirical studies by
consistent with the positive accounting theory                  Botosan and Plumlee (2000), Healy, Hutton, and Palepu
literature that suggests that political costs are               (1999), Lang and Lundholm (1993, 1996), and Welker (1995).
                   A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616           601

rankings available to us are based on the judg-                 sections devoted to general background informa-
ments of less experienced raters and do not reflect              tion that help users to interpret the financial
the same level of averaging across raters as the                statements. All three lists contain sections devoted
AIMR ratings. Nevertheless, the SMAC/UQAM                       to assessing the usefulness of the disclosure of
ratings are the best available source of disclosure             summarized historical results, and all three check-
ratings for a broad cross-section of Canadian                   lists assess the inclusion of forecasted information
firms. The only alternative measure of disclosure                within the annual report. In addition to assessing the
for Canadian companies would be researcher-                     types of disclosure made in the annual report, the
generated measures, as utilized by Botosan (1997).              UQAM researchers also attempted to make an
We choose not to generate our own disclosure                    assessment of the quality of the disclosure by
ratings because of the potential for researcher                 awarding more points for disclosures that contained
biases to influence the ratings and to avoid the                 quantitative data or reported more information.
severe limitations on sample size imposed by this               The extensive nature of the checklists utilized in the
approach.                                                       SMAC/UQAM disclosure ratings, combined with
   For each year from 1990 to 1992, researchers at              the attempt to discriminate between more and less
UQAM analyzed the annual reports of around                      informative disclosures, gives us confidence in the
700 Canadian companies coming from nine                         face validity of these ratings. While they are
industry sectors. The industry sectors reported on              undoubtedly noisy measures, they provide us
in their publication include: Manufacturing-                    with some ability to discriminate between firms
Industrial Products, Manufacturing-Consumer                     providing high levels of disclosure and those
Products; Oil, Gas and Chemicals; Mines, Metals                 providing minimal disclosure. Empirical analysis
and Forestry Products; Technology and Com-                      reported later in the manuscript also provides evi-
munications; Financial Institutions; Retail and                 dence corroborating the validity of our disclosure
Wholesale Trade; Management and Other; and                      measures.
Utilities. An extensive checklist of information
related to socially responsible activities was
developed that contained 170 subcategories of                   3. Empirical measure of cost of equity capital
information. Similarly, an extensive checklist
related to financial information was developed                     We follow Botosan (1997), Botosan and Plumlee
which allocated points across 261 individual                    (2000) and Gebhardt, Lee, and Swaminathan
disclosure elements.                                            (2000), and obtain estimates of the cost of
   Appendix A contains a summary of the 10                      equity capital using an accounting based valu-
categories of social information considered and                 ation model developed in Edwards and Bell
the maximum number of points allocated to each                  (1961), Feltham and Ohlson (1995) and Ohlson
category, as well as the sub-categories of infor-               (1995). Our empirical implementation of the
mation considered within each category. The                     model is very similar to the method employed
Appendix also contains similar information for                  by Gebhardt et al. and interested readers are
the financial disclosure checklist.                              referred to their paper for further details on the
   Two points should be noted about these check-                estimation procedure and for extensive empirical
lists. First, the social information captured in the            analyses of the properties of the estimates. We
checklist includes a much broader set of dis-                   provide a brief sketch of the estimation procedure
closures than just environmental disclosures that               later.
have been the subject of much of the past social                  The valuation model specifies a relation between
disclosure literature.                                          equity values and current book values and future
   Second, the checklist used to assess financial dis-           abnormal earnings. We briefly sketch a derivation
closure is similar in many respects to the checklists           of the empirical equation we use to estimate equity
utilized by the AIMR and developed by Botosan                   cost of capital beginning with the familiar divi-
(1997). For example, all of the checklists contain              dend discount model:
602                         A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616
                È       É
        X Et ditþ
         1                                                                  For our estimates that utilize I/B/E/S earnings
Pit ¼                                                          ð1Þ       forecasts, Eq. (3) is replaced with a version that
        ¼1
            ð 1 þ ri Þ 
                                                                         utilizes the earnings forecasts for the next three
                                                                         fiscal years from I/B/E/S.6 The terminal value
where d=dividends, r=cost of equity capital, and                         involves forecasting return on equity for 12 future
i and t are firm and time identifiers, respectively.                       years (i.e. 9 years beyond the latest available
   Feltham and Ohlson (1995) and Ohlson (1995)                           explicit earnings forecast from I/B/E/S). Fore-
demonstrate that, for clean-surplus accounting                           casted return-on-equity beyond year 3 is generated
systems, this dividend discount model is algebrai-                       using a linear fade-rate to the industry average
cally equivalent to a valuation formula based on                         return-on-equity (ROE). Our industry average
current book value and future abnormal earnings:5                        ROEs are compiled from data provided by Statis-
                   À          È        ÉÁ                                tics Canada (Statscan). We acquire industry aver-
              X Et xitþ À ri BVitþÀ1
               1
                                                                         age ROE data beginning with 1980 for all
Pit ¼ BVit þ                                     ð2Þ
              ¼1
                         ð 1 þ ri Þ                                     industries as defined and tracked by StatsCan. Our
                                                                         industry average ROE figures for year t are com-
                                                                         puted as the average industry ROE through time
where BV=book value of equity, x=earnings,                               starting in 1980 and ending in year tÀ1. For
and all other variables are as previously defined.                        example, for our 1990 industry average ROE
  The finite horizon version of Eq. (2) is:                               measure, we average the industry ROEs over
                                                                         the 10 year period from 1980 to 1989, and
                    X Et ðfFROEitþ À ri gBVitþÀ1 Þ
                     T
                                                                         the 1991 industry ROEs are the average of
Pit ¼ BVit þ
                    ¼1
                               ð 1 þ ri Þ                               the industry ROEs over the 11 year period
                                                                         from 1980 to 1990. These industry averages have
        þ TVit                                                 ð3Þ       a mean of 10.75% and range from 4.3%, (the
                                                                         1992 average for the iron, steel and related
where FROE=forecasted return on equity, and                              products industry) to 22.7%, (the 1990 average
TV=terminal value, or the present value at time t                        for the building materials and construction
of the abnormal earnings expected to be earned                           industry).
after time t+T, and all other variables are as                              Accordingly, the model we utilize to estimate
previously defined.                                                       cost of capital has the following form:


                    X Et ðfFROEitþ À ri gBVitþÀ1 Þ
                     3
Pit ¼ BVit þ
                    ¼1
                               ð 1 þ ri Þ 
           P
           11
                EfFROEitþ3 þ ð À 3Þ½fIROEit À FROEitþ3 g=9Š À ri gBVitþÀ1                      &                   '
                                                                                                     IROEit À ri
        þ ¼4                                                                                þ                         BVitþ11       ð4Þ
                                                 ð1 þ ri Þ                                           ri ð1 þ ri Þ11


                                                                            6
                                                                              About 10% of our firm year observations have two-year
                                                                         ahead EPS forecasts but do not have a 3-year ahead forecast.
                                                                         When the third year ahead forecast is missing, we forecast fiscal
                                                                         year 3 (FY3) EPS by assuming that the earnings growth rate
   5
     A clean surplus accounting system is one in which book              implicit in the fiscal year 2 (FY2) compared with fiscal year 1
value at time t is equal to book value at time tÀ1 plus earnings         (FY1) forecasts applies to fiscal year 3 as well. Specifically, we
minus dividends net of capital contributions. ‘‘Dirty surplus’’          forecast FY3 EPS as FY2 EPSÂ(FY2 EPS/FY1 EPS). If FY2
arises when gains and losses affecting book value bypass the              EPS/FY1 EPS< 0, we do not forecast FY3 EPS and omit the
income statement.                                                        observation.
                   A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                   603

where IROE is the historical industry average                   sample size to 225 firm year observations from 87
ROE and all other variables are as previously                   different firms.
defined.                                                           For these observations, we obtain the average
  The exact details of the estimation procedure,                stock price from the 6th month after year-end
including variable measurement, are described in                from Datastream. We choose a period 6 months
the following section. The sensitivity of our results           after year-end to ensure that all information con-
to variations in the assumptions required to esti-              tained in the annual financial statements has been
mate cost of capital are discussed in the section of            disclosed and is reflected in market prices.7 This
the paper entitled ‘‘sensitivity of results to cost of          choice is also consistent with the empirical analysis
capital estimation assumptions’’.                               in Botosan (1997). From Compustat, we obtain
                                                                the debt-to-equity ratio, return-on-equity, divi-
                                                                dend payout ratio, market to book value ratio,
4. Empirical analysis                                           and market value of equity. I/B/E/S provides the
                                                                earnings forecasts and the number of analysts fol-
4.1. Disclosure proxy and additional data                       lowing the firm, which we measure as the number
                                                                of analysts providing 1-year-ahead earnings fore-
   Our initial sample consists of all firms that                 cast for the firm.
received a disclosure rating based on any or all of               Calculation of forecasted book values requires
its 1990, 1991 or 1992 annual reports. In each of               an estimated future dividend payout ratio (k). We
these three years, the annual reports of over 700               estimate this ratio using the following procedure.
Canadian companies were collected and analyzed                  First, we obtain the historical 10-year average
by a group of research assistants at UQAM. The                  payout ratio for each year t from Compustat and
results of the ratings are summarized by industry               use this to proxy for future payouts if it is avail-
group and published each year by CMA Canada.                    able and positive. If the 10-year average is either
The survey only provides 3 years of data. Since                 unavailable or negative, we use the 5-year histor-
disclosure policies are probably relatively stable              ical average payout ratio. If the 5-year payout
firm attributes, this limited time-series should not             ratio is either unavailable or negative, we estimate
severely impact the generality of our results. In               future payout ratios based on the dividend payout
order to perform the initial empirical analysis, we             ratio for year t. Finally, if the year t payout ratio is
require financial statement data provided by                     negative, we follow a procedure similar to Geb-
Compustat, earnings forecasts and analyst follow-               hardt et al. (2000) and approximate ‘‘permanent’’
ing provided by I/B/E/S, and market price and                   earnings for year t as (BVtÀ1ÂIROE), the book
returns data acquired through Datastream. These                 value of equity at the beginning of the year times
additional data requirements leave us with a                    the industry average ROE. We then calculate the
sample of 324 firm year observations from 124                    dividend payout ratio as DVSt /(BVtÀ1ÂIROE),
different companies with all necessary price data,               where DVS is the dividends per common share for
financial and social disclosure scores, all necessary            year t. Our implementation of Eq. (4) then uses
Compustat data and at least 1-year ahead EPS                    the firm’s estimated dividend payout ratio (k) to
forecast available from I/B/E/S. For this initial               update book values as follows:
sample, we only require that 1-year ahead ana-                                     È                  É
lysts’ forecasts be available, and therefore the                BVit ¼ BVitÀ1 þ FROEit ð1 À kÞit BVitÀ1            ð4aÞ
number of analysts making a 1-year ahead fore-
cast, be available from I/B/E/S. In order to
                                                                   7
calculate cost of capital estimates, we require                      Our results are qualitatively similar using average stock
                                                                prices from the 4th month after fiscal year-end. We use the
that at least 2-year-ahead earnings forecasts be
                                                                average stock price for the month rather than monthly closing
obtained from I/B/E/S. We also require that                     prices to avoid extreme observations that may result from
unambiguous identification with a StatsCan                       temporary share price fluctuations reflected in a single price
industry group be possible, further reducing our                observation such as a closing price.
604                       A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

Table 1                                                                       Tables 1 and 2 provides distributional char-
Descriptive statisticsa                                                    acteristics and a correlation matrix for the vari-
Variable name N           Mean    Median Minimum Maximum                   ables used in the study. Financial disclosure scores
                                                                           average 32.5 (out of a possible 120), and range
FDISC             324   32.53   31.48    4.75             63.0
                                                                           between 4.75 and 63. Social disclosure scores tend
SDISC             324   11.04    8.25    0.25             50.0
MV ($000,000)     324 3833    1605      20.2          38,729               to be lower, averaging 11 (out of 100) and ranging
ANALFOL           324    9.32    9.0     1                37               between 0.25 and 50. The average firm size in the
LEV (%)           324   75.8    53.5     0              1095               sample is $3.8 billion and the median size is sub-
ROE (%)           324    0.19    5.98 À194.0              33.1             stantially lower at around $1.6 billion. Nine ana-
IND               324    0.38    0       0                 1
COST (%)          225    8.9     8.5     1.8              22.5             lysts follow the average firm, and this ranges
                                                                           between 1 and 37. The average debt to equity ratio
  a
     Variable definitions: FDISC=Financial disclosure score                 is 75%. The mean ROE for our sample firms is
for firm i, year t; SDISC=social disclosure score for firm i, year
t; MV=beginning of year market value of common equity for
                                                                           close to zero, reflecting the poor economic climate
firm i, year t; NANAL=number of analysts making a 1 year                    in Canada in the early 1990s.8 The median ROE is
ahead EPS forecast for firm i, year t; LEV=debt to equity ratio             around 6%. Around one third of our sample firms
for firm i, year t; ROE=return on equity for firm i, year t;                 come from the oil, gas and chemical industry or
IND=a dummy variable equal to one if firm i is a member of
the Oil, Gas and Chemicals or Mine, Metals and Forestry
                                                                           the mines, metals and forestry products industry,
Products industry sectors in year t, zero otherwise; COST=                 industries that have been depicted as environmen-
estimated cost of equity capital for firm i, year t.                        tally/socially sensitive industries in the past litera-


Table 2
Correlation matrix (Pearson above diagonal, Spearman below)a
                 FDISC            SDISC          MV              NANAL            LEV            ROE            IND            COST
FDISC             1                0.662*        0.499*           0.542*           0.067          0.009          0.229*        À0.046
SDISC             0.704*           1             0.294*           0.391*           0.080         À0.023          0.298*         0.011
MV                0.555*           0.474*        1                0.413*          À0.054          0.132*        À0.143*         0.091
NANAL             0.603*           0.509*        0.617*           1               À0.023          0.029          0.321*        À0.208*
LEV               0.177*           0.243*        0.024            0.042            1             À0.542*         0.011          0.054
ROE              À0.067           À0.096         0.136*           0.009           À0.251*         1             À0.121*         0.074
IND               0.281*           0.278*        0.065            0.346*          À0.013         À0.255*         1             À0.362*
COST             À0.053           À0.012         0.066           À0.156*           0.131*         0.102         À0.351*         1
  a
    Variable definitions: FDISC=Financial disclosure score for firm i, year t; SDISC=social disclosure score for firm i, year t;
MV=beginning of year market value of common equity for firm i, year t; NANAL=number of analysts making a 1 year ahead EPS
forecast for firm i, year t; LEV=debt to equity ratio for firm i, year t; ROE=return on equity for firm i, year t; IND=a dummy variable
equal to one if firm i is a member of the Oil, Gas and Chemicals or Mine, Metals and Forestry Products industry sectors in year t, zero
otherwise; COST= estimated cost of equity capital for firm i, year t.
  *=significant at the 5% level, two-tailed test.




   As Gebhardt et al. point out; the calculation of                        ture (Deegan & Gordon, 1996; RWH, 1999).
an implied cost of capital is the same as determin-                        Finally, our cost of capital estimates average close
ing the internal rate of return that equates the                           to 9%, and range between 1.8 and 22.5%.
stock price to the expected future benefits of share                          These estimates of cost of capital appear rea-
ownership. Gebhardt et al. also provide two                                sonable in relation to Canadian T-bill rates during
example calculations to which we refer interested                          our sample period. Our rates, measured with
readers. We perform this estimation using Micro-
soft Excel, and our estimate of the cost of capital                          8
                                                                                During the 1990–1992 periods, quarterly growth in gross
is simply the discount rate that equates the book                          domestic product in Canada was 0.3%, far below the average
value and future forecasted earnings to the current                        of 1.1% experienced during the remainder of the 1990s (Cal-
market price.                                                              culated based on Datastream data).
                   A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616           605

forecasted data as of June 1991 (for 1990 annual                estimates, financial performance and the number
reports), June 1992 and June 1993 average 9.85,                 of analysts following the firm tend to decline
9.5 and 8.0%, respectively. The 1-year T-bill rate              over time for both groups, though the financial
in Canada shows similar declines throughout our                 performance for the sensitive firms rebounded in
sample period. For example, the one-year T-bill                 1992.
rate in June 1991, 1992 and 1993 was 9.11, 6.63
and 5.79%, respectively. In addition, the risk-                 4.2. Validation of the disclosure proxies
premium inherent in our cost of capital estimates
varies between approximately 0.7 and 2.5%, with                    Since the SMAC/UQAM ratings of disclosure
a median of 2.2%. Gebhardt et al. find that                      have not been previously used in academic
risk premiums implied for their sample (including               research, we perform a series of tests that examine
over 10,000 observations from 1979 to 1995                      the relationship between these disclosure ratings
and the same method for estimating the cost                     and several variables that are related to disclosure
of equity capital) vary between À0.7 and 4.9%                   levels in the past literature. Specifically, we follow
with a median of 2.0%. Our cost of capital esti-                Botosan (1997) and Lang and Lundhom (1993)
mates display a similar relationship to the risk-free           and examine the relation between financial dis-
rate.                                                           closure and firm size, financial performance,
   The univariate correlations reveal no unex-                  leverage and analyst following. Past results sug-
pected patterns, and show that there is a strong                gest that a positive relationship should exist
positive relation between social and financial dis-              between each of these variables and financial dis-
closure, as might be expected if both types of dis-             closure. We also examine the relationship between
closure are part of an overall disclosure policy.               social disclosure ratings and firm size, industry
Cost of capital does not have a significant relation             membership, financial performance, leverage,
to either disclosure score. The correlation between             analyst following and the interaction of industry
the disclosure variables and other potential deter-             and firm size. Industry membership is coded to
minants of cost of capital (e.g. market value of                reflect membership in a socially/environmentally
equity, analyst following and industry) makes                   sensitive industry, namely the oil, gas and chemi-
interpretation of these univariate correlations                 cals industry or the mines, metals and forestry
problematic. However, these univariate correla-                 products industry. Since larger firms and firms in
tions do indicate that our main results are sensitive           these industries have their social and environ-
to the inclusion of control variables.                          mental performance closely scrutinized, past
   Table 3 provides selected descriptive informa-               research suggests a positive relation between
tion for firms in the sensitive, (oil, gas and chemi-            industry membership and the interaction of firm
cal or mines, metals and forestry products), versus             size and industry membership with social dis-
non-sensitive industries, and across time for both              closure (e.g. Deegan & Gordon, 1996).
groups. Several empirical regularities are revealed                The relationship between social disclosure and
in this descriptive information. First, firms in the             financial performance has been mixed in the past
sensitive industries have better financial and social            literature (Pava & Kraus, 1996) while the rela-
disclosure scores, are followed by more analysts,               tionship between leverage and analyst following
have inferior financial performance (except 1992),               and social disclosures have not been examined in
and have lower cost of capital estimates than do                the past literature. Since social disclosure may
their counterparts in the non-sensitive industries.             accomplish many of the same objectives as financial
The two groups appear roughly similar in terms of               disclosure, we expect to observe positive relation-
firm size, though the mean firm size is typically                 ships between these variables and social disclosure.
larger for the non-sensitive firms and the median                These tests provide evidence on the validity of our
firm size is larger for the sensitive firms. The firm              disclosure ratings as measures of the cross-sec-
size distribution is much more skewed for the                   tional variation in the level of disclosure provided
non-sensitive sample. Additionally, cost of capital             in Canadian companies’ annual reports.
606                   A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

Table 3
Descriptive information — across sensitive and non-sensitive industries and time

Variable name                 N                 Mean                    Median               Minimum                 Maximum

Sensitive industry—1990
FDISC                         37                  36.14                   34.75                15.5                      56
SDISC                         37                  13.82                   11.25                 1.25                     45.5
MV ($000,000)                 37                2478                    1982                   69.3                  12,543
NANAL                         37                  13.49                   12                    3                        34
ROE (%)                       37                 À1.58                     6.00              À142.07                     26.46
COST (%)                      29                   8.43                    8.12                 1.83                     15.26

Sensitive industry—1991
FDISC                         42                  37.15                   35.25                16.75                     58
SDISC                         42                  15.31                   14.38                 2                        40.5
MV ($000,000)                 42                2840                    1994                   85.3                  11,821
NANAL                         42                  12.12                   10.5                  2                        36
ROE (%)                       42                 À8.67                     1.95              À158.9                      17.54
COST (%)                      31                   7.56                    7.47                 3.52                     14.15

Sensitive industry—1992
FDISC                         43                  34.7                    34.35                14.25                     52.5
SDISC                         43                  13.95                   13.5                  2                        50
MV ($000,000)                 43                2511                    2002                   88.4                  10,554
NANAL                         43                  10.37                   10.0                  1                        30
ROE (%)                       43                 À0.81                     2.66               À38.38                     22.84
COST (%)                      34                   6.72                    6.23                 3.89                     13.73

Non-sensitive industry—1990
FDISC                         63                  31.9                    29                   11.25                     63
SDISC                         63                  10.2                     7                    0.75                     38
MV ($000,000)                 63                4675                    1364                   20.2                  32,179
NANAL                         63                   8.76                    8                    1                        37
ROE (%)                       63                   5.09                    9.98               À97.06                     23.68
COST (%)                      40                  10.84                   10.53                 6.55                     20.34

Non-sensitive industry—1991
FDISC                         71                  29.7                    46.75                 8.7                      59.5
SDISC                         71                   8.62                    7                    0.25                     33.5
MV ($000,000)                 71                4447                    1245                   27.5                  37,839
NANAL                         71                   7.82                    7                    1                        34
ROE (%)                       71                   4.32                    7.63               À77.71                     33.09
COST (%)                      47                  10.06                    9.62                 4.04                     19.74

Non-sensitive industry—1992
FDISC                         68                  29.81                   29.28                 4.75                     63
SDISC                         68                   8.35                    6.38                 1                        43.25
MV ($000,000)                 68                4452                    1393                   66.1                  38,729
NANAL                         68                   6.77                    6.0                  1                        26
ROE (%)                       68                 À1.59                     6.42              À194.0                      31.15
COST (%)                      44                   8.98                    9.1                  3.11                     22.48

Variable definitions: FDISC=financial disclosure score for firm i, year t; SDISC=social disclosure score for firm i, year t; MV=be-
ginning of year market value of common equity for firm i, year t; NANAL=number of analysts making a 1 year ahead EPS forecast
for firm i, year t; ROE=return on equity for firm i, year t; COST=estimated cost of equity capital for firm i, year t.
                        A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                         607

Table 4
Results of estimating Eq. (5) explaining variation in financial disclosure

FDISCit ¼  þ 1 DSIZEit þ 2 ROEit þ 3 LEVit þ 4 DANALit þ "

Variable (pred. sign)                     Coefficient estimate                        t-Statistic                     P-value (two-tailed)

Intercept (?)                             34.113                                    26.323                          0.0001
DSIZE (+)                                  6.895                                     5.481                          0.0001
ROE (+)                                    0.032                                     1.277                          0.2026
LEV (+)                                    0.014                                     2.535                          0.0117
DANAL (+)                                  8.505                                     6.776                          0.0001

No. of observations=324; adjusted R2=32.7%. Variable definitions: FDISC=financial disclosure score for firm i, year t; DSIZE=a
dummy variable equal to one if the beginning of year market value of equity for firm i, year t is above the sample median, zero
otherwise; ROE=return on equity for firm i, year t; LEV=debt to equity ratio, firm i, year t; DANAL=a dummy variable equal to 1
if the number of analysts providing a 1-year ahead earnings forecast for firm i, year t is above the sample median, zero otherwise.




  Additionally, we note that our ratings are based                     where FDISC=financial disclosure score for firm
only on the disclosures contained in annual                            i, year t, DSIZE=a dummy variable equal to one
reports and do not necessarily reflect the level of                     if the beginning of year market value of equity for
disclosures made through other media (c.f. Zeghal                      firm i, year t is above the sample median, zero
& Ahmed, 1990). While this is an acknowledged                          otherwise, ROE=return on equity for firm i, year
limitation of our proxy for disclosure, Botosan                        t, LEV=debt to equity ratio, firm i, year t,
(1997) shares this limitation. We also note that                       DANAL=a dummy variable equal to 1 if the
Lang and Lundholm (1993) and Welker (1995)                             number of analysts providing a 1-year ahead
examine the AIMR ratings for US companies and                          earnings forecast for firm i, year t is above the
report a high degree of correlation between dis-                       sample median, zero otherwise.
closure ratings based on the annual report and                            The results of estimating Eq. (5) are reported in
ratings based on other disclosure media. This                          Table 4.9 Consistent with the past literature, each
finding provides evidence of convergent validity of                     of the variables in the equation except ROE exhi-
annual report disclosure measures and disclosures                      bits a significant and positive relation with finan-
occurring in other media as well.                                      cial disclosure. The adjusted R2 of the regression is
                                                                       over 30%, indicating that the explanatory vari-
4.3. Relation of financial disclosure scores with size,                 ables are able to explain a reasonable portion of
financial performance, leverage and analyst following                   the cross-sectional variation in financial disclosure
                                                                       scores. The fact that our financial disclosure scores
  Past research has demonstrated that financial                         are strongly related to variables which the past
disclosure increases with firm size, financial per-                      literature suggests explain financial disclosure
formance, leverage, and the number of analysts fol-                    increases our confidence that variation in our dis-
lowing the firm. One way to validate our empirical                      closure measure captures the underlying phenom-
proxy for financial disclosure is to examine these                      enon of interest, variation in financial disclosure.
relationships based on our proxy. Accordingly, we
estimate the following empirical equation:
                                                                          9
                                                                            Our tabulated results provide two-tailed P-values. By
FDISCit ¼  þ 1 DSIZEit þ 2 ROEit                                    convention, we describe an estimated coefficient as statistically
                                                                       significant if the coefficient is significant at the 0.05 level in a
                                                                       one-tailed test if we predict the sign of the coefficient and a two-
                þ 3 LEVit þ 4 DANALit þ "                 ð5Þ        tailed test if we do not predict the sign of the coefficient.
608                     A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

Table 5
Results of estimating Eq. (6) explaining variation in social disclosure
SDISCit ¼ 
 þ ’1 DSIZEit þ ’2 ROEit þ ’3 INDit þ ’4 ðINDit  SIZEit Þ þ ’5 DANALit þ ’6 LEVIT þ it ð6Þ

Variable (pred. sign)                      Coefficient estimate                       t-Statistic                P-value (two-tailed)

Intercept (?)                              5.097                                    6.315                      0.0001
DSIZE (+)                                  3.507                                    3.021                      0.0027
ROE (?)                                    0.021                                    1.092                      0.2757
IND (+)                                    2.465                                    1.957                      0.0513
INDÂSIZE (+)                               2.958                                    1.713                      0.0876
DANAL (+)                                  3.931                                    3.918                      0.0001
LEV (+)                                    0.011                                    2.596                      0.0099

No. of observations=324; adjusted R2=26.8%. Variable definitions: SDISC=social disclosure score for firm i, year t; DSIZE=a
dummy variable equal to one if the beginning of year market value of equity for firm i, year t is above the sample median, zero
otherwise; ROE=return on equity for firm i, year t; LEV=debt to equity ratio, firm i, year t; DANAL=a dummy variable equal to 1
if the number of analysts providing a 1-year ahead earnings forecast for firm i, year t is above the sample median, zero otherwise;
IND=a dummy variable equal to one if firm i is a member of the Oil, Gas and Chemicals or Mine, Metals and Forestry Products
industry sectors in year t, zero otherwise.


4.4. The relationship of social disclosure scores                         or Mine, Metals and Forestry Products industry
with firm size, industry membership, financial                              sectors in year t, zero otherwise
performance, leverage and analyst following                                  All other variables are as previously defined.
                                                                             The results of estimating Eq. (6) are presented in
  Patten (1991) documents that social disclosure is                       Table 5. Again, the results are encouraging as our
increasing in firm size and is greater in highly                           measure of social disclosure appears to be related to
visible and politically sensitive industries. Deegan                      variables that the past literature suggests it should
and Gordon (1996) find an interaction effect                                be. Size, industry, and the interaction of industry and
between firm size and industry, such that the size                         size are all significantly related to social disclosure,
effect is particularly pronounced in sensitive                             as suggested by the past literature. Analyst following
industries. As Richardson et al. (1999) discuss,                          is also statistically positively related to social dis-
results of tests of the relation between social per-                      closure, consistent with our conjectures that similar
formance/disclosure and financial performance                              factors may influence financial and social dis-
have been mixed. Leverage and number of ana-                              closure. ROE is not statistically related to social
lysts following the firm have not been included in                         disclosure, in keeping with the insignificant or mixed
past studies of social disclosure. We include these                       relation documented in the past literature. Lever-
variables in our regression since they are related to                     age is also positively related to social disclosure,
financial disclosure. Social disclosure accomplishes                       again consistent with our conjectures that social and
similar objectives and may have similar deter-                            financial disclosures have similar determinants.
minants. We examine the relation between the                                 We conclude, based on the evidence discussed
SMAC/UQAM social disclosure ratings and these                             earlier, that the financial and social disclosure
variables by estimating the following equation:                           scores are valid measures of those disclosures by
                                                                          the firms in our sample. We now turn to the sub-
SDISCit ¼ 
 þ ’1 DSIZEit þ ’2 ROEit þ ’3 INDit                            stantive issue of the relationship between dis-
þ ’4 ðINDit  SIZEit Þ þ ’5 DANALit þ                                     closure and the cost of capital.
’6 LEVit þ it                                               ð6Þ
                                                                          Empirical tests of the relation between disclosure
                                                                          and the cost of equity capital
where SDISC=social disclosure score for firm i,
year t, IND=a dummy variable equal to one if                                Our tests of the relations between financial and
firm i is a member of the Oil, Gas and Chemicals                           social disclosure and the cost of equity capital are
                        A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                         609

based on the work of Botosan (1997) and Geb-                          COSTit ¼ 
 þ 1 NANALit þ                  2 LEVit
hardt et al. (2000). Similar to Botosan, we attempt                   þ 3 FDISCit þ 4 SDISCit
to document a negative relation between financial
                                                                      þ     5 ðLANALit  FDISCit Þþ
and social disclosure and the cost of equity capital
that is incremental to the effects of other variables                    6 ðLANALit  SDISCit Þ þ it                                 ð8Þ
known to influence cost of capital. Gebhardt et al.
find that the risk premia is negatively related to                     where COST is the cost of equity capital estimated
the number of analysts following the firm and                          by Eq. (4); NANAL is the number of analysts
positively related to leverage. Accordingly, our                      making 1-year ahead earnings forecast; LANAL is
empirical tests include these variables as control                    a dummy variable set equal to one if the number
variables.10 In addition, Botosan documents that                      of analysts following firm i in year t is below i’s
disclosure and analyst following has an interactive                   industry sector median for year t, zero otherwise.
effect on cost of capital. She finds that disclosure                    All other variables are as previously defined and all
reduces cost of capital only for those firms with                      variables are adjusted for industry sector medians.
low analyst following. We also estimate an equa-                         Gebhardt et al. (2000) document considerable
tion that allows for this potential interactive effect                 variation in their risk premia estimates across
and an interaction between analyst following and                      industries. Our results (documented in Tables 3
social disclosure as well. Specifically, our primary                   and 5) and the results of previous research
empirical tests come from the estimation of the                       demonstrate that disclosure practices also vary
following two equations:                                              across industries as well. Accordingly, all variables
                                                                      utilized in estimating Eqs. (7) and (8) are adjusted
COSTit ¼ 
 þ         1 NANALit      þ     2 LEVit
                                                                      for industry sector (as defined in the SMAC/
                                                                      UQAM disclosure ratings) year medians. This
             þ     3 FDISCit    þ    4 SDISC it   þ it        ð7Þ
                                                                      removes both industry and time effects from the
                                                                      data, avoiding potentially spurious associations.
                                                                      Since all variables in this specification are industry
                                                                      adjusted, firm size and analyst following directly
                                                                      enter the regressions without the conversion to
                                                                      dummy variables performed in earlier tests. We
  10
      Other potential risk proxies such as market beta, market
                                                                      exclude observations in the top and bottom 1% of
value of equity and book to market ratios could also be con-
trolled for in the empirical analysis. We omit beta from the
                                                                      the empirical distribution of cost of capital (i.e.
analysis because Gebhardt et al. document that they are statis-       two observations from each tail of the distribu-
tically unrelated to our measure of the cost of equity capital        tion) to ensure our results are not unduly affected
except in certain multivariate tests. We include size and book to     by extreme observations.11
market ratios in all our equations explaining the cost of capital        In accordance with our hypotheses outlined
and find that these variables have the correct sign but are sta-
tistically unrelated to our industry adjusted cost of capital esti-   earlier, we expect C1, C3, C4 and C5 to be nega-
mates. Gebhardt et al. also find that the dispersion in analysts’      tive and C2 to be positive. As discussed in H3a(ii),
earnings forecasts is significantly related to the cost of capital.    we expect C6 to be statistically insignificant.
We choose not to include this variable in our analysis for three         For comparative purposes, the results of esti-
reasons. First, the dispersion in analysts’ forecasts would pre-      mating Eqs. (5) and (6), explaining financial and
sumably be a function of the disclosure variables we include in
our analysis, so the inclusion of this variable would amount to       social disclosure, respectively, using the industry-
the inclusion of an alternative disclosure measure and could          adjusted data, are reported in Tables 6 and 7.
hamper our ability to observe a relation between more direct          Of course, the industry membership variables
disclosure measures and the cost of capital. Second, including a
measure of analysts’ forecast dispersion would reduce our
                                                                        11
sample size because a measure of dispersion requires that the              Our conclusions are not affected by excluding these obser-
firm be followed by multiple analysts Third, the dispersion in         vations. In general, there is a slight increase in statistical sig-
analysts’ forecasts is related to the number of analysts follow-      nificance when the observations are dropped, suggesting these
ing the firm, which we include for consistency with Botosan.           observations contain measurement error.
610                     A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

Table 6
Results of estimating Eq. (5) explaining variation in financial disclosure—industry adjusted data

FDISCit ¼  þ 1 SIZEit þ 2 ROEit þ 3 LEVit þ 4 NANALit þ " ð5Þ

Variable (pred. sign)                         Coefficient estimate                       t-Statistic               P-value (two-tailed)

Intercept (?)                                 À0.276                                   À0.524                    0.6005
SIZE (+)                                       0.001                                    5.467                    0.0001
ROE (+)                                        0.015                                    0.605                    0.5458
LEV (+)                                        0.007                                    1.472                    0.1420
NANAL (+)                                      0.508                                    5.291                    0.0001

No. of observations=324; adjusted R2=23.8%. Variable definitions: FDISC=financial disclosure score for firm i, year t—the industry
sector median for year t; SIZE=beginning of year market value of equity for firm i, year t—the industry sector median for year t;
ROE=return on equity for firm i, year t—the industry sector median for year t; LEV=debt to equity ratio, firm i, year t—the industry
sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for firm i, year t—the industry
sector median for year t.


Table 7
Results of estimating Eq. (6) explaining variation in social disclosure—industry adjusted data

SDISCit ¼ 
 þ ’1 SIZEit þ ’2 ROEit þ ’5 NANALit þ ’6 LEVit þ it ð6Þ

Variable (pred. sign)                         Coefficient estimate                       t-Statistic               P-value (two-tailed)

Intercept (?)                                 1.148                                    2.682                     0.0077
SIZE (+)                                      0.002                                    3.472                     0.0006
ROE (?)                                       0.033                                    1.687                     0.0936
NANAL (+)                                     0.172                                    2.196                     0.0461
LEV (+)                                       0.009                                    2.003                     0.0288

No. of observations=324; adjusted R2=8.4%. Variable definitions: SDISC=social disclosure score for firm i, year t—the industry
sector median for year t; SIZE=beginning of year market value of equity for firm i, year t—the industry sector median for year t;
ROE=return on equity for firm i, year t—the industry sector median for year t; LEV=debt to equity ratio, firm i, year t—the industry
sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for firm i, year t—the industry
sector median for year t.



Table 8
Results of estimating Eq. (7) explaining variation in cost of capital estimates—industry adjusted data

COSTit ¼ 
 þ    1 NANALit   þ   2 LEVit   þ    3 FDISCit   þ   4 SDISCit   þ it ð7Þ

Variable (pred. sign)                         Coefficient estimate                       t-Statistic               P-value (two-tailed)

Intercept (?)                                  0.00394                                  2.244                    0.0258
NANAL (À)                                     À0.00101                                 À3.459                    0.0007
LEV (+)                                        0.00002                                  1.584                    0.1147
FDISC (À)                                     À0.00040                                 À1.961                    0.0512
SDISC (À)                                      0.00064                                  2.354                    0.0195

No. of observations=221; adjusted R2=9.9%. Variable definitions: COST=estimated cost of equity capital for firm i, year t—the
industry sector median for year t; NANAL=number of analysts providing a one-year ahead earnings forecast for firm i, year t—the
industry sector median for year t; LEV=debt to equity ratio, firm i, year t—the industry sector median for year t; FDISC=financial
disclosure score for firm i, year t—the industry sector median for year t; SDISC=social disclosure score for firm i, year t—the industry
sector median for year t.
                        A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                      611

Table 9
Results of estimating Eq. (8) explaining variation in cost of capital estimates—industry adjusted data

                                 COSTit ¼ 
 þ     1 NANALit     þ   2 LEVit   þ    3 FDISCit   þ   4 SDISCit þ

                                   5 ðLANALit   Â FDISCit Þ þ   6 ðLANALit        Â SDISCit Þ þ it ð8Þ

Variable (pred. sign)                      Coefficient estimate                              t-Statistic           P-value (two-tailed)

Intercept (?)                               0.00094                                         0.474                0.6362
NANAL (À)                                  À0.00095                                        À3.258                0.0013
LEV (+)                                     0.00002                                         1.478                0.1408
FDISC (À)                                  À0.00004                                        À0.169                0.8663
SDISC (À)                                   0.00078                                         2.517                0.0126
LANAL*FDISC (À)                            À0.00098                                        À2.289                0.0231
LANAL*SDISC (?)                            À0.00036                                        À0.567                0.5715

No. of observations=221; adjusted R2=12.98%. Variable definitions: COST=estimated cost of equity capital for firm i, year t—the
industry sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for firm i, year t—the
industry sector median for year t; LEV=debt to equity ratio, firm i, year t—the industry sector median for year t; FDISC=financial
disclosure score for firm i, year t—the industry sector median for year t; SDISC=social disclosure score for firm i, year t—the industry
sector median for year t; LANAL=a dummy variable set equal to one if the number of analysts following firm i in year t is below i’s
industry sector median for year t, zero otherwise.




originally included in Eq. (6) explaining social                         number of analysts following the firm has a sta-
disclosure are omitted from this specification                            tistically reliable effect on cost of capital, with
which already includes industry adjustment. As                           higher analyst coverage resulting in a lower cost of
the results in Table 6 show, the results of estimat-                     capital. Financial leverage is positively associated
ing Eq. (5), which explains financial disclosure                          with the cost of equity capital, but this effect is not
variation, using the industry adjusted data, are                         significant at conventional levels. Financial dis-
very similar to our earlier results. The only differ-                     closure is negatively related to cost of capital,
ence is that the significance of leverage is dimin-                       consistent with our predictions. This result is
ished such that it is no longer a significant                             stronger than the full sample result in Botosan,
explanatory variable at conventional levels. As                          perhaps suggesting that financial disclosure plays
Table 7 reveals, the R2 of the regression explaining                     a more important role for Canadian firms. Sur-
social disclosure falls dramatically (from 27 to                         prisingly, social disclosure exhibits a statistically
8%) when industry adjusted data are used and                             reliable positive association with the cost of equity
industry related variables are excluded from the                         capital. For our sample firms and our time period,
regression. However, the explanatory power of the                        enhanced social disclosure results in a higher cost
remaining variables is very similar to that reported                     of capital.
in our earlier results.                                                     Table 9 reports the results of estimating the
  The results of estimating Eqs. (7) and (8) are                         expanded Eq. (8). This specification includes
reported in Tables 8 and 9, respectively.12 The                          interaction terms intended to determine if analyst
                                                                         following modifies the relation between our dis-
                                                                         closure variables and the cost of capital. Con-
                                                                         sistent with Botosan’s (1997) results, we find that
  12
     Recall that the sample sizes reflected in Tables 8, 9, and 10        firms with low analyst following receive benefits
are 221, not the 324 reflected in earlier tables. This reflects the
                                                                         from expanded financial disclosure in the form of
additional data requirements to estimate the cost of capital
(analysts’ forecasts and industry ROE) and the deletion of               a reduction in the cost of equity capital. The
observations with cost of capital below the 1st percentile or            interaction of analyst following and social dis-
above the 99th percentile of the empirical distribution.                 closure is not statistically significant.
612                A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

4.5. Specification checks and further analysis                   where ROE is equal to the return on equity for
                                                                firm i, year t—the industry sector median for year
   White’s test for heteroskedasticity/model speci-             t, DROE is a dummy variable set equal to one if
fication fails to reject the null hypothesis of                  firm i, year t return on equity is above the industry
homoskedasticity for all regressions. In addition,              sector median for year t, zero otherwise, and all
the highest condition index reported in any of our              other variables are as previously defined.
regressions is 3.6, suggesting that multicollinearity              In keeping with the above discussion, we expect
is not affecting our results.                                    C6 to be negative and make no predictions about
   One potential problem with our data is that                  C7.13 The results of estimating Eq. (9) are pro-
each firm contributes up to three observations to                vided in Table 10. Consistent with our conjectures,
the estimation, and these observations may not be               the coefficient on the social disclosure/financial
independent. Accordingly, we estimate Eqs. (7)                  performance interaction, is reliably negative. This
and (8) on a year-by-year basis rather than on the              coefficient is almost exactly equal in absolute
pooled sample. The results (not reported) are very              magnitude (À0.00109) to the coefficient on social
similar to those reported for the full sample. All              disclosure (0.00116). This indicates that there is
variables that are significant in our pooled regres-             essentially no relation between social disclosure
sions have consistent signs for each of the 3 years,            and the cost of capital for firms with above aver-
and are significant in at least one, often two, of the           age return on equity, but a significant increase
yearly regressions. This suggests that our results              in the cost of capital accompanying better social
are not due to our pooling of sample data.                      disclosure for below average return on equity
   We explore further our finding that social dis-               firms.14
closure increases the cost of capital. We conjecture
that this result may be related to the poor eco-                4.6. Sensitivity of results to cost of capital
nomic conditions that characterize our sample                   estimation assumptions
period. While we do not have data available from
another, more prosperous time period, we conduct                  We perform several alternative calculations of
an alternative test to assess this explanation for              the cost of capital by varying the assumptions
our results. If the relationship between social dis-            underlying that calculation. The primary results
closure and the cost of capital is mediated by eco-
nomic conditions, then we expect that, within our                 13
                                                                      Since this analysis is conducted in light of our earlier
sample, firms with above average financial perfor-                empirical results, we conduct two-tailed tests of statistical sig-
mance would not experience an increase in the                   nificance for this estimation.
cost of capital as social disclosure increases, while              14
                                                                      The distribution of ROE reveals the existence of some
those firms with below average financial perfor-                  extreme negative values. There are no negative book value
                                                                observations in our sample, so these observations are not
mance would. We test this conjecture by estimat-
                                                                caused by small negative denonimators. Since our ROE and
ing Eq. (9), which replaces the insignificant social             social disclosure interaction is based on a dummy variable for
disclosure/analyst following interaction from Eq.               ROE, this interaction term should not be impacted by these
(8) with a social disclosure/return on equity inter-            observations. However, it is possible that the estimated coeffi-
action. For completeness, we also include return                cient for the main effect of ROE is impacted by these observa-
                                                                tions, and that this affects the estimated coefficient on the
on equity in the equation to test for a direct
                                                                interaction term. We conducted two additional tests to ensure
impact of financial performance on the cost of                   that our results are not sensitive to extreme observations of
equity capital:                                                 ROE. We repeated the estimation of Eq. (9) after (1) eliminat-
                                                                ing all observations with ROE less than À25% (the 5th percn-
                                                                tile of the empirical distribution), and (2) retaining all
COSTit ¼ 
 þ     1 NANALit    þ    2 LEVit þ
                                                                observations but replacing the continuous version of ROE with
         þ 4 SDISCit þ
 3 FDISCit                                                      the dummy variable (DROE) to test for the main effect of
                                                                ROE. Neither change in specification qualitatively alters our
 5 ðLANALit  FDISCit Þþ
                                                                results. In particular, C6 remains significantly negative and C7
 6 ðDROEit   Â SDISCit Þ þ    7 ROEit   þ it         ð9Þ       remains insignificantly different from zero in both tests.
                        A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                          613

Table 10
Results of estimating Eq. (9) explaining variation in cost of capital estimates—industry adjusted data

                               COSTit ¼ 
 þ     1 NANALit     þ   2 LEVit   þ   3 FDISCit   þ    4 SDISCit þ

                                 5 ðLANALit   Â FDISCit Þ þ   6 ðDROEit     Â SDISCit Þ þ       7 ROEit   þ it ð9Þ

Variable (pred. Sign)                     Coefficient estimate                            t-Statistic                   P-value (two-tailed)

Intercept (?)                              0.00130                                       0.667                        0.5058
NANAL (À)                                 À0.00091                                      À3.221                        0.0015
LEV (+)                                    0.00003                                       1.863                        0.0639
FDISC (À)                                 À0.00007                                      À0.284                        0.7771
SDISC (À)                                  0.00116                                       3.462                        0.0006
LANALÂFDISC (À)                           À0.00096                                      À2.663                        0.0083
DROEÂSDISC (À)                            À0.00109                                      À2.469                        0.0143
ROE (?)                                    0.00009                                       1.101                        0.2719

No. of observations=221; adjusted R2=15.58%. Variable definitions: COST=estimated cost of equity capital for firm i, year t—the
industry sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for firm i, year t—the
industry sector median for year t; LEV=debt to equity ratio, firm i, year t—the industry sector median for year t; FDISC=financial
disclosure score for firm i, year t—the industry sector median for year t; SDISC=social disclosure score for firm i, year t—the industry
sector median for year t; ROE=return on equity for firm i, year t—the industry sector median for year t; LANAL=a dummy variable
set equal to one if the number of analysts following firm i in year t is below i’s industry sector median for year t, zero otherwise;
DROE=a dummy variable set equal to one if return on equity for firm i, year t is above the industry sector median for year t, zero
otherwise.




reported above are based on the assumption that                             relationship between the level of financial dis-
the ROE of each firm fades to its historical indus-                          closure and the cost of capital (H1, see Table 8).
try average ROE in a linear fashion between                                 We also confirm Botosan’s (1997) finding that
years +4 and +12. We check for the sensitivity                              higher levels of financial disclosure can reduce the
of our results to this assumption by performing                             cost of capital in cases where there is low financial
two new calculations, one in which the linear fade                          analyst following [H3a(i), see Table 9]. Our
occurs between periods +4 and +6, and one in                                results, however, suggest that this relation does
which the fade occurs between +4 and +18. Our                               not hold for social disclosures. There is a statisti-
primary empirical results are not sensitive to these                        cally significant, positive relation between the level
changes in specification. The statistical sig-                               of social disclosure and the cost of capital, that is,
nificance of most explanatory variables, including                           more social disclosure raises the cost of capital for
the disclosure variables of primary interest,                               the firm (H2, see Table 8). The number of analysts
increase with the length of the linear fade period,                         following the firm does not affect this result
perhaps suggesting that the cost of capital esti-                           [H3a(ii), see Table 9]. The positive relationship
mates contain less noise as the linear fade period is                       between cost of capital and social disclosure is
increased.                                                                  moderated by the return-on-equity of the firm
                                                                            with more successful firms being less penalized for
                                                                            social disclosures.
5. Conclusions and suggestions for future research                             It is important to recognize that these results are
                                                                            not based on the content of the disclosures. The
  This study provides further evidence on the the-                          disclosure scores reflect the completeness and
oretical and regulatory premise that improved                               informativeness of financial and social disclosures
corporate disclosure results in a lower cost of                             but they do not indicate whether the information
capital. We find that there is a significant negative                         is good or bad news. There are several possible
614                 A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616

explanations for the results on the relationship                 may be limited to periods of economic downturn.
between social disclosure and cost of capital. First,            Future research that expands the data set over a
if there were a consistent bias in social disclosures            complete business cycle to test for this effect is
where firms that experience higher than average                   clearly called for by our results.
social costs disclose more information, then, on                    The effect of social disclosure on the cost of
average, the results reported could hold. The                    equity capital documented in this study should not
descriptive literature on social disclosures has                 be taken to imply that social disclosure has an
reported that there are severe biases in reporting               overall negative effect on the firm. Social and
(e.g. Guthrie & Parker, 1990; Wiseman, 1982).                    environmental issues have significant distribu-
The reported bias is that firms tend to use social                tional effects. Although investors may require a
disclosures for self-promotion. This means that                  higher cost of capital for firms with a significant
that firms tend to report the positive social con-                social agenda, other groups such as employees,
tributions that they make but under-report nega-                 customers, regulators and supply-chain partners
tive social effects. Unfortunately, the relationship              may provide greater support to the firm because of
between this bias and the costs incurred and ben-                these actions. Much of the work on developing a
efits received by the firm is unclear (Richardson et               social accounting agenda has, in fact, been pre-
al., 1999).                                                      mised on the assumption that corporate social
   Second, the results could hold if two things are              disclosure will benefit a broader community of
true. It may be that social responsibility invest-               stakeholders than the capital providers that are
ments by firms are consistently negative present                  the primary audience for financial disclosures (e.g.
value projects increasing the overall risk of the                Gray, 2000). The effect of social disclosures on the
firm. While proponents of socially responsible                    expected cost of contributions to the firm from
corporate behavior point to the potential cost                   other stakeholders has still to be examined.
savings and long-term strategic advantage of such
behavior (e.g. Porter & van der Linde 1995; Scal-
tegger & Figge, 1998), the market may hold a dif-                Acknowledgements
ferent view. If this is the case and there is a positive
correlation between social disclosures and social                   The authors gratefully acknowledge the finan-
responsibility actions, then the observed results                cial support of the Certified General Accountants
could hold.                                                      of Canada Research Foundation and comments
   It is also possible that the results are specific to           on earlier drafts by Irene Gordon, Marc Epstein
the data used in this analysis. The time period for              and an anonymous reviewer. The authors also
which data were available was an economic reces-                 gratefully acknowledge the contribution of I/B/E/
sion. The positive link between social disclosure                S International Inc. for providing earnings per
and the cost of equity capital we document may be                share forecast data, available through the Institu-
contingent on these macro economic conditions.                   tional Brokers Estimate System. These data have
This interpretation is supported by our result that              been provided as part of a broad academic pro-
the effect of social disclosure on the cost of capital            gram to encourage earnings expectations
is moderated by return on equity (see Table 10).                 research.
For firms with ROE above the industry median,
there is a negative interaction between social dis-
closure and return on equity that offsets the main                Appendix A
effect between cost of capital and social disclosure.
In other words, for firms with above average finan-                   Panel 1: Social disclosure categories of informa-
cial performance, social disclosure may have no                  tion, maximum number of points allocated to the
effect on the cost of capital. If this is a reasonable            category, and number of sub-categories allocated
proxy for economic conditions, then the relation-                to each category—information provided in the
ship between social disclosure and cost of capital               1991 SMAC/UQAM Report:
                                                                                                     (continued on next page)
                      A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597–616                     615

                                                                   Other notes to                      7             13
Category of                Maximum            No. of sub-          financial statements
information                points             categories           Pension plans                       3             37
Human resources              18                 29                 and leases
Products, services,          10                 23                 Government aid                      3               8
and consumers                                                      and income tax
Community                   18                 24                  Exports and portion                 3               8
Environment                 18                 22                  of products
Energy resources             6                 10                  manufactured in Canada
Governments                 10                 14                  Information on effects               3               8
Suppliers                    6                 16                  of price fluctuations
Shareholders                 6                  9                  Special notes on total              6               2
Competitors                  4                  9                  quality, environment,
Miscellaneous                4                 14                  training, and technology
Totals                     100                170                  Miscellaneous                       6               3

                                                                   Totals                           120             261
  Panel 2: Financial disclosure categories of
information, maximum number of points allo-
cated to the category, and number of sub-cate-
gories allocated to each category—information
provided in the 1991 SMAC/UQAM Report.                             References

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