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The Economic Consequences of Increased Disclosure : Christian Leuz & Robert Verrecchia(2000)

The Economic Consequences of Increased Disclosure : Christian Leuz & Robert Verrecchia(2000). Presentation by Jangwon Suh. The Theory. The way from low level of disclosure to higher costs of capital Information asymmetry Adverse selection reduced level of liquidity for firm share

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The Economic Consequences of Increased Disclosure : Christian Leuz & Robert Verrecchia(2000)

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  1. The Economic Consequences of Increased Disclosure :Christian Leuz & Robert Verrecchia(2000) Presentation by Jangwon Suh

  2. The Theory • The way from low level of disclosure to higher costs of capital • Information asymmetry • Adverse selection • reduced level of liquidity for firm share • Issuing discounted capital to overcome the reluctance of potential investors → What is “the increased levels” of disclosure? “ The only requirement is that the information asymmetries manifest themselves as a liquidity premium in the price at which trades are executed ”

  3. Previous Studies • Previous studies deals with such as… • Disclosure index and the cost of capital only with low analyst rating firms(Botosan 1997) • Analyst rating on disclosure and the cost of capital(Welker 1995, Sengupta 1998) • Cost of capital only for voluntary disclosures, not a commitment to disclose (Healy, Hutton and Palepu 1999) • international data with insignificant results • Some that investigates disclosure and information asymmetry around equity offerings, and others that examines the behavior of trading volume and bid-ask spread: “Our focus is on the long-term effects of disclosure on information asymmetry and liquidity”

  4. Research Question • A commitment to increased levels of disclosure versus the costs of capital, with German data in switching period from German GAAP to the international reporting practices • Why the German Cases? → “There is empirical support that US GAAP improves measurement and produces accounting numbers that have higher information content and are more value-relevant and timelier than German GAAP”, from Alford et al(1998), and the like

  5. Research Design-Problems • (Problem 1)The cost of capital cannot be observed directly • (Problem 2)The result of a commitment to more disclosure is consisted of two components: the effect of “news” and the effect of “information asymmetry” reduction • (Problem 3)Self-selection bias

  6. Research Design-ProblemsProblem 1: The cost of capital cannot be observed directly • (The Solution for the Problem 1)The proxies for the cost of capital arethebid-ask spread, trading volume, and share price volatility, as established in theories. • The bid-ask spread addresses the adverse selection problem in the presence of information asymmetry. • Trading volume is a measure of liquidity inversely related to the existence of information asymmetry, although not exclusively. • Less volatility suggests the absence of information asymmetry, although not exclusively. • (Hypothesis)“A switch to an international reporting regime leads to a lower bid-ask spread, more trading volume, and less share price volatility”

  7. Research Design-ProblemsProblem 2: The confusion between “news” and “information asymmetry” • (The Solution for the problem 2)Assessing the impact of international reporting: by cross-sectional design and by event study • Cross-sectional design: Less prone to confusion between the “news” and “information asymmetry”. • “News” effect: occurs around the switch, and reveals by a change in expectation on future performance • “Information asymmetry” : long-lasting, and reveals a reduction in cost of capital → Examine long-term data, deal with cost of capital, and control other variables! • Event study: observes the proxies around the switch, and so mitigates the noise by other unobserved variables that are not included in cross-sectional model

  8. Research Design-ProblemsProblem 3: Self-selection bias • (The Solution for the problem 3)Firms consider the expected change in information asymmetry and their cost of capital when making the reporting decision. To measure the “treatment effect”, follow the equations below. (Disclosure Model) (Cost of Capital Model) Where d* : the firm’s unobserved net benefit d : reporting choice, =1 if d*>0 and =0 otherwise. z : variables determining the firm’s reporting strategy x : exogenous variables using means of truncated normal distribution.

  9. Cross-Sectional AnalysisData Used and Descriptive Analysis • (Data)102 firms on DAX100 in 1998, of which 21 firms are following the international reporting strategy • (Descriptive Analysis)Except the volatility, other dependent variables show significant difference between the firms with international reporting and those with German GAAP → self-selection problem?

  10. Cross-Sectional AnalysisDisclosure Model • (Independent variables)The market value of equity, capital intensity(LTA/TA), ROA, free float and a dummy for the listing in US or UK • (Probit Regression)All variables have expected signs are significant except the variable size and free float. • Excluding listing variable, since its high correlation with the firm size, the coefficient for size was significant, although the one for free float was not good yet.

  11. Cross-Sectional AnalysisCost of Capital Model – Bid-ask spread • (Independent variables)The market value of the firm’s equity, average daily share turnover, the standard deviation of daily returns, and free float as an inverse proxy for the presence of insiders • (Two-stage Regression)0.805 adjusted R-square with negative and significant international reporting coefficient → average reduction in the bid-ask spread of more than 35%

  12. Cross-Sectional AnalysisCost of Capital Model – Trading Volume • (Independent variables)Market value of the firm’s equity, standard deviation of daily returns, free float as a proxy for the concentration of ownership • (Two-stage Regression)0.343 adjusted R-square with positive and significant international reporting coefficient → turnover increase of 0.00447 above the German GAAP firms, which is more than 50% of sample average 0.00739 in descriptive analysis

  13. Cross-Sectional AnalysisCost of Capital Model – Other Subjects • (Share Price Volatility)Using independent variables with firm size, free float, and beta factor the international reporting dummy has a positive coefficient, with significant level 10% • (IAS versus US GAAP)Not significantly different and similar in size → What matters is the commitment, not the standard

  14. Cross-Sectional AnalysisCost of Capital Model–Robustness Check • (International Reporting Strategy and Investor Relation)A dummy variable that is one when analysts favor: insignificant • (Relative Spread)A problem may arise from the nontrivial minimum tick. With average of the period, the results are significant dummy and similar other results with the previous one • (Voluntary Disclosure)Replacing the dummy with the rates year 1997 annual reports out of 300 points: insignificant in 10% significant level • (Association between Spread and Volume)A concern that turnover was treated as exogenous in the bid-spread model. But the result was consistent with the previous model.

  15. Event StudySpread Ratio • (Spread Ratio) Spread ratio = (ave % spread after the publication)/(ave % spread before the publication) • (Data)Of DAX100 firms, 5 firms that switched at 12/31/97, and 10 firms that switched at 12/31/98 • (Result)Around 0.8, which is significantly different from one using a t-test and Wilcoxon test. • (Robustness Check)Index-adjusted test, Announcement effect adjustment. All results show lower estimates compared to the previous one. And the stock returns are negative in the event window.

  16. Event StudyTrading Volume and Volatility • (Turnover Ratio) Turnover ratio = (1 year average value in post-event period)/(1 year average value in the pre-event period) • (Data)15 firms that switched before the year end of 1997, out of DAX100 firms. Also for control sample was selected considering the market capitalization. • (Result)13.8% increase of median after market adjustment, 18.2% increase after control-firm adjustment, and 29.3% increase after market and non audit-firm adjustment, which are significantly different from one using Wilcoxon test. • (Robustness Check)Listing effect is removed since NYSE listing is outside event window. LSE and OTC trading volume increase was substantial, although the market is too small to have a significant effect. • (Volatility)The switch is not responsible for the decrease in volatility

  17. Question to this paper • Is there no need to investigate for collinearity in cost of capital Model? • The result is, what matters is the “commitment”, not individual “information”. What is the implication of it? Is there no need for some behavioral study? • There is no explanation that how trading volume and volatility are related the cost of capital. It may be the reason why those variables do not work well. • Why the period for spread is different from those for volume and volatility?

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