#06-20
Accounting Information, Disclosure, and the Cost of Capital
Richard Lambert, Christian Leuz, and Robert E. Verrecchia, August 2006
Abstract: In this paper we examine whether and how accounting information about a firm manifests in its
cost of capital, despite the forces of diversification. We build a model that is consistent with the
CAPM and explicitly allows for multiple securities whose cash flows are correlated. We
demonstrate that the quality of accounting information can influence the cost of capital, both
directly and indirectly. The direct effect occurs because higher quality disclosures affect the
firm’s assessed covariances with other firms’ cash flows, which is non-diversifiable. The indirect
effect occurs because higher quality disclosures affect a firm’s real decisions, which likely
changes the firm’s ratio of the expected future cash flows to the covariance of these cash flows
with the sum of all the cash flows in the market. We show that this effect can go in either
direction, but also derive conditions under which an increase in information quality leads to an
unambiguous decline the cost of capital.
Keywords: Cost of capital, Disclosure, Information risk, Asset pricing
JEL classifications : G12, G14, G31, M41
