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Accounting, Organizations and Society 26 (2001) 597616

www.elsevier.com/locate/aos

Social disclosure, nancial disclosure


and the cost of equity capital
Alan J. Richardson*, Michael Welker
School of Business, Queens University, Kingston, Canada K7L 3N6

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

Regulators have argued that equity markets


require comprehensive and transparent disclosures
of value-relevant information by rms in order to
function eciently (e.g. Levitt, 1999). Theoretically, adopting such a disclosure position (Gibbins, Richardson, & Waterhouse, 1990) should
benet rms through lower cost of capital for at
least two reasons. First, increased disclosure by
rms reduces transaction costs for investors
resulting in greater liquidity of the market and
greater demand for the rms securities (e.g. Diamond & Verrecchia, 1991). Second, increased disclosure reduces the estimation risk or uncertainty
regarding the distribution of returns (Clarkson,
Guedes, & Thompson, 1996).

* Corresponding author.

In spite of the regulatory and theoretical support for increased disclosure by rms, direct evidence of a negative empirical relation between
disclosure levels and the cost of capital is limited
(e.g. Botosan, 1997; Botosan & Plumlee, 2000, on
the cost of equity capital, and Sengupta, 1998 on
the cost of debt). In part, the lack of strong
empirical ndings on the relationship between
disclosure and cost of capital may be an artifact of
the markets and information set that are used in
empirical tests. If there is little variation in the
information disclosed due to eective regulatory
interventions, or if analysts routinely generate
information independently of the rms own disclosures, then the power of empirical tests will be
signicantly reduced. For example, Botosan
(1997) documents a statistically signicant negative relation between the level of nancial disclosure and cost of equity capital for her sample of
USA manufacturing rms, but this relation holds

0361-3682/01/$ - see front matter # 2001 Published by Elsevier Science Ltd.


PII: S0361-3682(01)00025-3

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A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

only for the subset of her sample characterized by


limited analyst following.
A stronger test of the relationship between corporate information disclosures and the cost of
equity capital is possible by choosing markets and
information sets where, ex ante, corporate disclosures play a larger role in market valuations. In
this paper we test this relationship in Canadian
markets and with both nancial and social disclosures. Both of these extensions to the literature
should improve the power of statistical tests as
explained later.
First, we examine a set of Canadian rms, providing an assessment of the benets of expanded
disclosure in an environment other than the United States of America (US). Since the US equity
markets are claimed to be among the most
sophisticated in the world (e.g. Levitt, 1999),
including some of the most stringent disclosure
standards in the world, this extension is potentially important. The generally less comprehensive
required disclosures in Canada create an environment where variation in voluntary disclosure
could be very important.1
Second, we examine the relation between both
social and nancial disclosures and cost of equity
capital estimates. The past literature has only
examined the relation between nancial disclosure
and cost of capital. As summarized in Botosan,
past literature suggests that nancial disclosures
could inuence the cost of capital because the disclosures reduce information asymmetry and/or
estimation error. As Richardson, Welker, and
Hutchinson (RWH, 1999) discuss, there are a
number of reasons to suspect a relation between
the cost of equity capital and social disclosure as

well. Past empirical examinations of the relation


between social performance, or social disclosure,
and equity market measures such as realized
equity returns have generally been poorly specied, leading to results that are dicult to interpret. RWH provide an extensive review of this
literature and present a comprehensive model
outlining the ways that social performance and
disclosure about that performance might inuence
equity market measures. Their analysis focuses on
three distinct ways in which social performance
and disclosure could aect the cost of capital.
Social disclosure could play a role similar to
nancial disclosure and reduce the cost of equity
capital by reducing transaction costs and/or
reducing estimation error. In addition to these
two eects, social disclosure could inuence the
cost of equity capital directly through investor
preference eects if investors are willing to
accept a lower expected return on investments
that also fulll social objectives. The relationship
between the cost of capital and social disclosures/
performance is one of the issues identied by
Epstein (2000) for future research in his review of
the eld.
Consistent with the past literature, we nd a
signicant negative relationship between the cost
of equity capital and nancial disclosure for those
rms with a small nancial analyst following.
Contrary to expectations, we nd a signicant
positive relationship between social disclosure
and the cost of equity capital. The cost of
equity penalty for rms with extensive social
disclosure is mitigated by higher nancial
performance.

1. Hypothesis development
1
The view that US disclosure practices provide more information than Canadian practices is apparently widely held.
Nearly 90% of the Canadian analysts surveyed between
November 1994 and January 1995 on behalf of the Toronto
Stock Exchanges Committee on Corporate Disclosure responded that disclosure was better in the USA. None of the analysts
felt that disclosure was better in Canada. Reasons provided for
the belief that disclosure is better in the USA included: more
stringent regulation, greater volume of information and more
detailed segmentation of information (Committee on Corporate Disclosure, 1995).

The relation between nancial disclosure and


the cost of equity capital has been extensively
developed in the past literature (Clarkson et al.,
1996; Diamond & Verrecchia, 1991). Botosan
(1997), for example, argues that nancial disclosure could result in decreased cost of capital
because expanded disclosure reduces estimation
risk, decreasing the total risk in owning the
equity security, or reduces risk by decreasing

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

information asymmetries and, hence, adverse


selection risk. In either case, an inverse relation
between nancial disclosure and cost of equity
capital is predicted.
Richardson et al. (1999) argue that there are at
least three reasons to expect a similar relation
between social disclosure and the cost of equity
capital.2 They conclude that there may be a direct
inuence of social disclosure on the cost of equity
capital either through investor preference eects,
or through reduced information asymmetry or
estimation risk. The eects stemming from
reduced information asymmetry and/or estimation
risk follow directly from the literature on nancial
disclosure. If information about social activities is
relevant to assessing the rms prospects, then
enhanced disclosure of social activities has the
same eect as enhanced disclosure of other nancial activities.
Investor preference eects arise if investors are
willing to accept a lower rate of return on investments by an organization that supports a social
cause for which some investors have an anity.3
This suggestion is consistent with the emergence of
Green Funds and Ethical Investing (e.g. Reyes &
Grieb, 1998). It also has a direct relationship to
the literature in organizational behavior, management, and marketing that suggests that advertising
with a social dimension can be employed to legitimate the rm in the eyes of consumers and contribute to the rms product/service market
success (e.g. Garrett, 1987; Menon & Menon,
1997). This literature suggests that consumers

RWH also argue that disclosure about social activities


undertaken by the rms could provide investors with information about future cash ows, or in terms consistent with the
model presented later, future abnormal earnings. This link
might exist, for example, if social activities decrease expected
future regulatory costs, inuence consumers to acquire the
rms products/services thereby increasing the rms contribution margins or market share, or reduce the costs of implicit or
explicit contracting. In short, if social activities have net present
value consequences, then information about social performance
should inuence investors assessments of the abnormal earnings the rm can earn in the future (see Scaltegger & Figge,
1998).
3
This linkage is more thoroughly discussed in RWH (1999).

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vote with their dollars and may (rationally)


choose to pay more to both acquire a product or
service and support a social cause for which they
have an anity. The extension of this literature to
the capital market is straightforward if investment
decisions are recognized as decisions to forego
current consumption in favor of future consumption. There is also considerable anecdotal evidence
suggesting a link between investor preferences and
social reporting. For example, Downing (1997)
reports that managers of the Canadian Pension
Plans $100 billion fund, among other investors,
might be attracted by the information provided by
social reporting.
Our empirical examination does not attempt
to discriminate between these potential eects,
but does stand in marked contrast to the past
literature examining the equity market consequences of social disclosure that has tended to
focus on the relation between social performance,
social disclosure and ex-post measures of nancial
performance. Ours is the rst empirical examination of social disclosure practices to explicitly
examine the cost of equity capital and the rst to
jointly examine the eects of both nancial and
social disclosure. The specic hypotheses we
examine are outlined later, each stated in alternative form.
The past literature has suggested that increased
nancial disclosure reduces information asymmetry and/or estimation risk. This literature also
suggests that enhanced nancial disclosures reduce
the cost of equity capital.
H1a: There is an inverse relation between the
level of nancial disclosure and the cost of
equity capital.
The arguments presented earlier suggest that
similar relations exist between the level of social
disclosure and information asymmetry, estimation
risk and the cost of equity capital. Also, if, as has
often been assumed in the past literature, there is a
perceived positive relation between the level of
social disclosure of the rm and the rms social
performance, increased social disclosure may
reduce the cost of capital through investor preference eects.

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H2a: There is an inverse relation between the


level of social disclosure and the cost of equity
capital.
Finally, we consider the interaction between
rms own disclosures about their activities and
the information available from third parties. We
hypothesize that the relationship will dier for
nancial disclosure and social disclosure. The
literature on nancial disclosure suggests that the
benets of nancial disclosure may be greater
for rms with little analyst following (Botosan,
1997). This assumes that stakeholders are
concerned with a rms nancial performance but
that the richness of the information set available
to them varies depending on the number of
analysts preparing independent reports on the
rm. In the absence of information about the
rm from analysts, the rms own disclosures are
the key source of information. The benets of
better nancial disclosure are primarily realized
when other information sources are absent.
Therefore we predict a negative relationship
between the cost of capital nancial disclosure
where there is a small number of analysts following a rm.
H3a(i): The relation between nancial disclosure levels and the cost of equity capital is
mediated by the level of analyst following.
The eect of social disclosure is expected to
follow the same pattern to the extent that social
disclosures inform stakeholders expectations of
the rms nancial performance. The importance
of social performance to stakeholders, however,
has been theorized to increase with the size of the
organization. Stinchcombe (1965), for example,
has argued that as a rm grows it develops a
structural position (i.e. ties within a network of
resource providers) that contributes to its success.
This structural position changes the demands of
the environment from a demand for short-run
economic eciency to a demand for long-run
economic and social eciency/legitimacy (see
Hannan, 1998; Oliver, 1991). This prediction is
consistent with the positive accounting theory
literature that suggests that political costs are

greater for larger rms (Watts & Zimmerman,


1986). The number of analysts following a rm
tends to be correlated with rm size (e.g. see
Table 1), thus the importance of social disclosure
and the independent information available from
analysts will increase in parallel. We, therefore,
predict no interaction eect between social disclosure and the number of analysts following the
rm.
H3a(ii): The relation between social disclosure
levels and the cost of equity capital is not
mediated by the level of analyst following.

2. Empirical measures of disclosure levels and


cost of equity capital
2.1. Disclosure proxy
Our empirical measures of nancial and social
performance are drawn from the joint Society of
Management Accountants of Canada (SMAC)/
University of Quebec at Montreal (UQAM)
sponsored assessments of the annual reports of
a broad cross-section of Canadian companies.
These assessments were conducted and publicly
reported based on 1990, 1991 and 1992 annual
reports, thus providing a limited time-series of
disclosure scores. To our knowledge, these data
are unique in North America because the
scores contain a ranking of rms on both the
quality and level of nancial disclosure and
social disclosure contained in annual reports.
This provides a signicant advantage over
other North American rankings such as the
Association for Investment Management and
Research (AIMR) rankings of US companies.4
However, the AIMR rankings are prepared
by professional analysts and represent the
rankings of several analysts, while the Canadian

4
The AIMR rankings are compiled annually by the Association for Investment Management and Research. These disclosure rankings have been used in empirical studies by
Botosan and Plumlee (2000), Healy, Hutton, and Palepu
(1999), Lang and Lundholm (1993, 1996), and Welker (1995).

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

rankings available to us are based on the judgments of less experienced raters and do not reect
the same level of averaging across raters as the
AIMR ratings. Nevertheless, the SMAC/UQAM
ratings are the best available source of disclosure
ratings for a broad cross-section of Canadian
rms. The only alternative measure of disclosure
for Canadian companies would be researchergenerated measures, as utilized by Botosan (1997).
We choose not to generate our own disclosure
ratings because of the potential for researcher
biases to inuence the ratings and to avoid the
severe limitations on sample size imposed by this
approach.
For each year from 1990 to 1992, researchers at
UQAM analyzed the annual reports of around
700 Canadian companies coming from nine
industry sectors. The industry sectors reported on
in their publication include: ManufacturingIndustrial Products, Manufacturing-Consumer
Products; Oil, Gas and Chemicals; Mines, Metals
and Forestry Products; Technology and Communications; Financial Institutions; Retail and
Wholesale Trade; Management and Other; and
Utilities. An extensive checklist of information
related to socially responsible activities was
developed that contained 170 subcategories of
information. Similarly, an extensive checklist
related to nancial information was developed
which allocated points across 261 individual
disclosure elements.
Appendix A contains a summary of the 10
categories of social information considered and
the maximum number of points allocated to each
category, as well as the sub-categories of information considered within each category. The
Appendix also contains similar information for
the nancial disclosure checklist.
Two points should be noted about these checklists. First, the social information captured in the
checklist includes a much broader set of disclosures than just environmental disclosures that
have been the subject of much of the past social
disclosure literature.
Second, the checklist used to assess nancial disclosure is similar in many respects to the checklists
utilized by the AIMR and developed by Botosan
(1997). For example, all of the checklists contain

601

sections devoted to general background information that help users to interpret the nancial
statements. All three lists contain sections devoted
to assessing the usefulness of the disclosure of
summarized historical results, and all three checklists assess the inclusion of forecasted information
within the annual report. In addition to assessing the
types of disclosure made in the annual report, the
UQAM researchers also attempted to make an
assessment of the quality of the disclosure by
awarding more points for disclosures that contained
quantitative data or reported more information.
The extensive nature of the checklists utilized in the
SMAC/UQAM disclosure ratings, combined with
the attempt to discriminate between more and less
informative disclosures, gives us condence in the
face validity of these ratings. While they are
undoubtedly noisy measures, they provide us
with some ability to discriminate between rms
providing high levels of disclosure and those
providing minimal disclosure. Empirical analysis
reported later in the manuscript also provides evidence corroborating the validity of our disclosure
measures.

3. Empirical measure of cost of equity capital


We follow Botosan (1997), Botosan and Plumlee
(2000) and Gebhardt, Lee, and Swaminathan
(2000), and obtain estimates of the cost of
equity capital using an accounting based valuation model developed in Edwards and Bell
(1961), Feltham and Ohlson (1995) and Ohlson
(1995). Our empirical implementation of the
model is very similar to the method employed
by Gebhardt et al. and interested readers are
referred to their paper for further details on the
estimation procedure and for extensive empirical
analyses of the properties of the estimates. We
provide a brief sketch of the estimation procedure
later.
The valuation model species a relation between
equity values and current book values and future
abnormal earnings. We briey sketch a derivation
of the empirical equation we use to estimate equity
cost of capital beginning with the familiar dividend discount model:

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A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Pit

1
X
Et dit
1 ri 
1

where d=dividends, r=cost of equity capital, and


i and t are rm and time identiers, respectively.
Feltham and Ohlson (1995) and Ohlson (1995)
demonstrate that, for clean-surplus accounting
systems, this dividend discount model is algebraically equivalent to a valuation formula based on
current book value and future abnormal earnings:5



1
X
Et xit  ri BVit1
Pit BVit
2
1 ri 
1
where BV=book value of equity, x=earnings,
and all other variables are as previously dened.
The nite horizon version of Eq. (2) is:
Pit BVit

T
X
Et fFROEit  ri gBVit1
1 ri 
1

TVit

where FROE=forecasted return on equity, and


TV=terminal value, or the present value at time t
of the abnormal earnings expected to be earned
after time t+T, and all other variables are as
previously dened.

Pit BVit
11
P

4

For our estimates that utilize I/B/E/S earnings


forecasts, Eq. (3) is replaced with a version that
utilizes the earnings forecasts for the next three
scal years from I/B/E/S.6 The terminal value
involves forecasting return on equity for 12 future
years (i.e. 9 years beyond the latest available
explicit earnings forecast from I/B/E/S). Forecasted return-on-equity beyond year 3 is generated
using a linear fade-rate to the industry average
return-on-equity (ROE). Our industry average
ROEs are compiled from data provided by Statistics Canada (Statscan). We acquire industry average ROE data beginning with 1980 for all
industries as dened and tracked by StatsCan. Our
industry average ROE gures for year t are computed as the average industry ROE through time
starting in 1980 and ending in year t1. For
example, for our 1990 industry average ROE
measure, we average the industry ROEs over
the 10 year period from 1980 to 1989, and
the 1991 industry ROEs are the average of
the industry ROEs over the 11 year period
from 1980 to 1990. These industry averages have
a mean of 10.75% and range from 4.3%, (the
1992 average for the iron, steel and related
products industry) to 22.7%, (the 1990 average
for the building materials and construction
industry).
Accordingly, the model we utilize to estimate
cost of capital has the following form:

3
X
Et fFROEit  ri gBVit1
1 ri 
1

EfFROEit3   3fIROEit  FROEit3 g=9


 ri gBVit1
1 ri 

5
A clean surplus accounting system is one in which book
value at time t is equal to book value at time t1 plus earnings
minus dividends net of capital contributions. Dirty surplus
arises when gains and losses aecting book value bypass the
income statement.


IROEit  ri
BVit11
ri 1 ri 11

6
About 10% of our rm 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 scal
year 3 (FY3) EPS by assuming that the earnings growth rate
implicit in the scal year 2 (FY2) compared with scal year 1
(FY1) forecasts applies to scal year 3 as well. Specically, we
forecast FY3 EPS as FY2 EPS (FY2 EPS/FY1 EPS). If FY2
EPS/FY1 EPS< 0, we do not forecast FY3 EPS and omit the
observation.

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

where IROE is the historical industry average


ROE and all other variables are as previously
dened.
The exact details of the estimation procedure,
including variable measurement, are described in
the following section. The sensitivity of our results
to variations in the assumptions required to estimate cost of capital are discussed in the section of
the paper entitled sensitivity of results to cost of
capital estimation assumptions.

4. Empirical analysis
4.1. Disclosure proxy and additional data
Our initial sample consists of all rms that
received a disclosure rating based on any or all of
its 1990, 1991 or 1992 annual reports. In each of
these three years, the annual reports of over 700
Canadian companies were collected and analyzed
by a group of research assistants at UQAM. The
results of the ratings are summarized by industry
group and published each year by CMA Canada.
The survey only provides 3 years of data. Since
disclosure policies are probably relatively stable
rm attributes, this limited time-series should not
severely impact the generality of our results. In
order to perform the initial empirical analysis, we
require nancial statement data provided by
Compustat, earnings forecasts and analyst following provided by I/B/E/S, and market price and
returns data acquired through Datastream. These
additional data requirements leave us with a
sample of 324 rm year observations from 124
dierent companies with all necessary price data,
nancial and social disclosure scores, all necessary
Compustat data and at least 1-year ahead EPS
forecast available from I/B/E/S. For this initial
sample, we only require that 1-year ahead analysts forecasts be available, and therefore the
number of analysts making a 1-year ahead forecast, be available from I/B/E/S. In order to
calculate cost of capital estimates, we require
that at least 2-year-ahead earnings forecasts be
obtained from I/B/E/S. We also require that
unambiguous identication with a StatsCan
industry group be possible, further reducing our

603

sample size to 225 rm year observations from 87


dierent rms.
For these observations, we obtain the average
stock price from the 6th month after year-end
from Datastream. We choose a period 6 months
after year-end to ensure that all information contained in the annual nancial statements has been
disclosed and is reected in market prices.7 This
choice is also consistent with the empirical analysis
in Botosan (1997). From Compustat, we obtain
the debt-to-equity ratio, return-on-equity, dividend payout ratio, market to book value ratio,
and market value of equity. I/B/E/S provides the
earnings forecasts and the number of analysts following the rm, which we measure as the number
of analysts providing 1-year-ahead earnings forecast for the rm.
Calculation of forecasted book values requires
an estimated future dividend payout ratio (k). We
estimate this ratio using the following procedure.
First, we obtain the historical 10-year average
payout ratio for each year t from Compustat and
use this to proxy for future payouts if it is available and positive. If the 10-year average is either
unavailable or negative, we use the 5-year historical average payout ratio. If the 5-year payout
ratio is either unavailable or negative, we estimate
future payout ratios based on the dividend payout
ratio for year t. Finally, if the year t payout ratio is
negative, we follow a procedure similar to Gebhardt et al. (2000) and approximate permanent
earnings for year t as (BVt1 IROE), the book
value of equity at the beginning of the year times
the industry average ROE. We then calculate the
dividend payout ratio as DVSt /(BVt1 IROE),
where DVS is the dividends per common share for
year t. Our implementation of Eq. (4) then uses
the rms estimated dividend payout ratio (k) to
update book values as follows:


BVit BVit1 FROEit 1  kit BVit1
4a

7
Our results are qualitatively similar using average stock
prices from the 4th month after scal year-end. We use the
average stock price for the month rather than monthly closing
prices to avoid extreme observations that may result from
temporary share price uctuations reected in a single price
observation such as a closing price.

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A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Table 1
Descriptive statisticsa
Variable name N
FDISC
SDISC
MV ($000,000)
ANALFOL
LEV (%)
ROE (%)
IND
COST (%)

Mean

Median Minimum Maximum

324
32.53
31.48
4.75
324
11.04
8.25
0.25
324 3833
1605
20.2
324
9.32
9.0
1
324
75.8
53.5
0
324
0.19
5.98 194.0
324
0.38
0
0
225
8.9
8.5
1.8

63.0
50.0
38,729
37
1095
33.1
1
22.5

Variable denitions: FDISC=Financial disclosure score


for rm i, year t; SDISC=social disclosure score for rm i, year
t; MV=beginning of year market value of common equity for
rm i, year t; NANAL=number of analysts making a 1 year
ahead EPS forecast for rm i, year t; LEV=debt to equity ratio
for rm i, year t; ROE=return on equity for rm i, year t;
IND=a dummy variable equal to one if rm 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 rm i, year t.

Tables 1 and 2 provides distributional characteristics and a correlation matrix for the variables used in the study. Financial disclosure scores
average 32.5 (out of a possible 120), and range
between 4.75 and 63. Social disclosure scores tend
to be lower, averaging 11 (out of 100) and ranging
between 0.25 and 50. The average rm size in the
sample is $3.8 billion and the median size is substantially lower at around $1.6 billion. Nine analysts follow the average rm, and this ranges
between 1 and 37. The average debt to equity ratio
is 75%. The mean ROE for our sample rms is
close to zero, reecting the poor economic climate
in Canada in the early 1990s.8 The median ROE is
around 6%. Around one third of our sample rms
come from the oil, gas and chemical industry or
the mines, metals and forestry products industry,
industries that have been depicted as environmentally/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

SDISC

MV

NANAL

LEV

ROE

IND

COST

1
0.704*
0.555*
0.603*
0.177*
0.067
0.281*
0.053

0.662*
1
0.474*
0.509*
0.243*
0.096
0.278*
0.012

0.499*
0.294*
1
0.617*
0.024
0.136*
0.065
0.066

0.542*
0.391*
0.413*
1
0.042
0.009
0.346*
0.156*

0.067
0.080
0.054
0.023
1
0.251*
0.013
0.131*

0.009
0.023
0.132*
0.029
0.542*
1
0.255*
0.102

0.229*
0.298*
0.143*
0.321*
0.011
0.121*
1
0.351*

0.046
0.011
0.091
0.208*
0.054
0.074
0.362*
1

a
Variable denitions: FDISC=Financial disclosure score for rm i, year t; SDISC=social disclosure score for rm i, year t;
MV=beginning of year market value of common equity for rm i, year t; NANAL=number of analysts making a 1 year ahead EPS
forecast for rm i, year t; LEV=debt to equity ratio for rm i, year t; ROE=return on equity for rm i, year t; IND=a dummy variable
equal to one if rm 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 rm i, year t.
*=signicant at the 5% level, two-tailed test.

As Gebhardt et al. point out; the calculation of


an implied cost of capital is the same as determining the internal rate of return that equates the
stock price to the expected future benets of share
ownership. Gebhardt et al. also provide two
example calculations to which we refer interested
readers. We perform this estimation using Microsoft Excel, and our estimate of the cost of capital
is simply the discount rate that equates the book
value and future forecasted earnings to the current
market price.

ture (Deegan & Gordon, 1996; RWH, 1999).


Finally, our cost of capital estimates average close
to 9%, and range between 1.8 and 22.5%.
These estimates of cost of capital appear reasonable in relation to Canadian T-bill rates during
our sample period. Our rates, measured with
8

During the 19901992 periods, quarterly growth in gross


domestic product in Canada was 0.3%, far below the average
of 1.1% experienced during the remainder of the 1990s (Calculated based on Datastream data).

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

forecasted data as of June 1991 (for 1990 annual


reports), June 1992 and June 1993 average 9.85,
9.5 and 8.0%, respectively. The 1-year T-bill rate
in Canada shows similar declines throughout our
sample period. For example, the one-year T-bill
rate in June 1991, 1992 and 1993 was 9.11, 6.63
and 5.79%, respectively. In addition, the riskpremium inherent in our cost of capital estimates
varies between approximately 0.7 and 2.5%, with
a median of 2.2%. Gebhardt et al. nd that
risk premiums implied for their sample (including
over 10,000 observations from 1979 to 1995
and the same method for estimating the cost
of equity capital) vary between 0.7 and 4.9%
with a median of 2.0%. Our cost of capital estimates display a similar relationship to the risk-free
rate.
The univariate correlations reveal no unexpected patterns, and show that there is a strong
positive relation between social and nancial disclosure, as might be expected if both types of disclosure are part of an overall disclosure policy.
Cost of capital does not have a signicant relation
to either disclosure score. The correlation between
the disclosure variables and other potential determinants of cost of capital (e.g. market value of
equity, analyst following and industry) makes
interpretation of these univariate correlations
problematic. However, these univariate correlations do indicate that our main results are sensitive
to the inclusion of control variables.
Table 3 provides selected descriptive information for rms in the sensitive, (oil, gas and chemical or mines, metals and forestry products), versus
non-sensitive industries, and across time for both
groups. Several empirical regularities are revealed
in this descriptive information. First, rms in the
sensitive industries have better nancial and social
disclosure scores, are followed by more analysts,
have inferior nancial performance (except 1992),
and have lower cost of capital estimates than do
their counterparts in the non-sensitive industries.
The two groups appear roughly similar in terms of
rm size, though the mean rm size is typically
larger for the non-sensitive rms and the median
rm size is larger for the sensitive rms. The rm
size distribution is much more skewed for the
non-sensitive sample. Additionally, cost of capital

605

estimates, nancial performance and the number


of analysts following the rm tend to decline
over time for both groups, though the nancial
performance for the sensitive rms rebounded in
1992.
4.2. Validation of the disclosure proxies
Since the SMAC/UQAM ratings of disclosure
have not been previously used in academic
research, we perform a series of tests that examine
the relationship between these disclosure ratings
and several variables that are related to disclosure
levels in the past literature. Specically, we follow
Botosan (1997) and Lang and Lundhom (1993)
and examine the relation between nancial disclosure and rm size, nancial performance,
leverage and analyst following. Past results suggest that a positive relationship should exist
between each of these variables and nancial disclosure. We also examine the relationship between
social disclosure ratings and rm size, industry
membership, nancial performance, leverage,
analyst following and the interaction of industry
and rm size. Industry membership is coded to
reect membership in a socially/environmentally
sensitive industry, namely the oil, gas and chemicals industry or the mines, metals and forestry
products industry. Since larger rms and rms in
these industries have their social and environmental performance closely scrutinized, past
research suggests a positive relation between
industry membership and the interaction of rm
size and industry membership with social disclosure (e.g. Deegan & Gordon, 1996).
The relationship between social disclosure and
nancial performance has been mixed in the past
literature (Pava & Kraus, 1996) while the relationship between leverage and analyst following
and social disclosures have not been examined in
the past literature. Since social disclosure may
accomplish many of the same objectives as nancial
disclosure, we expect to observe positive relationships between these variables and social disclosure.
These tests provide evidence on the validity of our
disclosure ratings as measures of the cross-sectional variation in the level of disclosure provided
in Canadian companies annual reports.

606

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Table 3
Descriptive information across sensitive and non-sensitive industries and time
Variable name

Mean

Median

Minimum

Maximum

Sensitive industry1990
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

37
37
37
37
37
29

36.14
13.82
2478
13.49
1.58
8.43

34.75
11.25
1982
12
6.00
8.12

15.5
1.25
69.3
3
142.07
1.83

56
45.5
12,543
34
26.46
15.26

Sensitive industry1991
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

42
42
42
42
42
31

37.15
15.31
2840
12.12
8.67
7.56

35.25
14.38
1994
10.5
1.95
7.47

16.75
2
85.3
2
158.9
3.52

58
40.5
11,821
36
17.54
14.15

Sensitive industry1992
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

43
43
43
43
43
34

34.7
13.95
2511
10.37
0.81
6.72

34.35
13.5
2002
10.0
2.66
6.23

14.25
2
88.4
1
38.38
3.89

52.5
50
10,554
30
22.84
13.73

Non-sensitive industry1990
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

63
63
63
63
63
40

31.9
10.2
4675
8.76
5.09
10.84

29
7
1364
8
9.98
10.53

11.25
0.75
20.2
1
97.06
6.55

63
38
32,179
37
23.68
20.34

Non-sensitive industry1991
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

71
71
71
71
71
47

29.7
8.62
4447
7.82
4.32
10.06

46.75
7
1245
7
7.63
9.62

8.7
0.25
27.5
1
77.71
4.04

59.5
33.5
37,839
34
33.09
19.74

Non-sensitive industry1992
FDISC
SDISC
MV ($000,000)
NANAL
ROE (%)
COST (%)

68
68
68
68
68
44

29.81
8.35
4452
6.77
1.59
8.98

29.28
6.38
1393
6.0
6.42
9.1

4.75
1
66.1
1
194.0
3.11

63
43.25
38,729
26
31.15
22.48

Variable denitions: FDISC=nancial disclosure score for rm i, year t; SDISC=social disclosure score for rm i, year t; MV=beginning of year market value of common equity for rm i, year t; NANAL=number of analysts making a 1 year ahead EPS forecast
for rm i, year t; ROE=return on equity for rm i, year t; COST=estimated cost of equity capital for rm i, year t.

607

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616


Table 4
Results of estimating Eq. (5) explaining variation in nancial disclosure
FDISCit  1 DSIZEit 2 ROEit 3 LEVit 4 DANALit "
Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
DSIZE (+)
ROE (+)
LEV (+)
DANAL (+)

34.113
6.895
0.032
0.014
8.505

26.323
5.481
1.277
2.535
6.776

0.0001
0.0001
0.2026
0.0117
0.0001

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

Additionally, we note that our ratings are based


only on the disclosures contained in annual
reports and do not necessarily reect the level of
disclosures made through other media (c.f. Zeghal
& Ahmed, 1990). While this is an acknowledged
limitation of our proxy for disclosure, Botosan
(1997) shares this limitation. We also note that
Lang and Lundholm (1993) and Welker (1995)
examine the AIMR ratings for US companies and
report a high degree of correlation between disclosure ratings based on the annual report and
ratings based on other disclosure media. This
nding provides evidence of convergent validity of
annual report disclosure measures and disclosures
occurring in other media as well.
4.3. Relation of nancial disclosure scores with size,
nancial performance, leverage and analyst following
Past research has demonstrated that nancial
disclosure increases with rm size, nancial performance, leverage, and the number of analysts following the rm. One way to validate our empirical
proxy for nancial disclosure is to examine these
relationships based on our proxy. Accordingly, we
estimate the following empirical equation:
FDISCit  1 DSIZEit 2 ROEit
3 LEVit 4 DANALit "

where FDISC=nancial disclosure score for rm


i, year t, DSIZE=a dummy variable equal to one
if the beginning of year market value of equity for
rm i, year t is above the sample median, zero
otherwise, ROE=return on equity for rm i, year
t, LEV=debt to equity ratio, rm i, year t,
DANAL=a dummy variable equal to 1 if the
number of analysts providing a 1-year ahead
earnings forecast for rm i, year t is above the
sample median, zero otherwise.
The results of estimating Eq. (5) are reported in
Table 4.9 Consistent with the past literature, each
of the variables in the equation except ROE exhibits a signicant and positive relation with nancial disclosure. The adjusted R2 of the regression is
over 30%, indicating that the explanatory variables are able to explain a reasonable portion of
the cross-sectional variation in nancial disclosure
scores. The fact that our nancial disclosure scores
are strongly related to variables which the past
literature suggests explain nancial disclosure
increases our condence that variation in our disclosure measure captures the underlying phenomenon of interest, variation in nancial disclosure.

9
Our tabulated results provide two-tailed P-values. By
convention, we describe an estimated coecient as statistically
signicant if the coecient is signicant at the 0.05 level in a
one-tailed test if we predict the sign of the coecient and a twotailed test if we do not predict the sign of the coecient.

608

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Table 5
Results of estimating Eq. (6) explaining variation in social disclosure
SDISCit  1 DSIZEit 2 ROEit 3 INDit 4 INDit SIZEit 5 DANALit 6 LEVIT it 6
Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
DSIZE (+)
ROE (?)
IND (+)
IND SIZE (+)
DANAL (+)
LEV (+)

5.097
3.507
0.021
2.465
2.958
3.931
0.011

6.315
3.021
1.092
1.957
1.713
3.918
2.596

0.0001
0.0027
0.2757
0.0513
0.0876
0.0001
0.0099

No. of observations=324; adjusted R2=26.8%. Variable denitions: SDISC=social disclosure score for rm i, year t; DSIZE=a
dummy variable equal to one if the beginning of year market value of equity for rm i, year t is above the sample median, zero
otherwise; ROE=return on equity for rm i, year t; LEV=debt to equity ratio, rm i, year t; DANAL=a dummy variable equal to 1
if the number of analysts providing a 1-year ahead earnings forecast for rm i, year t is above the sample median, zero otherwise;
IND=a dummy variable equal to one if rm 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


with rm size, industry membership, nancial
performance, leverage and analyst following
Patten (1991) documents that social disclosure is
increasing in rm size and is greater in highly
visible and politically sensitive industries. Deegan
and Gordon (1996) nd an interaction eect
between rm size and industry, such that the size
eect is particularly pronounced in sensitive
industries. As Richardson et al. (1999) discuss,
results of tests of the relation between social performance/disclosure and nancial performance
have been mixed. Leverage and number of analysts following the rm have not been included in
past studies of social disclosure. We include these
variables in our regression since they are related to
nancial disclosure. Social disclosure accomplishes
similar objectives and may have similar determinants. We examine the relation between the
SMAC/UQAM social disclosure ratings and these
variables by estimating the following equation:
SDISCit  1 DSIZEit 2 ROEit 3 INDit
4 INDit SIZEit 5 DANALit
6 LEVit it

where SDISC=social disclosure score for rm i,


year t, IND=a dummy variable equal to one if
rm i is a member of the Oil, Gas and Chemicals

or Mine, Metals and Forestry Products industry


sectors in year t, zero otherwise
All other variables are as previously dened.
The results of estimating Eq. (6) are presented in
Table 5. Again, the results are encouraging as our
measure of social disclosure appears to be related to
variables that the past literature suggests it should
be. Size, industry, and the interaction of industry and
size are all signicantly related to social disclosure,
as suggested by the past literature. Analyst following
is also statistically positively related to social disclosure, consistent with our conjectures that similar
factors may inuence nancial and social disclosure. ROE is not statistically related to social
disclosure, in keeping with the insignicant or mixed
relation documented in the past literature. Leverage is also positively related to social disclosure,
again consistent with our conjectures that social and
nancial disclosures have similar determinants.
We conclude, based on the evidence discussed
earlier, that the nancial and social disclosure
scores are valid measures of those disclosures by
the rms in our sample. We now turn to the substantive issue of the relationship between disclosure and the cost of capital.
Empirical tests of the relation between disclosure
and the cost of equity capital
Our tests of the relations between nancial and
social disclosure and the cost of equity capital are

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

based on the work of Botosan (1997) and Gebhardt et al. (2000). Similar to Botosan, we attempt
to document a negative relation between nancial
and social disclosure and the cost of equity capital
that is incremental to the eects of other variables
known to inuence cost of capital. Gebhardt et al.
nd that the risk premia is negatively related to
the number of analysts following the rm and
positively related to leverage. Accordingly, our
empirical tests include these variables as control
variables.10 In addition, Botosan documents that
disclosure and analyst following has an interactive
eect on cost of capital. She nds that disclosure
reduces cost of capital only for those rms with
low analyst following. We also estimate an equation that allows for this potential interactive eect
and an interaction between analyst following and
social disclosure as well. Specically, our primary
empirical tests come from the estimation of the
following two equations:
COSTit 

1 NANALit
3 FDISCit

2 LEVit

4 SDISC it

it

10
Other potential risk proxies such as market beta, market
value of equity and book to market ratios could also be controlled for in the empirical analysis. We omit beta from the
analysis because Gebhardt et al. document that they are statistically unrelated to our measure of the cost of equity capital
except in certain multivariate tests. We include size and book to
market ratios in all our equations explaining the cost of capital
and nd that these variables have the correct sign but are statistically unrelated to our industry adjusted cost of capital estimates. Gebhardt et al. also nd that the dispersion in analysts
earnings forecasts is signicantly related to the cost of capital.
We choose not to include this variable in our analysis for three
reasons. First, the dispersion in analysts forecasts would presumably be a function of the disclosure variables we include in
our analysis, so the inclusion of this variable would amount to
the inclusion of an alternative disclosure measure and could
hamper our ability to observe a relation between more direct
disclosure measures and the cost of capital. Second, including a
measure of analysts forecast dispersion would reduce our
sample size because a measure of dispersion requires that the
rm be followed by multiple analysts Third, the dispersion in
analysts forecasts is related to the number of analysts following the rm, which we include for consistency with Botosan.

COSTit  1 NANALit
3 FDISCit 4 SDISCit
5 LANALit FDISCit

LANAL
6
it SDISCit it

609

2 LEVit

where COST is the cost of equity capital estimated


by Eq. (4); NANAL is the number of analysts
making 1-year ahead earnings forecast; LANAL is
a dummy variable set equal to one if the number
of analysts following rm i in year t is below is
industry sector median for year t, zero otherwise.
All other variables are as previously dened and all
variables are adjusted for industry sector medians.
Gebhardt et al. (2000) document considerable
variation in their risk premia estimates across
industries. Our results (documented in Tables 3
and 5) and the results of previous research
demonstrate that disclosure practices also vary
across industries as well. Accordingly, all variables
utilized in estimating Eqs. (7) and (8) are adjusted
for industry sector (as dened in the SMAC/
UQAM disclosure ratings) year medians. This
removes both industry and time eects from the
data, avoiding potentially spurious associations.
Since all variables in this specication are industry
adjusted, rm size and analyst following directly
enter the regressions without the conversion to
dummy variables performed in earlier tests. We
exclude observations in the top and bottom 1% of
the empirical distribution of cost of capital (i.e.
two observations from each tail of the distribution) to ensure our results are not unduly aected
by extreme observations.11
In accordance with our hypotheses outlined
earlier, we expect C1, C3, C4 and C5 to be negative and C2 to be positive. As discussed in H3a(ii),
we expect C6 to be statistically insignicant.
For comparative purposes, the results of estimating Eqs. (5) and (6), explaining nancial and
social disclosure, respectively, using the industryadjusted data, are reported in Tables 6 and 7.
Of course, the industry membership variables
11
Our conclusions are not aected by excluding these observations. In general, there is a slight increase in statistical signicance when the observations are dropped, suggesting these
observations contain measurement error.

610

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Table 6
Results of estimating Eq. (5) explaining variation in nancial disclosureindustry adjusted data
FDISCit  1 SIZEit 2 ROEit 3 LEVit 4 NANALit " 5
Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
SIZE (+)
ROE (+)
LEV (+)
NANAL (+)

0.276
0.001
0.015
0.007
0.508

0.524
5.467
0.605
1.472
5.291

0.6005
0.0001
0.5458
0.1420
0.0001

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

Table 7
Results of estimating Eq. (6) explaining variation in social disclosureindustry adjusted data
SDISCit  1 SIZEit 2 ROEit 5 NANALit 6 LEVit it 6
Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
SIZE (+)
ROE (?)
NANAL (+)
LEV (+)

1.148
0.002
0.033
0.172
0.009

2.682
3.472
1.687
2.196
2.003

0.0077
0.0006
0.0936
0.0461
0.0288

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

Table 8
Results of estimating Eq. (7) explaining variation in cost of capital estimatesindustry adjusted data
COSTit 

1 NANALit

2 LEVit

3 FDISCit

4 SDISCit

it 7

Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
NANAL ()
LEV (+)
FDISC ()
SDISC ()

0.00394
0.00101
0.00002
0.00040
0.00064

2.244
3.459
1.584
1.961
2.354

0.0258
0.0007
0.1147
0.0512
0.0195

No. of observations=221; adjusted R2=9.9%. Variable denitions: COST=estimated cost of equity capital for rm i, year tthe
industry sector median for year t; NANAL=number of analysts providing a one-year ahead earnings forecast for rm i, year tthe
industry sector median for year t; LEV=debt to equity ratio, rm i, year tthe industry sector median for year t; FDISC=nancial
disclosure score for rm i, year tthe industry sector median for year t; SDISC=social disclosure score for rm i, year tthe industry
sector median for year t.

611

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616


Table 9
Results of estimating Eq. (8) explaining variation in cost of capital estimatesindustry adjusted data
COSTit 
5 LANALit

1 NANALit

FDISCit

2 LEVit

6 LANALit

3 FDISCit

4 SDISCit

SDISCit it 8

Variable (pred. sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
NANAL ()
LEV (+)
FDISC ()
SDISC ()
LANAL*FDISC ()
LANAL*SDISC (?)

0.00094
0.00095
0.00002
0.00004
0.00078
0.00098
0.00036

0.474
3.258
1.478
0.169
2.517
2.289
0.567

0.6362
0.0013
0.1408
0.8663
0.0126
0.0231
0.5715

No. of observations=221; adjusted R2=12.98%. Variable denitions: COST=estimated cost of equity capital for rm i, year tthe
industry sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for rm i, year tthe
industry sector median for year t; LEV=debt to equity ratio, rm i, year tthe industry sector median for year t; FDISC=nancial
disclosure score for rm i, year tthe industry sector median for year t; SDISC=social disclosure score for rm i, year tthe industry
sector median for year t; LANAL=a dummy variable set equal to one if the number of analysts following rm i in year t is below is
industry sector median for year t, zero otherwise.

originally included in Eq. (6) explaining social


disclosure are omitted from this specication
which already includes industry adjustment. As
the results in Table 6 show, the results of estimating Eq. (5), which explains nancial disclosure
variation, using the industry adjusted data, are
very similar to our earlier results. The only dierence is that the signicance of leverage is diminished such that it is no longer a signicant
explanatory variable at conventional levels. As
Table 7 reveals, the R2 of the regression explaining
social disclosure falls dramatically (from 27 to
8%) when industry adjusted data are used and
industry related variables are excluded from the
regression. However, the explanatory power of the
remaining variables is very similar to that reported
in our earlier results.
The results of estimating Eqs. (7) and (8) are
reported in Tables 8 and 9, respectively.12 The

12
Recall that the sample sizes reected in Tables 8, 9, and 10
are 221, not the 324 reected in earlier tables. This reects the
additional data requirements to estimate the cost of capital
(analysts forecasts and industry ROE) and the deletion of
observations with cost of capital below the 1st percentile or
above the 99th percentile of the empirical distribution.

number of analysts following the rm has a statistically reliable eect on cost of capital, with
higher analyst coverage resulting in a lower cost of
capital. Financial leverage is positively associated
with the cost of equity capital, but this eect is not
signicant at conventional levels. Financial disclosure is negatively related to cost of capital,
consistent with our predictions. This result is
stronger than the full sample result in Botosan,
perhaps suggesting that nancial disclosure plays
a more important role for Canadian rms. Surprisingly, social disclosure exhibits a statistically
reliable positive association with the cost of equity
capital. For our sample rms and our time period,
enhanced social disclosure results in a higher cost
of capital.
Table 9 reports the results of estimating the
expanded Eq. (8). This specication includes
interaction terms intended to determine if analyst
following modies the relation between our disclosure variables and the cost of capital. Consistent with Botosans (1997) results, we nd that
rms with low analyst following receive benets
from expanded nancial disclosure in the form of
a reduction in the cost of equity capital. The
interaction of analyst following and social disclosure is not statistically signicant.

612

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

4.5. Specication checks and further analysis


Whites test for heteroskedasticity/model specication fails to reject the null hypothesis of
homoskedasticity for all regressions. In addition,
the highest condition index reported in any of our
regressions is 3.6, suggesting that multicollinearity
is not aecting our results.
One potential problem with our data is that
each rm contributes up to three observations to
the estimation, and these observations may not be
independent. Accordingly, we estimate Eqs. (7)
and (8) on a year-by-year basis rather than on the
pooled sample. The results (not reported) are very
similar to those reported for the full sample. All
variables that are signicant in our pooled regressions have consistent signs for each of the 3 years,
and are signicant in at least one, often two, of the
yearly regressions. This suggests that our results
are not due to our pooling of sample data.
We explore further our nding that social disclosure increases the cost of capital. We conjecture
that this result may be related to the poor economic conditions that characterize our sample
period. While we do not have data available from
another, more prosperous time period, we conduct
an alternative test to assess this explanation for
our results. If the relationship between social disclosure and the cost of capital is mediated by economic conditions, then we expect that, within our
sample, rms with above average nancial performance would not experience an increase in the
cost of capital as social disclosure increases, while
those rms with below average nancial performance would. We test this conjecture by estimating Eq. (9), which replaces the insignicant social
disclosure/analyst following interaction from Eq.
(8) with a social disclosure/return on equity interaction. For completeness, we also include return
on equity in the equation to test for a direct
impact of nancial performance on the cost of
equity capital:
COSTit 

1 NANALit

2 LEVit

3 FDISCit

4 SDISCit

LANAL
5
it FDISCit
6 DROEit

SDISCit

7 ROEit

it

where ROE is equal to the return on equity for


rm i, year tthe industry sector median for year
t, DROE is a dummy variable set equal to one if
rm i, year t return on equity is above the industry
sector median for year t, zero otherwise, and all
other variables are as previously dened.
In keeping with the above discussion, we expect
C6 to be negative and make no predictions about
C7.13 The results of estimating Eq. (9) are provided in Table 10. Consistent with our conjectures,
the coecient on the social disclosure/nancial
performance interaction, is reliably negative. This
coecient is almost exactly equal in absolute
magnitude (0.00109) to the coecient on social
disclosure (0.00116). This indicates that there is
essentially no relation between social disclosure
and the cost of capital for rms with above average return on equity, but a signicant increase
in the cost of capital accompanying better social
disclosure for below average return on equity
rms.14
4.6. Sensitivity of results to cost of capital
estimation assumptions
We perform several alternative calculations of
the cost of capital by varying the assumptions
underlying that calculation. The primary results
13

Since this analysis is conducted in light of our earlier


empirical results, we conduct two-tailed tests of statistical signicance for this estimation.
14
The distribution of ROE reveals the existence of some
extreme negative values. There are no negative book value
observations in our sample, so these observations are not
caused by small negative denonimators. Since our ROE and
social disclosure interaction is based on a dummy variable for
ROE, this interaction term should not be impacted by these
observations. However, it is possible that the estimated coecient for the main eect of ROE is impacted by these observations, and that this aects the estimated coecient on the
interaction term. We conducted two additional tests to ensure
that our results are not sensitive to extreme observations of
ROE. We repeated the estimation of Eq. (9) after (1) eliminating all observations with ROE less than 25% (the 5th percntile of the empirical distribution), and (2) retaining all
observations but replacing the continuous version of ROE with
the dummy variable (DROE) to test for the main eect of
ROE. Neither change in specication qualitatively alters our
results. In particular, C6 remains signicantly negative and C7
remains insignicantly dierent from zero in both tests.

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A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616


Table 10
Results of estimating Eq. (9) explaining variation in cost of capital estimatesindustry adjusted data
COSTit 
5 LANALit

1 NANALit

FDISCit

2 LEVit

6 DROEit

3 FDISCit

SDISCit

4 SDISCit
7 ROEit

it 9

Variable (pred. Sign)

Coecient estimate

t-Statistic

P-value (two-tailed)

Intercept (?)
NANAL ()
LEV (+)
FDISC ()
SDISC ()
LANAL FDISC ()
DROE SDISC ()
ROE (?)

0.00130
0.00091
0.00003
0.00007
0.00116
0.00096
0.00109
0.00009

0.667
3.221
1.863
0.284
3.462
2.663
2.469
1.101

0.5058
0.0015
0.0639
0.7771
0.0006
0.0083
0.0143
0.2719

No. of observations=221; adjusted R2=15.58%. Variable denitions: COST=estimated cost of equity capital for rm i, year tthe
industry sector median for year t; NANAL=number of analysts providing a 1-year ahead earnings forecast for rm i, year tthe
industry sector median for year t; LEV=debt to equity ratio, rm i, year tthe industry sector median for year t; FDISC=nancial
disclosure score for rm i, year tthe industry sector median for year t; SDISC=social disclosure score for rm i, year tthe industry
sector median for year t; ROE=return on equity for rm i, year tthe industry sector median for year t; LANAL=a dummy variable
set equal to one if the number of analysts following rm i in year t is below is industry sector median for year t, zero otherwise;
DROE=a dummy variable set equal to one if return on equity for rm i, year t is above the industry sector median for year t, zero
otherwise.

reported above are based on the assumption that


the ROE of each rm fades to its historical industry average ROE in a linear fashion between
years +4 and +12. We check for the sensitivity
of our results to this assumption by performing
two new calculations, one in which the linear fade
occurs between periods +4 and +6, and one in
which the fade occurs between +4 and +18. Our
primary empirical results are not sensitive to these
changes in specication. The statistical signicance of most explanatory variables, including
the disclosure variables of primary interest,
increase with the length of the linear fade period,
perhaps suggesting that the cost of capital estimates contain less noise as the linear fade period is
increased.

5. Conclusions and suggestions for future research


This study provides further evidence on the theoretical and regulatory premise that improved
corporate disclosure results in a lower cost of
capital. We nd that there is a signicant negative

relationship between the level of nancial disclosure and the cost of capital (H1, see Table 8).
We also conrm Botosans (1997) nding that
higher levels of nancial disclosure can reduce the
cost of capital in cases where there is low nancial
analyst following [H3a(i), see Table 9]. Our
results, however, suggest that this relation does
not hold for social disclosures. There is a statistically signicant, positive relation between the level
of social disclosure and the cost of capital, that is,
more social disclosure raises the cost of capital for
the rm (H2, see Table 8). The number of analysts
following the rm does not aect this result
[H3a(ii), see Table 9]. The positive relationship
between cost of capital and social disclosure is
moderated by the return-on-equity of the rm
with more successful rms being less penalized for
social disclosures.
It is important to recognize that these results are
not based on the content of the disclosures. The
disclosure scores reect the completeness and
informativeness of nancial and social disclosures
but they do not indicate whether the information
is good or bad news. There are several possible

614

A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

explanations for the results on the relationship


between social disclosure and cost of capital. First,
if there were a consistent bias in social disclosures
where rms that experience higher than average
social costs disclose more information, then, on
average, the results reported could hold. The
descriptive literature on social disclosures has
reported that there are severe biases in reporting
(e.g. Guthrie & Parker, 1990; Wiseman, 1982).
The reported bias is that rms tend to use social
disclosures for self-promotion. This means that
that rms tend to report the positive social contributions that they make but under-report negative social eects. Unfortunately, the relationship
between this bias and the costs incurred and benets received by the rm is unclear (Richardson et
al., 1999).
Second, the results could hold if two things are
true. It may be that social responsibility investments by rms are consistently negative present
value projects increasing the overall risk of the
rm. While proponents of socially responsible
corporate behavior point to the potential cost
savings and long-term strategic advantage of such
behavior (e.g. Porter & van der Linde 1995; Scaltegger & Figge, 1998), the market may hold a different view. If this is the case and there is a positive
correlation between social disclosures and social
responsibility actions, then the observed results
could hold.
It is also possible that the results are specic to
the data used in this analysis. The time period for
which data were available was an economic recession. The positive link between social disclosure
and the cost of equity capital we document may be
contingent on these macro economic conditions.
This interpretation is supported by our result that
the eect of social disclosure on the cost of capital
is moderated by return on equity (see Table 10).
For rms with ROE above the industry median,
there is a negative interaction between social disclosure and return on equity that osets the main
eect between cost of capital and social disclosure.
In other words, for rms with above average nancial performance, social disclosure may have no
eect on the cost of capital. If this is a reasonable
proxy for economic conditions, then the relationship between social disclosure and cost of capital

may be limited to periods of economic downturn.


Future research that expands the data set over a
complete business cycle to test for this eect is
clearly called for by our results.
The eect of social disclosure on the cost of
equity capital documented in this study should not
be taken to imply that social disclosure has an
overall negative eect on the rm. Social and
environmental issues have signicant distributional eects. Although investors may require a
higher cost of capital for rms with a signicant
social agenda, other groups such as employees,
customers, regulators and supply-chain partners
may provide greater support to the rm because of
these actions. Much of the work on developing a
social accounting agenda has, in fact, been premised on the assumption that corporate social
disclosure will benet a broader community of
stakeholders than the capital providers that are
the primary audience for nancial disclosures (e.g.
Gray, 2000). The eect of social disclosures on the
expected cost of contributions to the rm from
other stakeholders has still to be examined.

Acknowledgements
The authors gratefully acknowledge the nancial support of the Certied General Accountants
of Canada Research Foundation and comments
on earlier drafts by Irene Gordon, Marc Epstein
and an anonymous reviewer. The authors also
gratefully acknowledge the contribution of I/B/E/
S International Inc. for providing earnings per
share forecast data, available through the Institutional Brokers Estimate System. These data have
been provided as part of a broad academic program to encourage earnings expectations
research.

Appendix A
Panel 1: Social disclosure categories of information, maximum number of points allocated to the
category, and number of sub-categories allocated
to each categoryinformation provided in the
1991 SMAC/UQAM Report:
(continued on next page)

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A.J. Richardson, M. Welker / Accounting, Organizations and Society 26 (2001) 597616

Category of
information
Human resources
Products, services,
and consumers
Community
Environment
Energy resources
Governments
Suppliers
Shareholders
Competitors
Miscellaneous
Totals

Maximum
points

No. of subcategories

18
10

29
23

18
18
6
10
6
6
4
4
100

24
22
10
14
16
9
9
14
170

Other notes to
nancial statements
Pension plans
and leases
Government aid
and income tax
Exports and portion
of products
manufactured in Canada
Information on eects
of price uctuations
Special notes on total
quality, environment,
training, and technology
Miscellaneous
Totals

Panel 2: Financial disclosure categories of


information, maximum number of points allocated to the category, and number of sub-categories allocated to each categoryinformation
provided in the 1991 SMAC/UQAM Report.

Category
General information
Financial retrospective
Financial forecasts
Graphs and tables
Points of view on
regulations, competition
and economy
Past performance
and highlights
Future prospects
Investment and
disinvestment
Research, development
and environment
Risks and uncertainties
Chairmans (sic) report
Financial statements
Sector Information
Income Statement
Accounting policies

Maximum No. of subpoints


categories
10
10
10
5

7
11
4
23

25

5
5

12
22

14

5
2

9
4

10
10
5

34
10
7

13

37

120

261

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