The objective of this paper is twofold. First, we investigate the relation between earnings quality and segment disclosure. Second, we analyze whether firms providing higher quality of segment information enjoy a lower cost of capital. For the analysis of the relation between earnings quality and segment disclosure we create an index of quantity of voluntary segment disclosure. We use the residuals of a regression of quantity of segment information on the determinants of segment disclosure as a proxy for the quality of segment disclosure. We argue that quality (and not quantity) of segment disclosure will have an impact on cost of capital.
We expect that earnings quality and segment disclosure will be related in a predictable way. The literature on information economics suggests that firms provide information to decrease information asymmetries (Grossman and Hart, 1980; Milgrom, 1981; Verrecchia, 1983). This provision of information could be achieved through several channels, including the reported accounting numbers and through additional disclosure. Verrecchia (1990) and Penno (1997) directly model the relation between earnings quality and disclosure, showing that more expansive disclosure is expected in firms with better earnings quality. However, results in the empirical literature are mixed, probably due to the use of empirical measures of disclosure that include information expected to be useful for investors (that disaggregates, explains or complements the reported numbers) and information that is difficult to verify and that might not be useful for investors.
In this study, we focus on segment disclosure. Prior literature suggests segment disclosure is useful for investors and increases firm value, as it increases the value relevance of accounting numbers (Chen and Zhang, 2003), it improves monitoring over management decisions, while diminishing agency costs (Hope and Thomas, 2008), and helps reducing information asymmetries (Greenstein and Sami, 1994). Consequently, we expect firms providing better earnings quality will also be likely to provide comprehensive segment disclosure to additionally decrease information asymmetries and increase firm value. Thus, we expect that, holding everything else constant, firms with better earnings quality will prepare more expansive segment disclosures.
The second objective of this paper is to study the relation between cost of capital and quality of segment information. There is an ongoing debate on whether and how accounting quality decreases cost of capital. One stream of literature suggests that information asymmetries affect the cost of capital: accounting quality reduces these information asymmetries; which in turn, affects the cost of capital (Easley and O’Hara, 2004). More recently, several studies demonstrate that information differences across investors affect a firm’s cost of capital through information precision, and not information asymmetry per se (Hughes, Liu and Liu, 2007; Lambert, Leuz and Verrecchia, 2007, 2008). As shown in prior research (Kinney, 1971; Collins, 1976; Baldwin, 1984; Balakrishnan, Harris and Sen, 1990), segment reporting improves the predictive ability of accounting numbers. Consequently, we expect that improved segment information will facilitate the estimation of firms’ cash flows, which in the Lambert et al. (2007, 2008) setting will lead to lower cost of capital.
Using a sample of non regulated and non financial firms for the period 2001-2006, we find that firms providing high quality segment disclosure, contingent upon good earnings quality, enjoy lower costs of equity capital. This result is robust to controls for the determinants of segment disclosure, and to the use of asset-pricing based tests and implied cost of capital based tests. In addition, we provide empirical evidence that segment disclosure improves investors’ ability to estimate firm’s cash flows by showing that better quality segment disclosure, contingent upon good earnings quality, reduces analysts’ forecast errors. Also, we show that the provision of high segment information quality, having good earnings quality, leads to a reduction in the firm’s assessed covariance with other firms’ returns. This is consistent with quality of segment disclosure reducing estimation risk. Unlike Francis, Nanda and Olsson (2008), we use a proxy of disclosure quality, not a proxy of disclosure quantity. Our results show that it is the quality of disclosure, not the quantity of disclosure, which reduces the cost of capital. The quantity of segment disclosures is only a proxy of the activity of the firm (i.e., a firm provides more segment information when it is more diversified).
