The effect of financial reporting frequency on information asymmetry and the cost of equity

In recent years, there have been calls to increase the frequency of reporting financial statements both in the U.S. and in other countries. This raises questions as to what are the effects of increased reporting frequency. In this study, we examine directly how the frequency of interim reporting affects information asymmetry and the cost of equity.

The predictions from the theoretical literature are unclear. While more frequent disclosures may reduce information asymmetry, they may also provide stronger incentives for sophisticated investors to acquire private information and discourage information production from other sources, resulting in wider information asymmetry among investors. Similarly, while some earlier studies suggest that more disclosures lower the cost of equity by reducing adverse selection and estimation risks, two recent studies suggest that the impact of disclosures on the cost of equity exists only when the disclosures convey information on non-diversifiable risks. Consistent with the different views in theoretical works, empirical evidence is mixed on the relation between disclosures and information asymmetry/cost of equity. Therefore, the impact of financial reporting frequency on information asymmetry/cost of equity remains an empirical issue.

The empirical evidence however is difficult to come by because, after 1970, all firms in the U.S. report on a quarterly basis, making it impossible to observe variations in reporting frequency. To overcome this obstacle, we hand collect reporting frequency data for U.S. firms for the years between 1951 and 1973. During these years, there are substantial variations in the reporting frequency because many firms report more frequently than required by the SEC. (The SEC required annual reporting in 1934, semi-annual reporting in 1955 and quarterly reporting in 1970.) By offering substantial cross-sectional and time-series variation in reporting frequency, our sample period provides an ideal setting to investigate our research question.

Model/Variable | OLS | Fixed Effects | 2SLS |

A. Bid-Ask Spread | –0.146^{***} | –0.093^{***} | –0.085^{***} |

(IA – Spread_{i,t}) | (0.047) | (0.020) | (0.018) |

B. Price Impact | –0.382^{***} | –0.225^{***} | –0.216^{***} |

(IAPI_{i,t}) | (0.094) | (0.049) | (0.047) |

C. Ex-post realized returns | –1.482^{***} | –0.854^{**} | –0.885^{**} |

(RET_{i,t}) | (0.489) | (0.385) | (0.370) |

D. Expected CAPM returns | –1.085^{**} | –0.655^{**} | –0.628^{**} |

(COE – RET_{i,t}) | (0.532) | (0.298) | (0.272) |

E. Expected FF3 returns | –1.014^{**} | –0.662^{**} | –0.658^{**} |

(COE – FF3_{i,t}) | (0.459) | (0.294) | (0.274) |

F. Earnings-price ratio model | –0.906^{**} | –0.591^{***} | –0.502^{***} |

(COE – EP_{i,t}) | (0.438) | (0.153) | (0.147) |

Standard errors are in parentheses. One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.

A typical model looks like
y = α + β_{1}⋅ Freq_{i,t – 1} + β_{2}⋅ Size_{ i,t – 1} + β_{3} ⋅ log(Turnover_{i,t – 1}) + β_{4}⋅ log(Volatility_{i,t – 1}) + ε_{i,t}
where y is the variable reported in the first two columns, and the reported coefficients are the reporting frequency, possibly IV-fitted. The reported coefficient is on the first variable, the frequency of reporting.

Our results based on the pooled sample are reported in Table 1. In a simple OLS regression of information asymmetry/cost of equity on reporting frequency and other control variables, the coefficient on reporting frequency is negative and significant, suggesting that firms with higher reporting frequency have lower information asymmetry/cost of equity. To alleviate the concern that that some unobservable firm characteristics, such as the firm's riskiness, affect both observed reporting frequency and information asymmetry/cost of equity, we also estimate a firm fixed effects model, a two-stage least squares estimation procedure (2SLS hereafter), and a matched control sample approach. We obtain similar inferences from both the firm fixed effects model and two-stage procedure. Specifically, results from the two-stage procedure suggest that an increase of one in the reporting frequency on average reduces our information asymmetry measure, the price impact, by 0.216% and the cost of equity measure based on the CAPM model by 0.628%.

Information asymmetry | Cost of equity | |||||

Variables | IA_{Spread} | IA_{PI} | COE_{RET} | COE_{CAPM} | COE_{FF3} | COE_{EP} |

Treatment×After | –0.162^{**} | –0.431^{***} | –1.613^{**} | –1.217^{***} | –1.308^{*} | –0.963^{**} |

(0.078) | (0.152) | (0.727) | (0.323) | (0.667) | (0.442) |

Information asymmetry | Cost of equity | |||||

Variables | IA_{Spread} | IA_{PI} | COE_{RET} | COE_{CAPM} | COE_{FF3} | COE_{EP} |

Treatment×After | –0.171^{**} | –0.455^{***} | –1.644^{***} | –1.279^{***} | –1.329^{**} | –1.049^{**} |

(0.076) | (0.116) | (0.611) | (0.215) | (0.544) | (0.425) |

Information asymmetry | Cost of equity | |||||

Variables | IA_{Spread} | IA_{PI} | COE_{RET} | COE_{CAPM} | COE_{FF3} | COE_{EP} |

Treatment×After | 0.102 | 0.381 | 1.053 | 1.224 | 1.255 | 0.874 |

(0.159) | (0.240) | (0.789) | (1.188) | (0.909) | (0.553) |

Standard errors are in parentheses. One, two, and three stars mark statistical significance at the 10%, 5%, and 1% level, respectively.

The table reports only OLS coefficient estimates (multiplied by 100) and firm-year-clustered standard errors for Treatment×After vs a control sample. The dependent variable is an information asymmetry (cost of equity measure). The treatment are three years of data from firms that change the reporting frequency. Control firms have zero. The sample sizes are 3,050 treatment and control firms, with between 550 and 1,100 effective observation per regression from the 1951–1973 period.

Results from the matched control sample approach (reported in Table 2) show that information asymmetry and the cost of equity decrease significantly for firms that increase their reporting frequency relative to control firms, regardless of whether the increase in reporting frequency is voluntary or mandatory. Specifically, the price impact decreases by 0.431% and 0.455% on average and the cost of equity based on the CAPM model drops by an average of 1.217% and 1.279% for firms with a voluntary increase and for firms with a mandatory increase in reporting frequency, respectively. Most increases amount to doubling the reporting frequency (i.e., from semi-annual reporting to quarterly reporting). Our results related to decreases in reporting frequency are much weaker, possibly because decreases in reporting frequency are typically temporary and do not reflect a commitment to reduced disclosures. Statistically, more than 90% of firms with a reduction in the reporting frequency revert back to the original level or higher level of reporting frequency over the three years after the reduction.

By showing that higher financial reporting frequency reduces information asymmetry and the cost of equity, our study documents the benefits of providing more frequent financial reporting. In particular, our results related to mandatory changes in reporting frequency suggest that these benefits remain, even when firms are forced to deviate from their chosen reporting frequency. We however cannot conclude that firms should be forced to report more frequently, because our analysis does not address the potential costs of increasing reporting frequency (e.g., out-of-pocket costs, proprietary costs). A more detailed analysis of these costs is a fruitful area for future research.

Rembrandt (1606–1669): The Anatomy Lesson of Dr. Nicolaes Tulp. Flemish, 1632.. At the age of 26, Rembrandt was already using strong lights and heavy shadows. Anatomy lessons were social events in those days (much like finance seminars these days). The event took place in a theatre with spectators who bought tickets to see dissection of a body. The body in the painting is that of a criminal convicted of armed robbery and sentenced to death by hanging. A solemn event, indeed, enjoyed by many! Did it reduce the incidence of armed robbery, increase scientific knowledge, or just entertain?