The fourth main issue of this study is to investigate the influence of risk disclosure on the cost of capital of sampled firms. The notion here is that when a firm discloses less risk-related information in its annual report, the financers would face more difficulties in predicting future cash flows. As a result, the financers ask for a higher rate of return because of the increased information risk. In other words, firms with a low level of risk disclosure (high information risk or uncertainty) are expected to have a higher cost of capital. Botosan (1997), Diamond and Verrecchia (1991), Healy and Palepu (2001), and Kim and Verrecchia (1994) argue that a higher level of disclosure leads to less uncertainty and, in turn, low estimation risk which results in lowering the cost of capital. In other words, providing a managerial perspective on the risks faced by the firm has the potential to reduce the cost of capital by lowering the level of uncertainty. This suggests a negative association between the level of disclosure and the cost of equity.
Jensen and Meckling (1976) state that one of the mechanisms for firms to mitigate investors’ uncertainties and information asymmetry is by applying good corporate governance principles. Any mitigation in information asymmetry would result in lowering the agency cost and the cost of equity by providing fair opportunities to small and large stockholders in obtaining information (Morris, 1987).
When information asymmetry prevails, firms that are considered riskier would pay a higher rate of interest on debts and would have a lower valuation for their stocks. Additionally, capital providers would put a higher risk premium which raises the cost of capital. Thus, the theoretical review suggests a negative relationship between risk disclosure and the cost of capital. However, it is hard to determine the precise effect of risk reporting on the cost of capital (ICAEW, 1997) because these two variables cannot be observed straightway (Hail, 2002). Nevertheless, Botosan (1997) declares that there are two distinct streams of research that theoretically support the negative correlation between disclosure and cost of equity. The first line of research suggests that firms increase the level of disclosure in order to increase the share market liquidity by motivating potential investors to buy the firms` stocks (e.g. Amihud and Mendelson 1986; Copeland and Galai 1983; Demsetz 1968; Diamond and Verrecchia 1991; Glosten and Milgrom 1985) cited by Botosan (1997). For instance, Diamond and Verrecchia (1991) claim that providing more information to the market would raise the incentives of investors to buy the firms` shares.
As a consequence, the stock liquidity would be increased resulting in less information asymmetry and, in turn, lower cost of equity (Diamond & Verrecchia, 1991). Similarly, Bloomfield and Wilks (2000) find that greater disclosure motivates investors to pay a high price which results in lowering the cost of equity and increasing the stock liquidity.
The second line of research proposes that higher quality of disclosure minimizes the cost of capital through mitigating information risk or estimation risk (e.g. Barry and Brown 1985; Clarkson, Guedes, and Thompson 1996; Coles, Loewenstein, and Suay 1995; Coles and Loewenstein 1988; Handa and Linn 1993; Klein and Bawa 1976) cited by Botosan (1997). This means investors demand compensation for the additional risk when there is a high level of uncertainty regarding the “true” parameters resulting from the lack of information (Botosan, 1997). When executives report a high level of information, the information risk is reduced and hence, investors demand a lower rate of return (lower cost of capital) (Healy & Palepu, 2001).
Other theories can also explain the proposed negative association between risk reporting and cost of capital such as pecking order and capital need theories. As discussed in the previous section, pecking order theory has been proposed by Donaldson (1961) and developed by Myers and Majluf (1984) in the purpose of explaining firms` financing decisions. It is a well-established theory in the literature on capital structure. It states that firms prioritize to finance their operations by retained profits, debts, and lastly by issuing equity. This implies that firms` managers may have the incentive to engage in risk disclosure just as they need to raise capital. In the same vein, capital need theory states that firms are encouraged to disclose voluntarily when they desire to raise capital at a lower cost (Abd-Elsalam & Weetman, 2003; Craven & Marston, 1999; Rajab, 2009). Hence, when firms experience shortages of liquidity, firms` directors would have the incentive to disclose more risk-related information in order to attract investors and raise capital at a lower possible cost. The above arguments suggest a negative relationship between risk disclosure and cost of capital.
Empirically, Botosan (1997) finds a negative association between the level of disclosure and the cost of equity. Hail (2002) discovers a negative association between the level of disclosure and the cost of capital. Sengupta (1998) finds that disclosure is negatively related to the cost of debt. With regards to risk disclosure literature, there are, to the best of my knowledge, only two studies that investigate the impact of risk reporting on
the cost of equity. The first study is conducted by Semper and Beltrán (2014) in Spain. Their findings indicate that there is no significant relationship between risk reporting and the cost of equity. However, financial risk disclosure is found to be significantly and positively related to the cost of equity. This is in contrast to what is expected theoretically. The other study is a PhD thesis conducted by Rajab (2009) in the UK. He finds that there is no significant association between risk reporting and the cost of equity.
From the discussion above, the nineteenth hypothesis to be tested is formulated as follows: H14: There is a significant and negative relationship between and risk disclosure
and cost of capital.
3.8.
Chapter summary
This chapter reviewed the previous literature on risk reporting. The key theories of risk disclosure have been discussed thoroughly (e.g. signaling theory, agency theory, proprietary cost theory, capital need theory, political cost theory, and institutional theory). The empirical studies conducted in the developed and developing markets have been reviewed. The determinants of risk disclosure are divided into four groups: (i) corporate governance mechanisms; (ii) ownership structure variables; and (iii) Islamic values. The reason for selecting these variables is based on prior research that explored the relationship between corporate governance and disclosure. The present study hypothesized that auditor type, board size, independent directors, non-executive directors, board education, risk management committee, institutional ownership, and Islamic values are significantly and positively related to risk disclosure. On the other hand, the present study hypothesized that government ownership, inside ownership, and block ownership are significantly and negatively related to risk disclosure. The current study expects that the introduction of the Loss-Making Firms Procedures (LMFPs) has a significantly positive relationship with risk disclosure. The theoretical and empirical review relating to the impact of risk reporting on the cost of capital has been also discussed. The present study hypothesized that risk disclosure has a significantly negative impact on the cost of capital.