UNC Kenan-Flagler Business School

Shaping Leaders, Driving Results

UNC Kenan-Flagler Business School


In the Interest of Full Disclosure


Issues of transparency and liquidity have taken on particular relevance

Investors feel more confident buying if they know what they’re getting for their money. The more confidence investors have in a company, the more likely they are to trade in its shares. And the more shares that trade, the lower the cost of capital for that firm.

Form 10K

Transparency is associated with higher liquidity, which reduces the cost of capital and increases firm value, according to accounting professor Mark Lang. But the benefit of increasing transparency differs depending on the business environment.

“The question is: Is there any benefit that attaches to increasing transparency?” Lang said. “That’s what we’re interested in.”

Lang and his colleagues measured bid-ask spreads to document transaction costs and counted the number of zero-return days to assess liquidity. Narrow bid-ask spreads indicated reduced transaction costs, and more zero-return days showed investors’ willingness to trade in the firm’s shares.

They looked at a number of factors to determine the amount of transparency:

  • Evidence of earnings management
  • Quality of accounting standards
  • Quality of auditors
  • Amount of analyst following
  • Accuracy of analyst forecasts

Firms with greater transparency along each of those dimensions had lower transaction costs and greater liquidity, which translated into substantially lower cost of capital and, consequently, higher firm value.

The relation between transparency and liquidity was more pronounced in periods of high volatility, when investor protection and disclosure requirements are poor and when ownership is more concentrated, the researchers found. Their findings suggest that firm-level transparency matters more when overall uncertainty is greater.

“Issues of transparency and liquidity have taken on particular relevance in light of recent disruptions in securities markets,” Lang said.

He focused his research on an international setting, where transparency and liquidity issues were likely to be more pronounced. While the U.S. market tends to be relatively transparent and homogeneous, the recent financial crisis has highlighted that liquidity varies widely across and within asset classes. Factors such as auditor choice, accounting standards, earnings smoothing and analyst following can have different implications internationally than in the United States.

In countries that have few rules protecting minority investors, transparency is all the more important. Other researchers have looked at transparency and liquidity primarily at the country level; Lang took into account factors at the firm level as well. The financial reporting quality, oversight by regulators and auditors, investor protection, analyst following and managerial incentives all played a part.

Firms following international accounting standards and those audited by top-tier audit firms had greater transparency, Lang found.

Companies can boost their transparency by holding themselves to higher accounting standards and hiring a well-respected auditor, for instance. Investors are more willing to invest when they have confidence that the firm directors are unlikely to expropriate firm assets, to overpay themselves or to mismanage earnings.

For example, earnings management tends to be more prevalent in international contexts, where oversight is weak and incentives to create opacity are strong. Although events inside and outside of a firm affect its profitability, the investor is privy only to what the firm reports. When a company manages reported earnings by, for example, smoothing out fluctuations in underlying cash flows, the investor has less information on what is really going on inside the firm and will be less willing to invest.

Similarly, analysts appeared to be important players in increased transparency and liquidity. Analysts gather and aggregate information from public and private sources, effectively disciplining firm reporting choices and improving transparency. The accuracy of analysts’ forecasts is a measure of the availability of information about the underlying economies of the firm, Lang concluded.

Lang’s research suggested that firms followed by more analysts who were able to accurately forecast earnings also experienced greater liquidity and lower cost of capital. From a firm’s perspective, the results suggested that efforts to increase analyst following and keep the market well-informed about important developments at the firm through improved investor relations, for example, have the potential to increase firm value.

“If there is more information available to market participants, either through public disclosure or private information acquisition,” Lang said, “analyst forecasts should be more accurate.”

Overall, the results suggested that firms have substantial control over the liquidity in their shares and cost of capital if they made choices likely to increase transparency. In terms of cost of capital and firm value, Lang’s results suggested that transparency is primarily important in terms of its effects on liquidity. Not only did more transparent firms enjoy greater liquidity, but the research suggests direct effects of that increase in liquidity on cost of capital as measured by the discount rate investors apply in valuing firms and, ultimately, in price they are willing to pay for the firm’s shares.

“But, obviously, disclosure costs money,” Lang said.

Firms that decide to increase transparency by improving investor relations, issuing press releases, holding conference calls with analysts, enhancing internal accounting systems and hiring more expensive auditors clearly incur additional direct costs.

“While it is easy to focus on the costs of increased transparency,” Lang said, “our goal was to provide insights into the potential benefits. Our results suggest that more transparent firms benefit in terms of increased liquidity and, potentially, higher valuations on the stock market. In trading off the costs and benefits, transparency is particularly important in crisis periods and when uncertainty is greater.”

Although Lang’s analysis was based on a broad sample of international firms, the overall message applies to firms everywhere.

“Investors prefer to own and trade in shares of firms that are more forthcoming,” he said, “and transparency potentially benefits not only shareholders but also executives through higher share price.”

Mark Lang is the Thomas W. Hudson Jr./Deloitte & Touche Distinguished Professor of Accounting.