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ISSN : 2288-4637(Print)
ISSN : 2288-4645(Online)
The Journal of Asian Finance, Economics and Business Vol.4 No.3 pp.5-17
DOI : http://dx.doi.org/10.13106/jafeb.2017.vol4.no3.5

# Financial Disclosure and the Cost of Equity Capital: The Empirical Test of the Largest Listed Companies of Kazakhstan

Aizhan Baimukhamedova1 , Gulzada Baimukhamedova2 , Albina Luchaninova3
1 First Author and Corresponding Author. Assistant Professor,
Department of Management Information Systems, Faculty of
Commercial Sciences, Baskent University, Turkey [Postal Address: Bağlıca Kampüsü, Eskişehir Yolu 20. Km., 06810 Etimesgut/Ankara,
2Co-Author. Assistant Professor, Department of Economics and Management, Kostanay Social-Technical University by Z.Aldamzhar, Republic of Kazakhstan.
3 Co-Author. Professor, Department of Economics and Management, Kostanay Social-Technical University by Z.Aldamzhar, Republic of Kazakhstan.
Corresponding Author. Aizhan Baimukhamedova E-mail: djanin50@mail.ru
January 24, 2017 July 31, 2017 August 5, 2017

## Abstract

This study extends research into whether disclosure of corporate and financial information is associated with firms’ costs of equity capital. This study sets out to examine empirically the determinants of corporate disclosure in the annual reports of 37 largest and most liquid firms listed on Kazakhstan Stock Exchange (KASE) in Kazakhstan. It also reports the results of the association between company-specific characteristics and disclosure of the sample companies. Based on the analysis of existing empirical research, the disclosure index has been constructed and regression analysis of the influence of the disclosure index on the cost of equity capital has been conducted. The obtained results show that the received findings correlate with foreign empirical studies, and the disclosure index in this sample has a negative impact on the cost of equity capital. Using cost of equity capital estimates derived from capital asset pricing model, we find that firms with higher levels of financial transparency are associated with significantly lower costs of equity capital. Economic theory assumes that by increasing the level of corporate reporting, firms not only increase their stock market liquidity, but also decrease the investors’ estimation risk, arising from uncertainty about future returns and payout distributions. The results show that firms on the Kazakhstan market can reduce their cost of equity capital by increasing the level of their voluntary corporate disclosures.

JEL Classification Code: G30, M48, M14.

## 1. Introduction

Corporate disclosure can be defined as the communication of information by people inside the public firms towards people outside. The main aim of corporate disclosure is “to communicate firm performance and governance to outside investors” (Haely & Palepu, 2001,p.405). This communication is not only called for by shareholders and investors to analyze the relevance of their investments, but also by the other stakeholders, particularly for information about corporate social and environmental policies. The significance of corporate disclosure practices has been of growing interest both in theory and in practice. Since the stock market collapsed in 1929, regulatory efforts have pointed on limiting the firm's decision in settling the timeliness, scope, content and form of disclosure provided to equity capital market participants and others (Welker, 1995). Though, there are still noticeable differences between the disclosure levels of firms in capital markets. In all these studies, accounting disclosure plays a main role and must be measured in some way. But disclosure is a theoretical concept that is difficult to measure directly. The literature on disclosure offers a variety of potential proxies that aim to measure disclosure.

There are many reasons for which firms must have incentives to disclose information to the public. Researchers applied many theoretical perspectives in order to explain the phenomena of disclosure and to explain what motivates companies’ managers to reveal more information than is required by legislation. However, no any single theory is available to explain disclosure phenomenon completely, and, to date, researchers tend to select whichever theory relates best with their hypothesis (Linsley & Shrives, 2000). It has been examined that increasing corporate disclosure is of great benefit to both stakeholders and the companies. From the stakeholders’ perspective, disclosure will enable them to better assess the financial performance of the company and to assure them that the managers are managing companies at their best. From the companies’ perspectives, disclosure gives significant messages about business performance and puts companies in direct contact with investors, which increases their confidence, and hence reduces the cost of capital (Botosan, 1997). If disclosure affects the company’s cost of capital, this should put the market in a better position by keeping it informed, and hence enhancing its functioning.

The importance of corporate disclosure arises from being a means of communication between management and outside investors and market participants in general. Demand for corporate disclosure arises from the information asymmetry problem and agency conflicts between management and outside investors (Healy & Palepu, 2001). Enhanced corporate disclosure is believed to mitigate these problems (Healy & Palepu, 2001; Graham, Campbell & Rajgopal, 2005; Lambert, Leuz & Verrecchia, 2007). Companies may benefit from providing more information to the public through a reduction in their cost of capital and an increase in the pure cash flows accruing to their shareholders, consequently increasing their values. However, providing information to the public is not a costless task. Among the costs of disclosure are the costs of information production and dissemination; for example the costs of adopting an information system to collect, process data and report information about the company and the costs of hiring accountants and audits, etc.

In this study, a framework for empirical tests of the relation between disclosure and the cost of equity capital is determined. Economic theory assumes a negative association between disclosure and cost of equity capital (Diamond & Verrecchia, 1991; Easley & O’Hara, 2004). The main issues that have been tackled or are currently being tackled in accounting disclosure literature as a whole include identifying what companies are reporting, the underlying factors that may affect the extent to which information is reported and motivates companies to make particular information disclosure. While some previous studies have focused on what information is disclosed, more studies are needed to examine how information is disclosed, and to examine the potential benefits of information disclosure, for example, its impact on the company’s cost of capital. Thus, with regards to corporate information reporting, the empirical literature provides only partial answers concerning disclosure practices, its characteristics and its determinants. In addition, there is a limited research on the potential impact of information disclosure on the company’s cost of equity capital. The scope of this research aims, therefore, to fill this gap in the literature.

The study of this issue is driven by the economic theory that greater disclosure lowers the information asymmetry (Glosten & Milgrom, 1985; Diamond & Verrecchia, 1991) and the estimation risk (Barry & Brown, 1985). First, disclosure reduces information asymmetry and, in turn, increases the liquidity of the stocks (Diamond & Verrecchia, 1991) and reduces the required rate of return (Easley & O’Hara, 2004). Disclosure also lowers the cost of equity by reducing the estimation risk, which is not diversifiable under certain conditions. For example, Clarkson, Guedes, and Thompson (1996) showed that if the portfolios of investors consist of many securities with a low information quality, then the estimation risk is non-diversifiable. Leuz and Verrecchia (2000) argued that better disclosure can improve the organization between firms and their investors with respect to the firm’s capital investment and reduce information risk.

Lang and Lundholm (1993) showed that firms disclosing more information have more accurate and less dispersed analyst earnings forecasts. Boubaker, Gounopoulos, Kallias and Kallias (2016) analyzed how management earnings forecast disclosure to investors affects the reliability of available information and investor behavior. Welker (1995) and Healy, Hutton, and Palepu (1999) further verify that firms providing more disclosure have lower bid-ask spreads, a measure of the cost related to information asymmetry. Botosan (1997) and Botosan and Plumlee (2002) provided a direct link by showing a negative relation between the disclosure in annual reports and the cost of equity capital for firms followed by few analysts and for firms in general. Further, Sengupta (1998) stated that firms with greater disclosure pay lower costs in issuing debt.

## 2. Aims and Objectives of the Research

The aim of this study is to establish the relationship between corporate disclosure quality of companies which is measured by the disclosure index and the cost of equity capital. Quality of disclosure is measured based on a disclosure index developed from Standard and Poor’s Transparency and Disclosure Survey. Further, this study aims to identify the driving forces behind the likely variable association of corporate disclosure with the cost of equity as well as contributing to the existing literature by discussing disclosure models on their relevance in economic decision making, constructing own disclosure index for Kazakh companies and identifying its relationship with company’s cost of equity capital.

The topic about informational transparency of companies for the Kazakh market is not disclosed. This study will contribute to the existing research by justifying the choice of theoretical and methodological approaches, construction of the disclosure index and the selection of factors for the model based on the specifics of Kazakhstan. We contribute to the literature on the relation between corporate disclosure and cost of capital (Botosan, 1997; Botosan & Plumlee, 2002; Hail, 2002; Francis, Khurana & Pereira, 2005) by showing that high disclosure levels are strongly associated with lower cost of capital for firms in countries with large variation in disclosure policies. Some firms may have incentives to provide disclosure levels superior to the average, while others do not. Thus, causing a larger variation in disclosure levels than those observed in countries where the general disclosure environment is superior. Previous research on this topic has been based on samples of firms from developed countries with low dispersion in disclosure levels. When a firm’s environment (e.g., regulation) demands superior disclosure levels, there will be a lower variation in disclosure policies adopted by firms. As the variation in cost of capital is influenced by other factors, a lower variance in disclosure policies adopted by firms is likely to result in a weak relation between disclosure and cost of capital. We expect to see a stronger relation between disclosure and cost of capital when the cross-sectional variation in disclosure is higher.

Another objective of this research is to examine the potential usefulness of disclosure made in the annual report. Previous accounting disclosure research offered insight into the potential usefulness and perceived benefits and costs of disclosure. For example, it has been asserted that improved disclosure enhances corporate transparency, develops corporate image, and provides useful information for decision making. Disclosure can also be seen as one of the mechanisms to mitigate adverse selection by reducing information asymmetry between managers and investors. It is a mechanism to lower a company’s cost of capital, increase liquidity of its shares, and lower transaction costs resulting from lower bid-ask spread. In addition, disclosure can be seen as one of the mechanism by which companies attempt to manage their stakeholders in order to gain their support and approval. Moreover, disclosure can also assist in staving off potential regulatory pressure and avoiding additional requirements

## 3. Literature Review and Hypothesis Development

Starting with the theoretical research of Amihud and Mendelson (1986) and Diamond and Verrecchia (1991), and continuing through empirical work by Botosan (1997), evidence seems to indicate a negative association between disclosure and cost of equity capital. Botosan and Plumlee (2002) validated Botosan’s (1997) findings that a negative relation exists between annual report disclosure and cost of equity capital, but also affirmed a positive relation between more timely disclosures and cost of equity capital. Piotroski (2002) explored one of these more timely disclosures by examining the effect that quarterly and annual management earnings forecasts have on short-term stock price volatility and found that forecasts seem to raise volatility in the shortterm.

By revealing private information, firms try to solve the reluctance of potential investors for holding shares in illiquid markets, and thus, reduce the cost of capital. In this line, Diamond and Verrecchia (1991) showed that companies reduce the cost of equity financing by improving disclosures, which implies higher liquidity of firms’ securities and increase the demand from large investors. Other benefit from improving disclosure is that by providing better information, firms try to reduce potential investors’ estimation risk regarding the parameters of a security’s future return or payoff distribution. It is assumed that investors attribute more systematic risk to an asset with low information than to an asset with high information (Handa & Linn, 1993; Klein & Bawa, 1976; Coles, Loewenstein & Suay, 1995; Clarkson et al., 1996). Mandatory disclosure can decrease information available in securities markets by crowding out the acquisition of private information that, through funds’ trading, would be reflected in prices (George & Hwang, 2015).

From the empirical evidence, we can also refer to several studies. Botosan (1997) demonstrated that among firms attracting a low analyst following, those that present higherquality disclosures benefitted from lower levels of cost of capital. The author used a sample of 115 firms and measured cost of capital using the residual income model. In Botosan and Plumlee (2002), they estimated cost of capital using four alternative methods, and found that after controlling firm size and market beta, greater disclosure is associated with a lower cost of capital.

The association between disclosure and firm characteristics has long been of interest to accounting researchers. The extent of corporate disclosure may be influenced by different firm factors such as financial factors, non-financial factors, social responsibility factors including firm size, industry type, listing status, leverage, performance, ownership structure, the size of audit firm and culture. However, some of these relationships are weak and not verified in the literature. The findings of previous research provided a good starting point to further examine the relationship between disclosure and its underlying firm factors. The present research relates the level of disclosure to three firm factors namely, firm size, leverage and risk. These factors are chosen because they are the most commonly used independent variables in accounting disclosure.

Prior theoretical research supporting a hypothesis of a negative association between disclosure level and the cost of equity has followed two distinct lines of research: stock market liquidity and an estimation risk perspective (Botosan, 1997). The first stream of research suggests that companies tend to increase disclosure to overcome the reluctance of potential investors for holding their shares, thereby enhancing stock market liquidity and reducing cost of equity capital either through reduced transaction costs or increased demand for a firm’s securities (Botosan, 1997). This stream of research includes Copeland and Galai (1983), Glosten and Milgrom (1985), Amihud and Mendelson (1986), Diamond and Verrecchia (1991), and Bloomfield and Wilks (2000). For example, Diamond and Verrecchia (1991) constructed a model in which they showed that revealing information can increase demand for securities by investors, thereby improving liquidity and reducing information asymmetry, hence reducing the cost of equity capital. Bloomfield and Wilks (2000) also showed that greater disclosure attracts increase demand for shares at a higher price from investors, thereby implicitly reducing the cost of capital and increasing liquidity. Amihud and Mendelson (1986) argued that the cost of equity is higher for securities with larger bid-ask spreads because investors require compensations for additional transaction costs.

The second stream of research suggests that firm enhancing disclosure is an attempt to reduce the cost of equity capital by reducing non-diversifiable estimation risk (Botosan, 1997). This second stream of research is represented by Klein and Bawa (1976), Barry and Brown (1985), and Clarkson et al. (1996). Primary to a variety of corporate decisions is a firm’s cost of capital. From determining the hurdle rate for investment projects to influencing the composition of the firm’s capital structure, the cost of capital influences the operations of the firm and its subsequent profitability. Given this importance, it is not surprising that a wide range of policy prescriptions have been advanced to help companies lower this cost.

Size is an important determinant of disclosure level and has been used in many disclosure studies (Singhvi & Desai, 1971; Firth, 1979; Chow & Wong-Boren, 1987; Hossain, Tan & Adams, 1994; Meek, Roberts & Gray, 1995; Raffournier, 1995; Botosan, 1997; Depoers, 2000; Abraham & Cox, 2007; Ratanajongkol, Davey & Low, 2006; Aljifri & Hussainey, 2007; Aljifri, 2008) that tested the association between disclosure and company size. Although most previous studies support a positive relationship, there is an unclear theoretical basis for such a relationship. The direction of association may be either positive or negative. Some previous studies found a negative association between size and the level of corporate disclosure (Aljifri, 2008; Aljifri & Hussainey, 2007; Kou & Hussain, 2007; Mak, 1996; Gray, Kouhy & Lavers, 1995a; Roberts, 1992; Davey, 1982; Ng, 1985; Stanga, 1976). These studies, therefore, did not support a positive relationship between size and disclosure. Thus, whether disclosure is useful in reducing the cost of equity capital becomes an empirical issue, which can be tested by using the following hypotheses.

Hypothesis 1: There is a negative association between disclosure and the company’s cost of equity capital.

Since larger firms are more exposed to public scrutiny than smaller firms, they tend to disclose more information (Alsaeed, 2006). Furthermore, information disclosures may be used to decrease agency costs, to reduce information asymmetries between the company and the providers of funds, and to reduce political costs (Inchausti, 1997). Cooke (1992) and Cerf (1961) found the existence of significant positive association between firm size and the level of disclosure. Thus, the hypothesis 2 has been developed as:

Fama and French (1992) and Baginski and Wahlen (2003) found a negative relation between size and cost of capital.

Hypothesis 3: The cost of equity is negatively related to company size

Firms which have higher debt in their capital structure are prone to higher agency cost (Alsaeed, 2006). Information disclosure may be used to avoid agency costs and to reduce information asymmetries (Inchausti, 1997). Therefore, it is argued that leveraged firms have to disclose more information to satisfy information needs of the creditors (Uyar & Kilic, 2012). Hence, the following hypothesis 4 was formulated:

Hypothesis 4: There is a positive relationship between disclosure level and leverage. : There is a positive relationship between disclosure level and leverage.

## 4. Sample Construction and Data Description

The main objective of this study is to investigate whether firms that publish greater disclosure benefit in terms of a lower cost of equity capital. In this section, the research methods used to address this objective are described. First, the selection process of the sample of listed firms examined in the study is discussed, followed by a description of the process by which the main data for the analysis is collected. This includes a discussion of how financial disclosure and the cost of equity capital measures are determined. Disclosure of financial information is measured using a disclosure index developed from a content analysis of annual reports. The approach implemented in this study involves the use of a dichotomous procedure, where a particular information item is awarded one (for yes) and zero (for no) if it is disclosed or not disclosed, respectively. The level of disclosure for each firm is then calculated as the total number of items scored (total count of all the ones and zeros).

In using the disclosure index approach, it is first necessary to develop a checklist of items of information that firms disclose or may disclose (Marston & Shrives, 1991). In this study, a checklist comprising 79 financial disclosure items was developed. Disclosure is divided into two parts: information quality and information quantity. However, in the absence of a generally agreed model for disclosure quality and lack of relevant and reliable techniques to measure it, prior studies tend to use disclosure quantity (Hail, 2002) as a proxy for disclosure quality assuming that quantity and quality are positively related, although quantity and quality measures may lead to different ranking for a sample of companies. Core (2001) proposed some ways to achieve a measure of disclosure quality. However, up to date there is no single measure of disclosure quality that does not attract criticisms (Beretta & Bozzolan, 2004; Brown & Hillegeist, 2007). Botosan (2006) claimed that quantifying the qualitative characteristics underlying disclosure quality is extremely difficult and that it would be nearly impossible to apply the procedure in an empirical setting. In sum, the academic debate on this issue is still open and scholars are invited to review the extensive research on construct measurement in other disciplines to obtain new perspectives on how to measure disclosure quality. Hence, prior studies to date tend to count information items provided in a disclosure vehicle (e.g. disclosure index and content analysis studies).

The present research attempts to measure directly the cost of equity capital through Capital Asset Pricing Model. Prior research encountered several complications in estimating a firm’s cost of capital. There is considerable debate and disagreement among academics and practitioners with respect to the magnitude of the market risk premium (Kothari, 2001). Some scholars use forecast data to estimate the future cash flows of a firm (Botosan & Plumlee, 2002), others rely on industry research reports to obtain growth estimates (Fischer, 2003), whereas more accounting-based approaches use accounting items to derive reasonable estimates. Previous academic studies have generally used ex post (average realized) returns to estimate the cost of capital and to test asset-pricing models. This study has been inspired by the fact that expected returns are not easily publicly observed. Hence, historic data was used to calculate estimates for the cost of capital.

### 4.1. Sample Selection

Initially we considered all the companies for which we have disclosure data for years 2008 and 2014. Then we have to exclude all companies for which some of the data needed in order to calculate the cost of equity capital measure were missing. The sample consists of a total of 37 Kazakh firms listed on the stock exchanges. In order to be included in this study, a firm must have a full set of financial information covering the entire fiscal year. This study aims to provide an objective view of current disclosure practices at the largest public companies in Kazakhstan. The centerpiece of this study is a comprehensive survey instrument designed to assess the level of corporate disclosure practices across firms.

### 4.2. Disclosure Data

Several items are graded in order to produce a score that measures the quality of the information provided in the annual report. Among them we found: historical data, analytical account of results, composition of shareholding, shares percentage held by the board of directors, order and clarity of the report, design, number of branches, directors’ remuneration, returns on shares, market evolution, review of operations and on-line information. Each question is evaluated on a binary basis to ensure objectivity, and rankings for the three broad categories and an overall ranking is developed from the answers to individual questions. These categories broadly correspond to the analytical criteria employed in Standard and Poor’s corporate governance scoring process. They address disclosure patterns along a broad spectrum of factors that affect corporate governance practices. This presentation format provides analysts and investors the flexibility to focus on specific investment analysis needs. One point is awarded for each attribute that is found to be present.

Using the content analysis method, the extent of compliance of listed financial and non-financial Kazakh companies with the required disclosures is measured by using disclosure index. Disclosure indices are extensive lists of selected items, which may be disclosed in company report (Marston & Shrives, 1991). Each company was scored in all applicable areas of the survey. While assessing the level of corporate disclosure for an individual company can be subjective, the survey is designed to minimize this problem. In addition to crosschecking and auditing by different raters, nearly every survey measure has been refined so as to be quantifiable. This is also a unique feature of this study, as previous research has only checked for the presence of a specific corporate disclosure measure. This study adds to the existing literature by adding a qualitative dimension to the disclosure measures. Companies that omit or do not comply with a specific scoring criterion receive a ‘zero’ score. Meeting the legal compliance standard and those that exceed the regulatory requirements and/or meet international standards earns a firm a score of ‘one.’ Once the assessment is complete, a single composite score for transparency (DISCL) is calculated by taking a sum across the scores for each question. No weighting is used so that the overall score represents a simple summation of its components suggesting that every item analyzed is equally important. If a company reports all the requested data, a total of 79 points is assigned. With these scores we have created a revelation index based on the sum of scores obtained.

Financial data used to construct control variables as well as measures of return, are taken from Bloomberg and S&P Capital IQ and analytical reports, published by Halyk Finance for Kazakh firms. Corporate disclosure variables (e.g., board composition and ownership concentration) are constructed using manually collected data gathered from annual reports and government sources.

## 5. Research Design and Methodology

### 5.1. The Model

The statistical analyses performed in the present research, includes the use of multiple linear regression models to examine the relationship between annual report disclosure level and the influencing factors. We test our hypothesis by regressing expected cost of equity capital (COE) on market beta (BETA), the natural log of market value (LMVAL), financial leverage (LEV), book to market value of equity (BM) and total disclosure score (DISCL). That is,

COE = α + β1 BETA + β2LMVAL + β3 LEV + β4 BM + β5 DISCL + ε

In the present research, there are four independent variables indicating the financial characteristics of the firm whereas there are three independent variables indicating corporate disclosure characteristics of the firm. These include firm size, leverage and beta. These factors are the most commonly used independent variables in the accounting disclosure literature (Aljifri, 2008; Branco & Rodrigues, 2008; Aljifri & Hussainey, 2007; Linsley & Shrives, 2006; Xiao & Yuan, 2007; Oliveira, Rodrigues & Craig, 2006; Haniffa & Cooke, 2005; Raffournier, 1995; Hossain et al., 1994) and will be used here for testing with disclosure. Beta and size were included in the analysis because prior research placed a control on them when testing the relationship between disclosure level and the cost of equity capital (Petersen & Plenborg, 2006; Chen, Chen & Wei, 2003; Froidevaux, 2004; Botosan & Plumlee, 2002; Hail, 2002; Botosan, 1997).

### 5.2. Sample Design

The sample size of this research is constructed by selecting firms listed on the Kazakhstan Stock Exchange (KASE). With the foundation of the KASE, equity trading started on the secondary markets in Kazakhstan and KASE is now one of the remarkable stock exchange among the Central Asian countries. There are 130 firms listed on to the KASE as of 2007 and 37 of them were selected to form the sample size. Trading volume of the sample size includes 46% of the KASE's total trading volume as the year end of 2007.

## 8. Conclusion

In this work the main empirical research was done on corporate disclosure of information and exploring the relationship between company transparency and its impact on company value. In most research, methodology for building the disclosure index was based on the analysis of corporate websites. The firm characteristic values affecting the level of information disclosed and cost of equity are used to build a regression model to test the relationship between information transparency and cost of capital. In this sense, the results of this study are compatible with the results of the foreign empirical studies. The regression results show that a higher level of disclosure is associated with a lower cost of equity capital, after controlling factors such as beta and firm size. Theoretical research supports this claim by emphasizing the effect of greater disclosure on stock market liquidity and estimation risk.

Under the lights of this research, it is concluded that there is a significant relationship between corporate transparency and cost of equity. The findings of the study are in conformance with prior studies examining relationship between corporate transparency and company value. According to results of this study, firm characteristics proxied by BETA, LMVAL and LEV are statically significant at the 10% level. However, BM value shows no significant relationship between corporate transparency and firm characteristic.

The findings of the study indicate that significant positive relationships between dependent variable (COE) and independent variables (BETA and LEV) exist and a significant negative relationship between COE and DISCL and LMVAL exists. Evidence on the issue of disclosure outside the annual report and cost of equity capital is still limited and requires further investigation, and is, therefore, a potential area for future research. Overall, the findings of the present research supported the view that companies disclose substantial but rather incomplete information in annual reports.

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