Corporate Disclosure Determinants and their Effect on Cost of Equity: An Application of Entropy Based Disclosure Measures

by Fouzi Ali Mukhtar

Abstract

The effect of disclosure on the cost of equity capital has taken a considerable amount of discussion among many researchers and is a very important topic to the financial reporting community and investors alike. However, there are several questions that remain unanswered among different studies with regard to the validity of existing disclosure measurements.

Thus far, no single scale for which to measure company disclosure has been recommended. Early research in this field had used institutional disclosure ranking measures provided by Association for Investment Management and Research (AIMR). This ranking is no longer available as AIMR discontinued its operations in 1997 (after ranking fiscal year 1995), and other countries have never had similar rankings available. Later studies had used self-constructed disclosure measures.

The self-constructed scoring indices are criticised for two reasons: firstly, they are quantitative in nature and in some cases subjective to the researcher’s background and to the scoring sheet. As the main idea of which the disclosure indices is being derived from a comparison of the researcher’s check list and the existence of a particular item, of which a score of one point is given to that item if it appears in a company’s annual report, and a score of zero is allocated otherwise.

Secondly, researchers who used self-constructed disclosure index assume quantity as a proxy for quality. This study tests an alternative approach to quantify disclosure that is derived from Entropy, ‘A mathematical quantification method which is based on prpbabilityfr. A comparison between three measures of disclosure will be examined, they are Normal disclosure index, Entropy scores and Modified entropy scores.

Normal disclosure measures cannot capture the variations in company disclosure from one year to another; this is because companies can always omit some items from their annual report and in the mean while disclosing new items. This leaves a slight change or no change to the overall score of disclosure.

A revised method which can capture those minor changes to disclosure level might help to better understand the effect of disclosure on the cost of equity capital, and especially when it comes to inter-company analysis over a specific period of time. 

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