The relative importance of earnings and other information in the valuation of rd intensive firms

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THE RELATIVE IMPORTANCE OF EARNINGS AND OTHER
INFORMATION IN THE VALUATION OF R&D INTENSIVE FIRMS

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Denise Jones
MBA, University o f Colorado at Denver, 1996
MS Finance, University o f Colorado at Denver, 1996
B.S.B.A., Bryant College, 1989

A thesis submitted to the
Faculty o f the Graduate School o f the
University o f Colorado in partial fulfillment
o f the requirement for the degree of
Doctor o f Philosophy
Department of Accounting
2000

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This thesis entitled:
The Relative Importance of Earnings and Other Information
in the Valuation of R&D Intensive Firms
written by Denise Jones
has been approved for the Department o f Accounting

Lewis

David ArGuenther

Date

]y

/ 3/ ^ l o <3

The final copy of this thesis has been examined by the
signatories, and we find that both the content and the form
meet acceptable presentation standards o f scholarly work in
the above mentioned discipline.

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Jones, Denise (Ph.D., Accounting)
The Relative Importance o f Earnings and Other Information in the
Valuation o f R&D Intensive Firms
Thesis directed by Professor Barry Lewis

Abstract
This dissertation uses the residual income valuation model (Feltham and
Ohlson, 1995) to examine the relative roles o f earnings and non-earnings information
in valuing R&D intensive firms. In this model, the trade off between book value and
expected future abnormal earnings makes the accounting treatment of research and
development expenditures irrelevant as long as expected future abnormal earnings are
predictable. However, the high degree of uncertainty about future payoffs from R&D
investments makes predicting future abnormal earnings difficult for R&D intensive
firms.
Expected future abnormal earnings depend on past earnings and other
information not contained in past earnings, such as changes in the competitive
environment o f the firm or new product introductions. Since accounting earnings are
generally more reliable than other information, it is important to understand the role
each o f these play in valuing different types o f firms. Using the residual income
valuation model, I hypothesize that the magnitude o f the valuation coefficient on
earnings is lower for R&D intensive firms. Empirical results do not support this

hypothesis. However, I find that the magnitude o f the valuation coefficient on other
information is higher for R&D intensive firms.
Other information gets incorporated into firm value through its impact on
future expectations o f earnings. Market participants, such as financial analysts,
forecast fiiture earnings using past earnings and other information voluntarily
provided by firms. I examine the voluntary disclosure o f other information that firms
make in their annual reporting to shareholders and the SEC and throughout the year to
financial analysts. I separate the voluntary disclosures into two types: general
disclosures and R&D related disclosures. R&D related disclosures include
information on research projects in process and completed projects that have resulted
in a new product. General disclosures include all other disclosures such as
information on past operating results, competitive environment, employees, product
markets, etc. I hypothesize and find that an increase in the amount of R&D related
disclosures improves the accuracy o f analysts’ earnings forecasts. However, an
increase in the amount of general disclosures appears to have no effect on forecast
accuracy.

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Acknowledgement
I would like to thank the members of my dissertation committee, Barry Lewis,
David Guenther, Phil Shane, Don Waldman and Chris Leach, for their many
insightful suggestions and comments.

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Contents
1.
2.

Introduction................................................................................

1
6

Literature Review .........................................................................
2 .1
Evidence on the Market Treatment of Research and
Development Expenditures...............................
2.2.
Disclosure.........................................................................

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3.

Model and Hypothesis D evelopm ent......................................
3 .1. Role o f Earnings and Other Information in Valuation .
3.2.
Voluntary Disclosure o f Other Inform ation..................

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4.

Research Design and Empirical Results for the Relative Roles
of Earnings and Other Inform ation...............................
4.1.
Time Series Properties o f Abnormal Earnings and
Other Information...............................................
4.2.
Empirical Version o f EBD M o d el.................................
4.3.
Sample and Variable M easurem ent................................
4.4.
R esults..............................................................................

5.

6.

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Research Design and Empirical Results for the Effect o f
Voluntary Disclosure......................................................
5.1. Sample Selection...............................................................
5.2. Empirical M odel...............................................................

5 .3.
Measurement of D isclosure...........................................
5.4.
R esults..............................................................................

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Conclusion.................................................................................

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Bibliography
Appendix
A.
B.
C.
D.

Change in Valuation Coefficients with Respect to Differences
in Persistence Param eters...............................................
General Disclosure S c o re............................................................
R&D Disclosure S co re.................................................................
Companies in Sam ple....................................................................

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Tables
Table
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Calculation o f Persistence Parameters for the Sample Partitioned
into Quintiles Based on R&D Intensity............................................ 31

2.

Sample Determination and Com position....................................................... 35

3.

Descriptive Statistics........................................................................................ 36

4.

Regression o f Market Value on Dividends, Earnings, and
Other Information................................................................................ 41

5.

Number o f Firms by Industry by R&D Intensity in 1997 ............................ 43

6.

Descriptive Statistics of Firms with Disclosure D a ta .................................... 49

7.

Correlation between Analyst Forecast Error, Disclosure Score,
and Control Variables.......................................................................... 50

8.

Regression o f Analyst Forecast Error on Disclosure Score and
Control Variables................................................................................. 51

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1. Introduction
This dissertation addresses two related research questions. First, do the
relative roles o f earnings and other information in firm valuation differ for R&D
intensive firms? Second, to what extent do firms’ disclosure policies mitigate
difficulties in valuing R&D intensive firms?
Prior research suggests that the market treats R&D expenditures as an asset
(Lev and Sougiannis, 1996; Hall, 1993; Bublitz and Ettredge, 1989; Hirschey and
Weygandt, 1985). Therefore, expensing R&D investments immediately may lead to
omission o f an important asset on the balance sheet. The residual income valuation
model (Feltham and Ohlson, 1995; Ohlson, 1995; Peasnell, 1982) separates the value

of the firm into two components, book value plus the present value o f expected future
abnormal earnings. In this model, failure to record assets as part o f book value will
not affect the value o f the firm, as long as future abnormal earnings can be estimated
accurately. Unfortunately, the high degree o f uncertainty about future economic
benefits from R&D activities that prevents capitalization of R&D assets on the
balance sheet (see SFAS No. 2, paragraphs 48-50) also makes it difficult to estimate
future abnormal earnings for R&D intensive firms. Kothari, Laguerre and Leone
(1999) provide evidence on this issue, reporting that future earnings variability related
to R&D expenditures is three times the future earnings variability related to capital
expenditures. Therefore, difficulty in predicting future abnormal earnings could lead
to larger valuation errors for firms whose R&D activities comprise a substantial
portion of the business and which, therefore, have a significant R&D expense.

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Using assumptions about the time-series process o f abnormal earnings, the
residual income valuation model can be expressed in terms o f current earnings, book
value, dividends, operating assets and other information (Ohlson, 1998; Feltham and
Ohlson 1995). In this model, multiples of the earnings and other information
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variables represent expected future abnormal earnings. Earnings are capitalized into
firm value to the extent they are expected to persist into the future. Other information
not contained in past earnings, such as new product introductions, is incorporated into
firm value through its impact on expected future eamings. Following Dechow,
Hutton and Sloan (1999) and Ohlson (1998), I use analysts’ expectations about future
eamings to proxy for other information. Specifically, I define other information as
the difference between one-year ahead eamings forecasts and forecasts based on the
time-series o f abnormal eamings.
As a first step in understanding differences in how abnormal eamings
contribute to firm value for R&D intensive and non-R&D intensive firms, I address
whether the magnitude of the valuation coefficients on eamings and other information
differs for R&D intensive firms. To determine if the magnitudes o f the coefficients
on eamings and other information should differ for R&D intensive firms, I look at the
theoretical values o f the coefficients. The coefficients depend on the persistence o f
abnormal eamings and the persistence o f other information. I hypothesize that the
persistence of abnormal earnings decreases with R&D intensity. Many smaller R&D
intensive firms are in a rapid growth stage and have high variability in their earnings.
For example, periods of prosperity after a new product introduction are often
followed by less successful periods, as the new product technology becomes

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outdated. Even stable firms face pressures to constantly introduce new products to
keep ahead o f changing technology. Consistent with my hypothesis, I find that R&D
intensive firms have less persistent abnormal earnings. Whether the persistence of

other information differs for R&D intensive firms is less clear. High persistence of
other information indicates that the impact o f the new information will persist for
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several periods into the future. Other information can take many different forms and

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can impact eamings positively or negatively. For example, the cost o f a strike should
impact eamings negatively and should have a short term effect only. In contrast, a
new product introduction should positively impact eamings and could affect eamings
for several periods into the future. I find no systematic differences in the persistence

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of other information for R&D intensive and non-R&D intensive firms.

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The theoretical value o f the coefficient on eamings is positively related to the
persistence o f abnormal earnings and inversely related to the persistence of other
information. Given the result that the persistence o f abnormal eamings is lower for

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R&D intensive firms, I hypothesize that the eamings of R&D intensive firms are

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valued less by the market than the eamings of firms with no R&D activities. Test
results do not support this hypothesis. However, I do find that the coefficient on
other information is significantly higher for R&D intensive firms. For R&D intensive
firms, the market places a higher weight on other information, presumably because
the abnormal eamings are less persistent and alternative information sources are
needed to value the firm.
Investigating the relative importance o f eamings and other information in firm
valuation is important because these two variables combined determine expectations

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about future abnormal earnings. However, eamings and other information can not be
used with equal ease in predicting future abnormal eamings. Mechanical time-series
models can be developed to predict how current eamings translate into future
eamings (and hence future abnormal eamings). The effect of other information on
future eamings is less clear. One reason for this is that there are many types o f new
information, such as new products, changing competitive environment, change in
management, etc., and each market participant values the information differently.
Additionally, firms provide this information to market participants voluntarily, and
the specific information provided varies by firm.
The first half of the dissertation establishes the importance o f other
information, not contained in the basic financial statements, for the valuation o f R&D
intensive firms. The second research question I consider is whether the voluntary
disclosure o f this other information mitigates difficulties in firm valuation. Other
information gets incorporated into firm value through its impact on future
expectations o f earnings. Market participants, such as financial analysts, forecast

future eamings using past eamings and other information voluntarily provided by
firms. One way of determining the impact that voluntary disclosures have on market
participants' ability to accurately value the firm is to examine the impact of voluntary
disclosures on eamings forecast prediction errors.
I collect data on the voluntary disclosures made by 144 firms over a one year
time period. I examine disclosures from two sources: annual reports to shareholders
and the SEC and summaries of financial analysts’ conversations with management
during both conference calls and other times. I examine two types o f voluntary

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disclosures: general disclosures and R&D related disclosures. R&D related
disclosures include information on current research projects and the output from those
research projects in the form o f new products. General disclosures are all other types
of disclosures including information on the manufacturing and sales of current
products, competitive environment, major contractual relationships, changes in
current operating results, and forward looking information. After controlling for
variables known to affect analyst forecast accuracy, I hypothesize and find that an
increase in the voluntary disclosure o f R&D related information results in an
improvement in analyst eamings forecast accuracy. In addition, I find that general
disclosures have no impact on analyst eamings forecast accuracy.
The remainder of the dissertation is organized as follows. Section 2 reviews
the existing literature on research and development expenditures and voluntary
disclosure. Section 3 develops the model and hypotheses. Section 4 describes the
research design and reports the results o f empirical tests of the roles of eamings and
other information in firm valuation. Section 5 describes the research design and
reports the results of empirical tests of the impact of voluntary disclosure on eamings

forecast accuracy. Section 6 concludes the paper.

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2. Literature Review
This dissertation will contribute to two streams o f literature: research on the
valuation of firms with significant research and development outlays and research on
voluntary disclosure. The relevant papers from each are discussed below.

2.1. Evidence on the M arket Treatment o f Research and Development Expenditures
In 1974 the Financial Accounting Standards Board (FASB) issued Statement
o f Financial Accounting Standards No. 2 (FAS 2) requiring the immediate and full
expensing of all research and development outlays. Since that time, several studies
have documented that, on average, the market treats R&D outlays as an asset. Early
studies found a positive relationship between R&D expenditures and the market value
of the firm. Hirschey and Weygandt (1985) find that R&D and advertising
expenditures are positively related to Tobin’s Q (market value o f the firm divided by
the replacement cost o f tangible assets). Hall (1983) examines the relationship
between the market value o f the firm and current R&D expenditures and R&D
capital. R&D capital is estimated by assuming 100% capitalization o f R&D
expenditures and a 15% yearly amortization rate. The sample is all firms in the
National Bureau o f Economic Research database from the period 1976 to 1991. The
advantage of this database is that the variables are inflation adjusted. Hall finds a
positive relationship between the market value o f the firm and both the R&D
expenditures and the R&D capital. However, the value the market places on R&D
expenditures decreased over the period 1986 to 1991.

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Extending this prior work, Lev and Sougiannis (1996) use the relationship
between current R&D expenditures and future operating income to calculate the
average future benefit o f a current R&D outlay. They use this to estimate yearly,
industry specific R&D amortization rates and to compute the portion o f successful
R&D outlays that should have been capitalized. They report that, on average, book

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value is understated by 22% and eamings are understated by 21%. In addition, these
firm specific adjustments to eamings and book values for R&D capitalization are

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positively related to stock prices. Similarly, Deng and Lev (1998) study the
relationship between stock prices and the fair market value of R&D projects in
process that is estimated and disclosed when a firm is acquired. Their sample
consists o f 375 cases where technology in process was part of an acquisition during
the period 1985 to 1996. As expected they report a positive association between
stock prices and the disclosed value o f R&D in process.
An alternative market based technique is to look at stock returns. Bublitz and
Ettredge (1989) examine the relationship between annual unexpected market returns

and annual changes in eamings broken down into changes in sales, advertising
expenses, R&D expenses and other expenses. They hypothesize that if advertising
and R&D expenditures benefit future periods then there is a correlated omitted
variable that will bias the coefficient on advertising and R&D toward zero. As
predicted they find that the coefficient on R&D expense is not different from zero.
In one o f the few studies examining variation in the stock market’s valuation
of R&D expenditures, Lev and Zarowin (1998) use a time series approach to calculate
a firm specific price response to research and development expenditures. They report

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that this R&D response coefficient is positively related to the expected future payoff
from the R&D investment (estimated from a regression o f current eamings on lagged
R&D expenditures) and positively related to the risk of the firm’s overall R&D
activities (payoff period of R&D benefits and volatility o f R&D outlays).
Studies have also shown that the market uses information besides the direct
R&D outlay in determining an asset value for innovative activities. Using financial
statement footnote disclosures on R&D limited partnerships, Shevlin (1991) estimates
the value to the firm of the option to exploit technology developed by the limited
partnership. He finds that the market positively values both in-house R&D and the
calculated value of the limited partnership R&D project. In addition to financial
statement disclosures, other public information appears to be used by the market.
Hirschey, Richardson and Scholz (1998) examine patent data for 403 high technology
companies over the period 1989 to 1995. They regress the market value of the firm
on book value, eamings, R&D expenditures, and four patent measures: number of
patents, patent impact (ratio o f patent citations to the average number of citations),
link to other research (references cited on patent application), and technology cycle
time (time elapsed from the previous generation of patents in the same area). They
report that, consistent with prior studies, R&D expenditures are positively valued by

the market. In addition, the number o f patents, patent impact and link to other
research are also positively valued by the market. Similarly, Hall, Jaffe and
Trajtenberg (1998) find a positive relationship between citation weighted patent
counts and Tobin’s-Q (market value o f the firm divided by the replacement cost of

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tangible assets) for a sample o f over 4,800 US manufacturing firms over the past 30
years.
High growth, technology based industries often have periods o f losses and low
eamings due to the immediate expensing of R&D and other start up costs. In
addition, many companies such as internet or communications companies have
sustained periods of losses. Several studies have addressed whether traditional
financial statement measures such as eamings and book values are used to value these
firms or whether the market uses other non-financial measures. Amir and Lev (1996)
report that, for a small sample o f independent cellular phone companies, neither book
values nor eamings explains stock price. However, when population in the service
area (a measure of growth potential) and penetration rate (ratio o f subscribers to the
population) are added to the regression, eamings becomes positive and significant and
both population and penetration ratio are positively related to market value. Recent
studies have examined how internet stocks are valued. Trueman, Wong, and Zhang
(2000) examine a sample o f 56 internet companies. They find gross profit to be
positively associated with stock prices but not net income. In addition, they report
that two measures o f internet usage, number o f unique visitors and number o f pages
viewed, are positively related to stock price. In a similar study o f 86 internet firms,
Rajgopal, Kotha and Venkatachalam (2000) report a positive relationship between
market value and the average monthly unique visitors as a percentage o f the total web
population.

Although R&D outlays lead to future economic benefits and have been shown
to be relevant to the market, there still could exist a problem if management had to

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estimate an amount o f R&D capital. The management o f a firm has incentives to
manage the firms eamings for reasons such as to increase compensation, make the
firm look more favorable before stock offerings, meet regulatory requirements, etc.
(see, e.g., Teoh, Wong and Rao, 1997; Jones, 1991; Healy, 1985). If R&D
capitalization were mandatory, then it would create an opportunity to use the
capitalization process as an eamings management tool. Ely and Waymire (1999)
investigate the value relevance of intangible assets capitalized by firms in 1927, a
period when management had complete discretion in the capitalization, amortization,
and disclosure policies o f the firm. Unlike the studies previously discussed, covering
the most recent time period, they find no relationship between capitalized intangibles
and share prices. In addition, the relationship between eamings and share prices
decreases with the level o f capitalized intangibles, possibly because investors
perceive that managers overstate eamings through intangibles capitalization.
In addition to the possibility o f eamings management, a high degree of
uncertainty about future benefits from current R&D projects could hamper
management’s ability to estimate an amount o f R&D to be capitalized. Kothari,
Laguerre, and Leone (1999) show that the variability o f future eamings due to R&D
investments is greater than the variability o f future eamings due to capital
expenditures and therefore, R&D investments generate more uncertain future
benefits.
Several studies have focused on the implications o f alternative methods o f
accounting for research and development activities. Loudder and Behn (1995)

examine a sample of firms during the period that FAS 2 was implemented, 1973-

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1975. They find that, prior to FAS 2, the response of stock returns to the firm’s
eamings was higher for firms that capitalized R&D. After the adoption o f FAS 2,
there was a decline in the eamings response coefficient for firm’s previously
capitalizing R&D but no decline for firms that always expensed R&D. The authors
conclude that the eamings of capitalizing firms were more useful than the eamings o f
expensing firms. Supporting this with a more recent sample, Chambers, Jennings and
Thompson (1998) calculate “as if ’ earnings and book values under a policy o f 100%
capitalization of R&D outlays and amortization over industry specific periods. They
show that there is a small increase in the ability of earnings and book values to
explain share prices when the capitalization policy is followed. In addition, when the
components of eamings and book values are examined, the R&D asset and R&D
expense from a policy o f 100% capitalization are reflected in prices similarly to
property, plant, and equipment and depreciation.
Healy, Myers and Howe (1997) use simulated data from the pharmaceutical
industry to construct financial statements under three methods o f reporting for R&D
outlays: cash method (full expense), full cost capitalization, and successful efforts
capitalization. They find that the successful efforts method o f capitalizing R&D
provides more information about economic returns and values. When discretion in
the w rite down of the R&D asset is introduced, the relation between economic returns
and R&D write-downs declines significantly but overall value relevance is still higher
under the successful efforts method.
To determine an asset value for R&D capital, market participants must first
understand how current R&D outlays translate into future cash flows or eamings for

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the firm. This dissertation will contribute to this literature by examining whether the
market extrapolates current eamings into future eamings or whether there is
additional information that the market requires to estimate future eamings. This is
important because one benefit of capitalizing R&D expenditures is that it provides
information on the amount o f R&D expenditures that management considers spent on
successful projects. However, this one capitalized amount does not tell the market
which particular research programs were successful and the capitalization is subject
to manipulation by management. As a first step in understanding how R&D firms are
valued it is important to understand whether it is the R&D outlays themselves that
inform the market or whether it is alternative information such as new product
introductions.

2.2. Disclosure
Early theoretical models o f disclosure show that when traders have a rational
expectation about management’s motivation to withhold unfavorable information
about the firm then a manager is forced to follow a policy o f full disclosure.
Otherwise the traders will assume the worst about the firm and discount the value of
the firm. In contrast to the predictions o f these early models, there is wide variation
in the amount and types of voluntary disclosures made by firms. Firms have different
incentives for how to choose their overall level o f disclosure as well as what specific
items to voluntarily disclose. Verrecchia (1983) shows that the existence o f
proprietary information extends the range of possible explanations about why
management is withholding information and therefore the withheld information is not

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unambiguously considered bad news. A manager will only disclose proprietary
information when the increase in the firm value from the information exceeds the
proprietary costs o f its disclosure.
Proprietary costs can take many forms. For example, knowledge o f certain
operating costs or profits from different operating segments could lead to labor union
renegotiations. Additionally, knowledge o f the initial development stages o f a new
technology could allow an existing competitor to begin development and reduce the
firm’s advantage o f an early entry o f the product to the market place. Information
about the profitability o f an industry could also lead to the entry of new competitors
into the industry. Harris (1998) studies 929 firms reporting information on separate
business segments during the period 1987 to 1991. She reports that in less
competitive industries (industries with high market share concentrations and a slow
rate o f abnormal profit adjustment) managers are less likely to report operations as a
separate industry segment, suggesting a desire to protect abnormal profits and higher
market share in these industries.
Possible reasons for a firm to make voluntary disclosures are to reduce legal
costs by pre-empting a negative stock price response to bad news, reduce information
asymmetry between managers and shareholders, reduce the cost of capital, increase
analyst following, increase the holdings o f institutional investors, and maximize firm
value prior to a security offering. For example, Healy, Palepu and Sweeney (1995)
examine 90 firms with sustained increases in one measure o f disclosure
informativeness, FAF reports. The FAF (now AIMR) makes a yearly assessment o f a
firms overall effectiveness in communicating with investors in three categories,

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annual published information, quarterly and other published information and investor
relations. Healy, Palepu and Sweeney find that managers increase disclosure, as rated
in the FAF reports, when their firm’s earnings growth is undercapitalized by
investors. Undercapitalization occurs when the response o f stock returns to changes
in eamings over a fifteen month period is lower for a firm than other firms in the
same industry.
Several studies have addressed the issue o f whether firms are more
forthcoming with their disclosures when they require external financing. Frankel,
McNichols and Wilson (1995) study whether disclosure o f numeric or qualitative
eamings forecasts is related to external financing decisions. They report that firms
that access capital markets for debt or equity financing are more likely to issue
management eamings forecasts. However, firms are not more likely to issue a
management eamings forecast right before an offering. Similarly, Clarkson, Kao and
Richardson (1994) examine voluntary disclosures made in the MD&A section o f the
annual report from 1989 to 1991 o f firms listed on the Toronto Stock Exchange.
They report that there is a positive association between the extent of external
financing activities in the previous year and the propensity to disclose forward
looking information on the expected change in operating results. However, this
relationship holds for firms with good news to report only. Similar to Harris, they
also find that the probability o f disclosure is decreasing in the threat of competitor
entry.
Lang and Lundholm (1993) examine the relationship between certain firm
characteristics and the FAF disclosure rating. Similar to the other studies, they find a

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positive relationship between FAF disclosure rating and the occurrence of a debt or
equity offering in the current year or previous two years. In addition, they find that
larger firms have a higher disclosure score. In a similar study, Clarkson, Kao and
Richardson (1999) asked the Toronto Society o f Financial Analysts to rate the
disclosure quality of the MD&A section of the 1991 and 1992 annual reports o f 55
firms listed on the Toronto Stock Exchange. They report that MD&A disclosure
quality is positively related to the amount of equity issued in the subsequent year.
Similar to Lang and Lundholm, they also find that larger firms have a higher
disclosure rating.
These studies show that specific firms have a number of reasons to disclose or
withhold information about the firms operations. This is particularly true of high
technology firms that have incentives to withhold proprietary information from
competitors about the success of their R&D programs and also have incentives to
disclose information to gain access to capital to fund their programs. Because each
firm is faced with a different opportunity set and different financing needs, there
should be high variation in the amount and types of disclosures each firm makes
about its research and development activities.
There is little research on the benefits o f voluntary disclosure. Primarily due
to the difficulty in measuring disclosure policy and its related benefits and costs. It is
difficult to find a proxy for a disclosure policy that is both comprehensive and
available for a wide variety of firms.
Botosan (1997) creates an overall disclosure index for disclosures made in the
annual report. This index is used to rank the disclosures of 122 firms in the

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machinery industry. Botosan finds that a higher disclosure ranking is associated with
a lower cost o f capital for firms with a low analyst following. No evidence o f an
association between disclosure ranking and the cost o f capital is found for firms with
a high analyst following. Botosan attributes this to the disclosure index being limited
to the annual report and therefore may not be a good proxy o f a firm's overall level of
disclosure for firms with a high analyst following. Supporting the Botosan study with
a broader sample, Sengupta (1998) finds a negative relationship between the cost of
debt and the FAF disclosure ratings o f 103 firms in 15 different industries.
Two recent studies have examined the properties o f analysts’ eamings
forecasts and a proxy for disclosure quality. Barron, Kile and O’Keefe (1999) study
MD&A disclosure quality as measured by the SEC. The SEC reviewed the MD&A
section o f the annual report o f 650 firms during the period 1987 to 1989 and assigned
a compliance rating to each firm. Barron, Kile and O ’Keefe find that firms with a
higher SEC compliance rating have lower analyst eamings forecast errors. Lang and
Lundholm (1996) examine the relations between the FAF overall communication
score and properties o f analysts’ eamings forecasts. They find that firms with a
higher FAF score have more accurate eamings forecasts.
There are limitations to using the FAF scores as a measure o f disclosure.
First, the disclosure scores are subjective and reflect analyst perception of a firm’s
disclosures only. For example, Bamber and Cheon (1998) show that, in the FAF
report, analysts rate the communication policies o f firms that issue management
forecasts in meetings with analysts more favorably than they rate the communication
policies o f firms issuing management forecasts in press releases. Second, the firms

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