Cost of Capital and Liquidity of Foreign Private Issuers Exempted From Filing with the SEC: Information Risk Effect or Earnings Quality Effect?

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The sample of foreign private issuers (FPIs) active in the US capital market provides a rare setting to observe the interaction of disclosures, earnings quality and cost of capital under different institutional factors – investors’ protection, disclosure requirements, and legal enforcement. In this paper we examine whether receiving an exemption from SEC reporting is associated with greater information risk and ensuing capital market penalties (higher cost of equity capital) and, further, the extent to which this information risk is mitigated by the reporting of higher quality earnings. Our results indicate that, as expected, exempt foreign private issuers, who provide less disclosure to the market, exhibit a higher cost of equity capital, higher total cost of capital, and wider bid-ask spread. Further, as a previous study finds the reporting exemption is associated with lower earnings quality, we also tested our hypotheses conditional on earnings quality. Our results show that findings in Francis et al. (2008) cannot be generalized ipso facto to an international sample. Indeed, the primary relation between disclosures and cost of capital remains significant in our sample even after controlling for earnings quality, disclosure requirements, and enforcement mechanism, and there results are driven by firms from countries characterized by weak investor protection environments. These results enhance our knowledge of the characteristics of exempt and reporting FPIs and extend prior empirical evidence on the relations between information risk, earnings quality, cost of capital and firm liquidity.