The association between earnings quality and the cost of equity capital: Evidence from the UK |
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| Institution: | 1. School of Business and Economics, Loughborough University, UK;2. Faculty of Commerce, Cairo University, Egypt;3. Management School, Sheffield University, UK;4. School of Business & Technology, Excelsior College, United States;1. University of Texas at El Paso, Department of Accounting and Information Systems, College of Business Administration, 260, 500 W. University Ave., El Paso, TX 79968-0542, United States;2. University of West Georgia, Department of Accounting & Finance, Richards College of Business, Adamson Hall 202-A, 1601 Maple St., Carrollton, GA 30118-3010, United States;3. Creighton University, Department of Accounting, Heider College of Business, Harper 4076, 2500 California Plaza, Omaha, NE 68102-0308, United States;4. Case Western Reserve University, Department of Accountancy, Weatherhead School of Management, 10900 Euclid Avenue, Cleveland, OH 44106-4235, United States;1. Mackenzie Presbyterian University, Rua Dr. Gabriel dos Santos, 794 – apto 111, São Paulo, 01231-010, Brazil;2. Mackenzie Presbyterian University, Rua São Bento, 545 – 5SL, São Paulo, 01011-904, Brazil |
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| Abstract: | Empirical evidence that examines the association between earnings quality and the cost of equity supports theoretical work that information risk is a non-diversifiable risk factor. However, the main body of evidence, centred on Francis et al.'s (2004) seminal work, focuses on earnings quality measures that are based on US GAAP. This study extends the analysis of Francis et al. (2004) for a sample of UK listed firms during the period 2005 to 2011. This setting and time period enables us to examine the effect of IFRS based earnings on the pricing of earnings quality and how this relation is influenced by a period of severe macro-economic turbulence as in the case of the recent global financial crisis. We find a significant negative association between each accounting-based earnings quality proxy considered separately and the cost of equity. Our results also indicate that during the financial crisis the relationship between earnings quality and cost of equity becomes more prominent than in the pre-crisis period. Our results also document that investors place more importance on the innate component of accruals quality than on the discretionary component. Our results should be of interest to US standard setters who are considering adopting or converging to IFRS. |
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