Some personal observations on the debate on the link between financial reporting quality and the cost of equity capital

Abstract

Within the last decade there has been much written about the possible link between the quality of a firm’s external financial reporting and its cost of equity capital. In this paper I provide my personal observations about the literature. I make the following points. I find the Francis et al. (2005) paper interesting and innovative. This paper documents a positive association between portfolio returns formed on the basis of accrual quality and firms’ realized returns after controlling for the Fama-French three factors. Francis et al. conclude that accrual quality is a priced risk factor. Second, while this conclusion might be too strong based on their results, I think the Core et al. (2008) critique of the Francis et al. claim is also too strong and does not lead me to reject accrual quality as a priced risk factor. Third, the evidence of an association between financial reporting quality and implied cost of capital estimates is robust. However several papers question the construct validity of these measures which are based on analyst earnings forecasts. I discuss these papers and conclude that the implied cost of capital does have empirical validity. Finally, various papers model the relation between financial reporting quality and cost of capital and, while interesting, mostly restrict themselves to a single factor asset pricing model. However, restricting the model to a single factor model by assumption rules out the possibility of information quality being a separately priced risk factor and further restricts the role information quality to informing about a firm’s covariances (or estimation error in the CAPM beta) because it is assumed that information quality is diversifiable. I think whether something is diversifiable is an empirical question that cannot be resolved by assumption within a theoretical model.

The association between disclosure level and cost of capital in an emerging market: evidence from Egypt

“…For example, the report of the American Institute of Certified Public Accountants' special committee on financial reporting (AICPA Report, 1994) suggests that a lower COEC is a direct consequence of greater disclosure. This articulation is consistent with the remarks of Shevlin (2013) who has recently confirmed the robustness of the evidence, documented by many seminal papers, on the existence of a negative association between financial reporting quality and the implied COEC estimates which are calculated based on analysts' earnings forecasts. In addition, Botosan (1997) demonstrates that the COEC is negatively related to the voluntary disclosure level for low analyst following firms but not for high analyst firms.…”

Using the deterministic factor systems in the analysis of return on equity

“…Growth of this indicator is possible due to the formation of the Organization of the credit portfolio, the average interest rate of which is minimal (Shevlin, 2013).…”

Delegated trade and the pricing of public and private information

“…18 If accounting quality is priced 17 See Francis et al (2005), Core et al (2008), Kim andQi (2010), andOgneva (2012). For a review see Shevlin (2013).…”

“…Existing economic theory suggests that, in large economies populated by rational investors, the …rm's information environment has no e¤ect on the risk premium incremental to the …rm's exposure to common risk factors, i.e., factor-betas. Based on this theory, a large empirical literature examines whether the quality of public information (e.g., "accounting quality") represents a separate, common risk factor (see Shevlin, 2013 for a review). 1 A standard assumption in this literature is that individual investors (both informed and uninformed) trade on their own accounts, or "self-direct" their trades.…”