The association between earnings quality and the cost of equity capital: Evidence from the UK

Abstract

This study examines the association between earnings quality and the cost of equity in the United Kingdom (UK) over the time period 2005-2011. 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 macroeconomic 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. This strengthening of the relationship during a period of macroeconomic turbulence shows the importance investors place on earnings quality as a measure of risk. Our results also document that investors place more importance on the innate component of accruals quality than on the discretionary component. These results should be reassuring to US standard setters who are considering adopting or converging to IFRS.

The Effect of Disclosure and Earnings Quality on the Cost of Equity in Indonesia

“…The results of this study support agency theory and signal theory which states that companies that disclose information relevantly or reflect the actual state of the company will be able to reduce the cost of equity. The results of the study are also consistent with previous studies, namely Fatma and Abdelwahed (2010), Persakis (2015), Eliwa et al (2016), Pramita (2016), and Lahaya (2017) that income is more relevant (better the quality of earnings), the lower the cost of equity issued by the company.…”

“…This becomes the basis of how the better quality of earnings in a financial report can increase investor interest and trust which ultimately can reduce the company's equity costs. This empirical evidence is supported by Barvidi (2015) and Eliwa et al . (2016).…”

“…However, the results obtained from several previous studies are still not consistent. On the one hand, several studies show that earnings quality is negatively related to the cost of equity, that high accrual quality and more relevant income make it possible to reduce the cost of equity issued by companies (Fatma and Abdelwahed, 2010;Persakis, 2015;Eliwa et al, 2016;Pramita, 2016;and Lahaya 2017). Other studies have found a positive relationship between earnings quality and the cost of equity.…”

Accruals quality and the cost of debt: the European evidence

“…A number of empirical accounting studies examine the relationship between earnings quality (EQ) and CoD (e.g., Ahmed et al, 2002;Francis et al, 2005;Ashbaugh-Skaife et al, 2006;Bharath et al, 2008;Zhang, 2008;Gray et al, 2009). The primary question is that poor EQ is linked with the high cost of capital (e.g., Mouselli et al, 2012;Artikis and Papanastasopoulos, 2016;Eliwa et al, 2016). This question is extracted from the theoretical studies and theories that support the view that high-quality accounting information is expected to reduce the cost of equity and debt capital, through decreasing information asymmetry and information risk (Easley and O'hara, 2004;Lambert et al, 2012).…”

“…Since 2005, all listed EU firms were obliged to adopt IFRS. As such, they are required to follow IFRS in the preparation of their financial statements from 2005 onwards (Iatridis, 2008;Eliwa et al, 2016). The primary objectives of adopting IFRS are to improve the quality of reported accounting information and to accomplish better comparability and transparency of this information (Ball, 2006;Iatridis, 2010;Iatridis and Dimitras, 2013;Dayanandan et al, 2016).…”