Earnings quality and the cost of equity capital: evidence on the impact of legal background
DOI | https://doi.org/10.1108/IJAIM-05-2021-0092 |
Published date | 17 September 2021 |
Date | 17 September 2021 |
Pages | 631-650 |
Subject Matter | Accounting & finance,Accounting/accountancy,Accounting methods/systems |
Author | Ahmed Hassan Ahmed,Yasean Tahat,Yasser Eliwa,Bruce Burton |
Earnings quality and the cost of
equity capital: evidence on the
impact of legal background
Ahmed Hassan Ahmed
School of Business, University of Dundee, Dundee, UK and Faculty of Commerce,
South Valley University, Qena, Egypt
Yasean Tahat
College of Business Administration, Gulf University for Science and Technology,
Mishref, Kuwait
Yasser Eliwa
School of Business and Economics, Loughborough University, Loughborough, UK
and Faculty of Commerce, Cairo University, Cairo, Egypt, and
Bruce Burton
School of Business, University of Dundee, Dundee, UK
Abstract
Purpose –Earnings quality is of great concern to corporate stakeholders, including capital providers in
international marketswith widely varying regulatory pedigrees and ownershippatterns. This paper aims to
examine the associationbetween the cost of equity capital and earnings quality, contextualised via tests that
incorporate the potential for moderating effects around institutional settings. The analysis focuses on and
compares evidencerelating to (common law) UK/US firms and (civil law) German firms over the period 2005–
2018 and seeksto identify whether, given institutional dissimilarities,significant differences existbetween the
two settings.
Design/methodology/approach –First, the authors undertake a review of the extant literature on the
link between earningsquality and the cost of capital. Second, using a sample of 948 listed companies from the
USA, the UK and Germany over the period 2005 to 2018, the authors estimate four implied cost of equity
capital proxies. The relationshipbetween companies’cost of equity capital and their earnings quality is then
investigated.
Findings –Consistent with theoretical reasoning and prior empirical analyses, the authors find a
statisticallynegative association between earnings quality,evidenced by information relating to accrualsand
the cost of equity capital. However, when they extend the analysis by investigating the combined effect of
institutionalownership and earnings quality on financing cost,the impact –while negative overall –is found
to vary across legalbackdrops.
Research limitations/implications –This paper uses institutionalownership as a mediating variable
in the association between earningsquality and the cost of equity capital, but this is not intended to suggest
that other measures may be of relevancehere and additional research might usefully expand the analysis to
incorporate other forms of ownership including state and foreign bases. Second, and suggestive of another
avenue for developing thework presented in the study, the authors have used accrualmeasures of earnings
quality.
Practical implications –The results are shown to provide potentially important insights for
policymakers, creditors and investors about the consequences of earnings quality variability. The results
should be of interestto firms seeking to reduce their financing costs and retain financial viability in the wake
of the impact of the Covid-19pandemic.
EQ & CoEC
631
Received8 May 2021
Revised23 July 2021
Accepted20 August 2021
InternationalJournal of
Accounting& Information
Management
Vol.29 No. 4, 2021
pp. 631-650
© Emerald Publishing Limited
1834-7649
DOI 10.1108/IJAIM-05-2021-0092
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1834-7649.htm
Originality/value –The reported findings extends the single-country results of Eliwa et al. (2016) for
the UK firms and Francis et al. (2005) for the USA, whereby both reported that the cost of equity capital is
negatively associated with earnings quality attributes. Second, in a further increm ent to the extant
literature (particularly Francis et al., 2005 and Eliwa et al.,2016),the authors find the e ffect of institutional
ownership to be influential, with a significantly positive impact on the association between earnings
quality and the cost of equity capital, suggesting in turn that institutional ownership can improve firms’
ability to secure cheaper funding by virtue of robust monitoring. While this result holds for the whole
sample (the USA, the UK and Germany), country-level analysis shows that the result holds only for the
common law countries ( the UK and the USA) and not for Germany, c onsistent with the notion that exta nt
legal systems are a determining factor in this context. This novel finding points to a role for institutional
investors in watching and improving the quality of financial reports th at are valued by the market in its
price formationactivity.
Keywords Cost of equity Capital, Earnings quality, Accruals quality, Legal system,
Institutional ownership
Paper type Research paper
1. Introduction
Corporate reporting is critical for the functioning of capital markets as an efficient allocator of
scarce investment resources (Healy and Palepu, 2001), reducing the extent of principal-agent
information asymmetry and thereby improving firm liquidity whilst lowering the cost of
financing (Diamond and Verrecchia, 1991). Agency conflicts necessitate high quality financial
reporting in order that “suppliers of finance to corporations assure themselves of getting a
return on their investment”(Shleifer and Vishny, 1997, p. 737), and the extant literature
indicates that a reduction in information asymmetry enables investors to perform more robust
monitoring of managerial activities (Lee et al., 2008;El-Helaly, 2016;Hao et al., 2019;Liu and
Lee, 2019). Investors with access to the information thus drive reductions in the cost of capital,
although uninformed investors will continue to face non-diversifiable information risk, priced
through higher expected returns (Easley and O’Hara, 2004). Francis et al. (2004) suggest that
“poor-quality reporting impairs the coordination between firms and their investors with respect
to the firm’s capital investment decisions and thereby creates information risk. Anticipating
this, investors demand a higher risk premium; that is, they charge a higher cost of capital”
(p. 971). By implication, high quality reporting should improve communication flows between
firms and their investors, ultimately resulting in a reduction in the cost of financing.
It is also widely accepted that accounting information and reporting practices are shaped by
a number of external factors, including extant legal systems and traditions, in particular the
common law –civil law distinction. A large literature suggests that differences in the latter
impact on accounting practices (La Porta et al., 1998;Ball et al., 2000;La Porta et al., 2002;Ball,
2006), with common law countries (i.e. those where the law is customarily established on an un-
written basis by precedent and finance is dominated by dispersed shareholdings, typically in
the English-speaking world) generally found to have more transparent accounting systems,
stronger investor protection mechanisms and more robust corporate governance practices than
do civil law nations (i.e. those where codification of laws and statutes is the norm, along with
significant debt holdings and block ownership of equity). However, empirical evidence
examining the association between earnings quality and the cost of equity capital is mostly US-
based (Francis et al., 2004,2005;Biddle et al., 2009;Bhattacharya et al.,2011) potentially limiting
the generalisability of the findings, particularly to civil law countries. The current study
investigates the moderating role of a country’s legal system on the association between
earnings quality and the cost of equity capital to identify the extent to which the latter
relationship is influencedby a regulatory base.
IJAIM
29,4
632
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