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.

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