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Asian Review of Financial Research Vol.28 No.1 pp.37-69
The Effect of Accounting Information Quality on Cost of Equity
Hee-Young Ahn Ph. D. Candidate, College of Business Administration, Chonnam National University
Sungho Choi* Associate Professor, College of Business Administration, Chonnam National University
Key Words : Accounting Information Quality,Accruals quality,Cost of equity,Residual Income Valuation Model,Information Risk

Abstract

The information asymmetry between managers and outside investors is a significant cost to firms. The related literature suggests that there is a negative relationship between information quality and cost of equity. The poor information quality represents imprecise information about firms' future cash flows and is associated with higher information asymmetry, such that it increases the cost of equity capital. Bhattacharya et al. (2012) show that both accounting information quality and information asymmetry are related to the cost of equity. We measure firms' accounting information quality based on the earnings accruals model in Francis et al. (2005), in which accounting information quality proxied by accruals quality is estimated based on the extended model of Dechow and Dichev (2002). The extended model posits an association between current period working capital accruals and operating cash flows in the prior, current and future periods, controlling for changes in revenues, property, plant and equipment as additional explanatory variables. Francis et al. (2005) show that working capital accruals reflect managerial estimates of cash flows, and the extent to which those accruals do not map into cash flows and, changes in revenues, property, plant and equipment is an inverse measure of accruals quality. They use an accruals measure that does not distinguish between intentionalearnings management and unintentional estimation errors from the model, as both measures imply poor accounting information quality. A cost to firms is measured by the implied cost of equity capital (ICOE) from an extension of the residual income valuation model (Ohlson, 1995). The ability to reliably estimate the cost of equity capital is an important issue for both academics and practitioners. In financial decision making, the ex-ante cost of equity capital is one of the most important factors, as it affects the value of a project or asset. However, as it is not easily observable in the market, we must estimate the ex-ante cost of equity capital. The literature suggests an approach (the residual income valuation model, or RIM) that calculates the internal rate of return by equating the stock prices with the present value of all future cash flows to common shareholders based on contemporaneous earnings forecasts. Gebhardt et al. (2001) estimate the rate of return (ICOE) that the market implicitly uses to discount a firm's expected future cash flows. They find that the ICOE based on the RIM is a reliable proxy for the ex-ante cost of equity capital. Lee and Masulis (2009) measure a firm's information asymmetry by its accounting information quality based on the extended earnings accruals model of Dechow and Dichev (2002). Lee and Masulis (2009) investigate whether poor accounting information quality raises uncertainty about a firm's financial condition among outside investors, resulting in higher flotation costs in seasoned equity offerings. They find a significant and negative relationship between accounting information quality and flotation costs, and thus claim that their measures of accounting information quality are credible proxies for the information asymmetry. In this paper, we investigate the association between accounting information quality and the implied cost of equity capital. Specifically, we examine whether high- quality accounting information proxied by quality of accruals can alleviate information asymmetry among participants in the market, effectively reducing the cost of firms' equity capital. To test our main hypothesis, we use a sample period from 2003 to 2007 and our alignment of accounting information quality and the implied cost of equity variables is based on the fiscal years used to measure the quality of accruals. Our sample includes only non-financial companies listed on the Korea Exchange. The final sample comprises 474 firm years. Our results reveal a statistically significant and negative relationship between accounting information quality (measured by accruals quality), as estimated by Francis et al. (2005), and the implied cost of equity capital, estimated from the residual income valuation model (Gebhardt et al., 2001), which is consistent with the literature. This finding implies that high-quality accounting information about firms' future cash flows reduces information asymmetry between insiders and outside investors, thus lowering the cost of equity capital. However, the common proxies for information asymmetry, such as corporate governance indices and analysts' earnings forecast errors, are not related to the implied costs of equity. We also find a significantly negative association between accounting information quality and the cost of equity capital estimated from Easton's (2004) model. In conclusion, the results of our analysis suggest that higher- quality accounting information is a more effective way of reducing the cost of equity capital than good corporate governance and low volatility of earnings forecasts.
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