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Journal ArticleDOI

Earnings Quality and the Equity Risk Premium: A Benchmark Model*

01 Sep 2006-Contemporary Accounting Research (John Wiley & Sons, Ltd)-Vol. 23, Iss: 3, pp 833-877
TL;DR: In this article, the authors propose a model that links earnings quality to the equity risk premium in an infinite-horizon consumption capital asset pricing model (CAPM) economy, where risk-averse traders hold diversified portfolios consisting of risk-free bonds and shares of many risky firms.
Abstract: This paper solves a model that links earnings quality to the equity risk premium in an infinite-horizon consumption capital asset pricing model (CAPM) economy. In the model, risk-averse traders hold diversified portfolios consisting of risk-free bonds and shares of many risky firms. When constructing their portfolios, traders rely on noisy reported earnings and dividend payments for information about the risky firms. The main new element of the model is an explicit representation of earnings quality that includes hidden accrual errors that reverse in subsequent periods. The model demonstrates that earnings quality magnifies fundamental risk. Absent fundamental risk, poor earnings quality cannot affect the equity risk premium. Moreover, only the systematic (undiversified) component of earnings-quality risk contributes to the equity risk premium. In contrast, all components of earnings-quality risk affect earnings capitalization factors. The model ties together consumption CAPM and accounting-based valuation research into one price formula linking earnings quality to the equity risk premium and earnings capitalization factors.
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Journal ArticleDOI
TL;DR: In this paper, a meta-analysis identifies 12 significant relationships by integrating results from 48 prior studies and finds that audit committee independence, as measured by fee ratio and total fee, is also a deterrent to earnings management.
Abstract: Earnings management is of great concern to corporate stakeholders. While numerous studies have investigated the effects of various corporate governance and audit quality variables on earnings management, empirical evidence is rather inconsistent. This meta-analysis identifies 12 significant relationships by integrating results from 48 prior studies. For corporate governance, the independence of the board of directors and its expertise have a negative relationship with earnings management. Similar negative relationships exist between earnings management and the audit committee's independence, its size, expertise, and the number of meetings. The audit committee's share ownership has a positive effect on earnings management. For audit quality, auditor tenure, auditor size, and specialization have a negative relationship with earnings management. Auditor independence, as measured by fee ratio and total fee, is also a deterrent to earnings management.

447 citations

Journal ArticleDOI
TL;DR: In this paper, the authors provide evidence on the impact of the quality of corporate social responsibility (CSR) reporting on the cost of equity capital for a sample of Spanish listed firms.
Abstract: In this paper, we provide evidence on the impact of the quality of corporate social responsibility (CSR) reporting on the cost of equity capital for a sample of Spanish listed firms. We aim to verify whether firms with higher CSR disclosure ratings enjoy significantly lower costs of equity capital, after controlling for the well-known Fama and French risk factors (i.e. beta, market-to-book, and size). Consistent with our main hypothesis, we find a significant negative relationship between CSR disclosure ratings and the cost of equity capital. We also obtain that the negative relationship between CSR reporting quality and the cost of equity capital is more pronounced for those firms operating in environmentally sensitive industries. Our findings contribute to the debate on whether CSR activities are value-enhancing or value-neutral by showing that improved CSR can enhance firm value by reducing the firm's cost of equity capital. This implies that CSR reporting is a part of a firm's communication tools in order to decrease information asymmetries between managers and investors. In other words, mandatory social responsibility reporting is called for in order to produce a more precise valuation of a firm. Copyright © 2011 John Wiley & Sons, Ltd and ERP Environment.

207 citations

Journal ArticleDOI
TL;DR: In this paper, the authors examine whether and how earnings quality, measured as accruals quality (AQ), affects the cost of equity capital and find that the AQ risk factor is significantly priced, after controlling for low-priced stocks.
Abstract: This study examines whether and how earnings quality, measured as accruals quality (AQ), affects the cost of equity capital. Using two-stage cross-sectional regression tests, we find that the AQ risk factor is significantly priced, after controlling for low-priced stocks. This result is robust in tests using individual stocks, various portfolio formations, and different beta estimations. Furthermore, we show that AQ and its pricing effect systematically vary with business cycles and macroeconomic variables. In particular, this pricing effect is prominent in total AQ and innate AQ but not in discretionary AQ. The risk premium associated with AQ exists only in economic expansion but not in recession periods. Poorer AQ firms are more vulnerable to macroeconomic shocks. The risk premium and the dispersion of AQ are also related to future economic activity. Overall, our results suggest that AQ contributes to the cost of equity capital and that its pricing effect is associated with fundamental risk.

152 citations

Journal ArticleDOI
TL;DR: In this article, the authors used the CSRwire news service to find that managers' disclosure decisions involving greenhouse gas emissions produce positive returns to shareholders, independent of differences in public information availability.

138 citations

Journal ArticleDOI
TL;DR: In this article, the authors examine whether and how earnings quality, measured as accruals quality (AQ), affects the cost of equity capital and find that the AQ risk factor is significantly priced, after controlling for low-priced stocks.
Abstract: This study examines whether and how earnings quality, measured as accruals quality (AQ), affects the cost of equity capital. Using two-stage cross-sectional regression tests, we find that the AQ risk factor is significantly priced, after controlling for low-priced stocks. This result is robust in tests using individual stocks, various portfolio formations, and different beta estimations. Furthermore, we show that AQ and its pricing effect systematically vary with business cycles and macroeconomic variables. In particular, this pricing effect is prominent in total AQ and innate AQ but not in discretionary AQ. The risk premium associated with AQ exists only in economic expansion but not in recession periods. Poorer AQ firms are more vulnerable to macroeconomic shocks. The risk premium and the dispersion of AQ are also related to future economic activity. Overall, our results suggest that AQ contributes to the cost of equity capital and that its pricing effect is associated with fundamental risk.

125 citations

References
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Journal Article
TL;DR: In this paper, the authors examined the relationship between disclosure level and the cost of equity capital by regressing firm-specific estimates of cost of capital on market beta, firm size and a self-constructed measure of disclosure level.
Abstract: The effect of disclosure level on the cost of equity capital is a matter of considerable interest and importance to the financial reporting community However, the association between disclosure level and cost of equity capital is not well established and has been difficult to quantify In this paper I examine the association between disclosure level and the cost of equity capital by regressing firm-specific estimates of cost of equity capital on market beta, firm size and a self-constructed measure of disclosure level My measure of disclosure level is based on the amount of voluntary disclosure provided in the 1990 annual reports of a sample of 122 manufacturing firms For firms that attract a low analyst following, the results indicate that greater disclosure is associated with a lower cost of equity capital The magnitude of the effect is such that a one-unit difference in the disclosure measure is associated with a difference of approximately twenty-eight basis points in the cost of equity capital, after controlling for market beta and firm size For firms with a high analyst following, however, I find no evidence of an association between my measure of disclosure level and cost of equity capital perhaps because the disclosure measure is limited to the annual report and accordingly may not provide a powerful proxy for overall disclosure level when analysts play a significant role in the communication process

3,621 citations

Journal ArticleDOI
TL;DR: In this article, the authors extend the standard finance model of the firm's dividend/investment/financing decisions by allowing the managers to know more than outside investors about the true state of the current earnings.
Abstract: We extend the standard finance model of the firm's dividend/investment/financing decisions by allowing the firm's managers to know more than outside investors about the true state of the firm's current earnings. The extension endogenizes the dividend (and financing) announcement effects amply documented in recent research. But once trading of shares is admitted to the model along with asymmetric information, the familiar Fisherian criterion for optimal investment becomes time inconsistent: the market's belief that the firm is following the Fisher rule creates incentives to violate the rule. We show that an informationally consistent signalling equilibrium exists under asymmetric information and the trading of shares that restores the time consistency of investment policy, but leads in general to lower levels of investment than the optimum achievable under full information and/or no trading. Contractual provisions that change the information asymmetry or the possibility of profiting from it could eliminate both the time inconsistency and the inefficiency in investment policies, but these contractual provisions too are likely to involve dead-weight costs. Establishing which route or combination of routes serves in practice to maintain consistency remains for future research.

3,393 citations

Journal ArticleDOI
TL;DR: In this article, the authors studied the causes and consequences of a security's liquidity, especially the effect of future liquidity on the security's current price-equivalently the effect on its required expected rate of return, its cost of capital.
Abstract: This paper shows that revealing public information to reduce information asymmetry can reduce a firm's cost of capital by attracting increased demand from large investors due to increased liquidity of its securities. Large firms will disclose more information since they benefit most. Disclosure also reduces the risk bearing capacity available through market makers. If initial information asymmetry is large, reducing it will increase the current price of the security. However, the maximum current price occurs with some asymmetry of information: further reduction of information asymmetry accentuates the undesirable effects of exit from market making. THIS PAPER STUDIES THE causes and consequences of a security's liquidity, especially the effect of future liquidity on the security's current price-equivalently the effect on its required expected rate of return, its cost of capital. Under conditions that we identify, reducing information asymmetry reduces the cost of capital. Under other (less typical) conditions, this reduced information asymmetry can have the opposite effect. We use public disclosure of information as the means of changing information asymmetry, but the points are more general. Our model is related to those of Kyle (1985), Glosten and Milgrom (1985), and Admati and Pfleiderer (1988). They assume that there is unlimited risk bearing capacity devoted to market making, which implies that changes in future liquidity never influence a security's cost of capital.1 In contrast, we develop a model of trade in an illiquid market with limited risk bearing capacity of risk-averse market makers and examine the effects of private information on the incentives of market makers to provide risk bearing

3,360 citations

Journal ArticleDOI
TL;DR: In this paper, the authors examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism.
Abstract: We examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism. We characterize the first four attributes as accounting‐based because they are typically measured using accounting information only. We characterize the last three attributes as market‐based because proxies for these constructs are typically based on relations between market data and accounting data. Based on theoretical models predicting a positive association between information quality and cost of equity, we test for and find that firms with the least favorable values of each attribute, considered individually, generally experience larger costs of equity than firms with the most favorable values. The largest cost of equity effects are observed for the accounting‐based attributes, in particular, accrual quality. These findings are robust to controls for innate determinants of the earnings attributes (firm siz...

2,262 citations

Journal ArticleDOI
TL;DR: In this article, the authors investigate the role of information in affecting a firm's cost of capital, and they show that differences in the composition of information between public and private information affect the costs of capital.
Abstract: We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can influence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.

2,082 citations