Costs of Equity and Earnings Attributes

TLDR

The study characterizes the first four earnings attributes—accrual quality, persistence, predictability, and smoothness—as accounting‑based, while the last three—value relevance, timeliness, and conservatism—are treated as market‑based. The authors examine the relationship between the cost of equity capital and these seven earnings attributes. Based on theoretical models that predict a positive link between information quality and cost of equity, the study tests and finds that firms with the least favorable values of each attribute, considered individually, generally face higher equity costs than those with the most favorable values. The strongest equity‑cost effects appear for the accounting‑based attributes, particularly accrual quality, and these findings remain robust after controlling for firm size, cash‑flow and sales volatility, loss incidence, operating cycle, intangibles intensity, capital intensity, and alternative cost‑of‑equity proxies.

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 size, cash flow and sales volatility, incidence of loss, operating cycle, intangibles use/intensity, and capital intensity), as well as to alternative proxies for the cost of equity capital.