Investigating the Mediating Effect of Financial Reporting Readability on the Relationship between Earnings Management and Cost of Capital

Abstract

Objective: The aim of this study is to examine the mediating role of financial reporting readability in the relationship between earnings management and cost of capital. Method: To assess the readability of financial reporting, FOG and text length indices were used, and to measure earnings management and capital costs, the modified Jones model (2002) and Gordon growth model were used, respectively. The data of 68 companies listed in the Tehran Stock Exchange during the years 1390 to 1396 were studied. Results: Findings indicated that Financial Reporting Readability, including FOG and text length indices, has complete mediation effect on the relationship between earnings management and cost of capital. Conclusion: Based on opportunistic profit management approach, companies publish complex financial reports with low readability to hide opportunistic behavior of managers and reduce the ability of investors, financial analysts and other legal entities to disclose opportunistic behavior. On the other hand, lower readability of financial reporting and more complexity in exposing opportunistic behavior increase asymmetric information and reduce investors' awareness and inference about company's future performance, making investors unable to interpret annual financial reports.Therefore, companies with more ambigious annual report should take higher risks that increase their cost of capital.