The Influence of Earnings Quality and Liquidity on the Cost of Equity

Ming-Feng Hsu,Jean Yu

doi:10.5539/ibr.v8n4p194

Abstract

This study uses sample companies listed in Taiwan Stock Exchange and GreTai Securities Market during 2000 to 2011 to investigate the influence of earnings equality and liquidity on the cost of equity. We define discretionary accruals with three measures and real earnings management with three measures as indicators of earnings quality; trading volume, individual stock liquidity and market liquidity as liquidity measures and individual stock and market liquidity risk as liquidity risk measures. Panel data is suggested for this analysis. Firms manipulating discretionary accruals increase in the cost of equity, but ones operating real earnings management decrease in it when considering that the earnings quality and liquidity directly impact on it. The cost of equity is indirectly influenced by earnings quality and liquidity through information asymmetry measured by bid-ask spreads. The results show that no matter firms engaging in discretionary accruals or real earnings can decrease the cost of equity under higher levels of information asymmetry. The higher the trading volume or the individual stock liquidity risk, the lower the cost of equity when information asymmetry is low.

Highlights

Bhattacharya et al (2013) follow Francis et al (2005) using an accruals-based measure as proxy for earnings quality, for the firms list on the New York Stock Exchange (NYSE) and NASDAQ to test the relationship between information asymmetry and earnings quality
We investigate the impact of earnings quality and liquidity on cost of equity for listed firms in Taiwan from 2000 to 2011
The proxies of discretionary accruals are calculated by using abnormal discretionary current accruals, abnormal discretionary long-term accruals and abnormal total discretionary accruals

Summary

Introduction

The company cost of capital decided by manager decisions, asset valuation and financial reporting has become an important research topic, in particular the relationship between earnings quality and the cost of equity in the accounting field. Francis et al (2004) present the accounting-based attributes significantly impact the cost of equity, especially on the quality of accruals. Bhattacharya et al (2013) follow Francis et al (2005) using an accruals-based measure as proxy for earnings quality, for the firms list on the New York Stock Exchange (NYSE) and NASDAQ to test the relationship between information asymmetry and earnings quality. Bhattacharya et al (2012) use path analysis to exam the direct and indirect links between three measures of earnings quality and the cost of equity They specify analytical models that specify both a direct link and an indirect link that is reconciled by information asymmetry consisting selection component of the bid-ask spread and PIN (the probability of informed trading). Following three-factor model of Fama-French (1993), we use abnormal returns as the cost of equity capital by collecting data from 2000 to 2011 in Taiwan to discuss a direct impact on cost of equity from earnings quality and liquidity of the shares, along with various levels of information asymmetry factor.

Hypothesis Design

Research Model

Summary Statistics

Effects of Earning Management and Liquidity

Effects of Information Asymmetry

Conclusions