The association between earnings quality and the cost of equity capital: Evidence from the UK

Empirical evidence that examines the association between earnings quality and the cost of equity supports theoretical work that information risk is a non-diversifiable risk factor. However, the main body of evidence, centred on Francis et al.'s (2004) seminal work, focuses on earnings quality measures that are based on US GAAP. This study extends the analysis of Francis et al. (2004) for a sample of UK listed firms during the period 2005 to 2011. This setting and time period enables us to examine the effect of IFRS based earnings on the pricing of earnings quality and how this relation is influenced by a period of severe macro-economic turbulence as in the case of the recent global financial crisis. We find a significant negative association between each accounting-based earnings quality proxy considered separately and the cost of equity. Our results also indicate that during the financial crisis the relationship between earnings quality and cost of equity becomes more prominent than in the pre-crisis period. Our results also document that investors place more importance on the innate component of accruals quality than on the discretionary component. Our results should be of interest to US standard setters who are considering adopting or converging to IFRS.