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

This study examines the association between earnings quality and the cost of equity in the United Kingdom (UK) over the time period 2005-2011. 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. This strengthening of the relationship during a period of macro-economic turbulence shows the importance investors place on earnings quality as a measure of risk. Our results also document that investors place more importance on the innate component of accruals quality than on the discretionary component. These results should be reassuring to US standard setters who are considering adopting or converging to IFRS.