Estudiantinas Colombianas tomadas como base para el desarrollo del trabajo

Literature in finance conceives that the quality of financial information affects individual firms’ cost of equity capital in two ways, i.e. through market liquidity or investor’s information risk exposure. In one hand, high quality information can increase market liquidity in a way it reduce transaction costs or increase the demand for the securities(Amihud & Mendelson 1986; Diamond & Verrecchia 1991). On the other hand, as the decisions made by rationale investors are mainly depending on the quality and quantity of information available to them, investors will compensate the information inadequacy that can cause them a higher exposure on risk by charging higher cost of equity capital (Easley & O'Hara 2004; Leuz, C. & Verrecchia 2004).

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Cost of capital is determined by the level of non-diversifiable risk associated to the firm; low quality and insufficient information supplied by the firm is firm-specific information risk which is priced in the share market. Information risk is attributable to, in the context of capital investment, the coordination of information between investors and the firm (Leuz, C. & Verrecchia 2004); and the differences in the proportion of private and public information available in the market which distinguish the ability of informed and informed investors to decide their effective fund allocation (Easley & O'Hara 2004). Information risk for this case is referred to the possibility that investors’ decisions are uncertain as it is made based upon inadequate and less transparent firm-specific information that can cause the investors additional cost of investing. If the uncertainty is low, the lower the investors anticipate for the cost of capital. By considering that market value of firms is an unbiased present value of expected current and future cash flows discounted at the risk-adjusted cost of capital, low cost of capital indicates a better value of firm (Gaio & Raposo 2011).

The following subsections present the discussion on the possible relationships and testable hypotheses are to summarise the relationships corresponds to the specific earnings quality attributes, i.e. accruals quality, predictability and conservatism.

Link between Accruals Quality and Firm Value

Accruals quality represents the content of abnormal accrual embedded the whole structure of firm’s reported earnings. Abnormal accrual is commonly used to justify earnings management activities which embody the manager’s opportunistic behaviour. The lower the content of abnormal accrual indicates that reported earnings are derived with less managers’ discretion and more presentable as a true value.

Reported earnings with high discretionary accruals are presumed to be of poor quality and less reliable and become one of the factors attributed to investor’s uncertainty condition particularly for the pricing decision. Since earnings information is relevant for the decision to be made, accruals quality can simply be considered as firm-specific non- diversifiable information risk that affects individual firm cost of capital. Consistently, the notion is depicted in Francis, J et al. (2005, p. 296) as they state that “By information risk, we mean the likelihood that firm-specific information that is pertinent to investor pricing decisions is of poor quality”. As cash is the primitive element that investors price, poor

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quality of accruals indicates that the information about the transformation stream of earnings into cash provided to the investors is unclear, this can cause an increase in information risk and thus firm cost of capital (Francis, J et al. 2005).

In considering that market value of firms is referred as the unbiased present value of expected current and future cash flows discounted at the risk-adjusted cost of capital, low cost of capital indicates a better value of firm (Gaio & Raposo 2011). Consistent with the previous studies discussed above, it is expected that there is a positive relationship between accruals quality and firm value across difference measures.

Provided below are the hypotheses to be tested to examine the direct effect of accruals quality on each of the measures of firm value:

Link between Predictability and Firm Value

Following Lipe (1990) and Francis, J et al. (2004), predictability for this thesis is referred to the ability of current reported earnings to predict the future earnings. This particular earnings attributes is considered as a desirable attributes by standard setter and an important component for firm valuation by analysts (Francis, J et al. 2004).

A few studies evidence the relevance of earnings predictability in capital market, Imhoff, E and Lobo (1992) and Pincus (1983), among others, document an association between earnings predictability and market response to an earnings announcement. Additionally, Crabtree and Maher (2005) found positive association between earnings predictability and firm’s bond rating, besides a negative association between earnings predictability and cost of debt capital. Further, related to firm actual cost of equity capital, Affleck-Graves, Callahan and Chipalkatti (2002) found the influence of earnings predictability on bid-ask spread (a measure of cost of equity capital). They argue that low earnings predictability increases information asymmetry and increase trading opportunities for inform trader that can lead to an increase in adverse selection cost, and hence conclude that cost of capital is low for firm with high predictability earnings.

In considering that market value of firms is referred as the unbiased present value of expected current and future cash flows discounted at the risk-adjusted cost of capital, low cost of capital indicates a better value of firm (Gaio & Raposo 2011). Consistent with the

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previous studies discussed above, it is expected that there is a positive relationship between earnings predictability and firm value across difference measures.

The following hypotheses are tested to examine the direct relationship between earnings predictability and the measures of firm value:

Link between Conservatism and Firm Value

Despite the oppositions made by capital market regulators, standard setter and academia on the important attribute of conservatism in accounting3, this thesis proposes its relevance on firm valuation based on previous literature which highlights on the ex-ante

motivations for conservative accounting. Watts, Ross L (2003), for instance, particularly posits that contracting benefits, asymmetric shareholder litigation costs, taxation benefits and political pressures are factors which justify the significance of conservatism in accounting, and Kothari, S. P., Ramanna and Skinner (2010) has documented the significance of accounting conservatism in mitigating agency conflicts of shareholder and the managers.

Agency problems that is inherent in the relationship between shareholders and managers in public firms are potentially reduced by the practice of conservative accounting. Kothari et al. (2010) argue that accounting conservatism diminish agency problem in three ways. First, since managers’ compensation are linked directly to firm performance, it is common that managers are unwilling to disclose bad news to avoid bad impact on their current compensation, but conservative accounting provides them an obligation to recognise and disclose the bad news in timely manner. Second, in situation where managers delay the disclosure of bad news, managers tend to undertake risky investment with anticipation that it will be traded-off with other indicator within pool performance. Conservative accounting then provide shareholders with timely signals and urge them to take proper actions to avoid manager to make such bad decision. Third, conservative accounting also prevents shareholders to overly compensate the managers, as managers may potentially compensate themselves by the delay in bad news recognition.

3 _{FASB and IASB question on the importance of conservatism in accounting, as they state that “Financial}

information needs to be neutral – free from bias intended to influence a decision or outcome. To that end, the common conceptual framework should not include conservatism or prudence among desirable qualitative characteristics of accounting information. However, the framework should not the continuing need to be careful in the face of uncertainty.” (FASB and IASB Board Meeting, 2005)

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As of the above arguments presented by Kothari (2010) and reliance on finance literature, which argues that the quality of financial information has a direct impact in reducing individual firm’s cost of capital (Easley & O'Hara 2004; Leuz, C. & Verrecchia 2004), specifically, accounting conservatism reduce cost of capital and hence increase firm value in two ways. First, conservative accounting reduces the costs of agency conflict and provide better future cash flow available to the shareholders that can reduce cost of equity (Watts, Ross L 2003). Second, conservatism also reduces information asymmetry which is exist within shareholders-managers relationship, as shareholders may require high cost of capital for low conservative firm as a compensation for the less transparent information available for them (Ball, Ray, Kothari & Robin 2000; LaFond & Watts 2008).

In considering that market value of firms is referred as the unbiased present value of expected current and future cash flows discounted at the risk-adjusted cost of capital, low cost of capital indicates a better value of firm (Gaio & Raposo 2011). Consistent with the previous studies discussed above, it is expected that there is a positive relationship between conservatism and firm value across difference measures.