Earnings quality and information risk

1229 equity which is contrary to theoretical assertion. An explanation for this is that timely disclosure increases volatility of share prices and hence cost of equity. Francis et al 2004 examine the relationship between earnings attributes as proxy to information quality and cost of equity. Earnings attributes are categorized as market based and accounting based, each as described earlier. As a whole their findings confirm previous results of negative relationship between earnings quality and cost of equity. When considered individually the accounting based earnings attributes, in particular accrual quality, have larger effect on cost of equity than market based attributes. 3. Methodology 3.1 Data sources The required accounting data, market value, book to market value, prices and beta are obtained from Datastream data base for the financial year end 2004 or as at financial year end 2004 as applicable. For the purpose of estimating accrual quality accounting data for year 2003 and 2005 are also required. Estimated earnings per share for years 2005 and 2006 required for calculating cost of equity are downloaded from Bloomberg data base services in January 2005.

3.2 Sample profile

The sample comprises of companies with IBES‘s estimated earnings per share for year 2005 and 2006. The sample size is first reduced due to the availability of data for the estimation of cost of equity Table 3.1. Since the data requirements varies for the calculation of the earnings quality measures, the composition of companies are further reduced into two samples- 1 ABRES and 2 ABSDATCAABSDATA Table 3.2. 1230 ABRES denotes the accrual quality as measured by the absolute residual from the regression of total current accrual on current, last and next period cash flows. ABSDATCAABSDATA denotes the discretionary current accruals and discretionary total accruals. Table 3.1 Sample Number of companies with estimated earnings forecasts 213 Eliminated due to change in accounting year end and insufficient data to calculate cost of equity 10 203 Table 3.2 Sample size based on available data for the calculation of earnings quality variables Market Capitalization ABRES 141 31 ABSDATCA ABSDATA 151 32 3.3 Variable definition and measurement 3.3.1 Accruals quality There are two measures of accrual quality as operationalized in Aboody, Hughes and Liu 2005 based on models developed by Jones 1991, Dechow, Sloan and Sweeney 1995 and Dechow and Dichev 2002 . The first measure of accruals quality is defined as the amount of discretionary accruals DA or abnormal accruals. Large DA is associated with low quality. First non-discretionary accruals NDA is measured from a model developed by Jones 1991 and subsequently modified by Dechow et al 1995. This modified version is used in many earnings management studies. The estimation is done in the following way time t refers to year 2004: NDA t A t-1 = 1A t-1 +  REV t - REC t A t-1 + PPE t A t-1 Where, NDA t - Non-discretionary accruals at time t