Accruals Quality and Cost of Capital: Evidence from Chinese Stock Market

Abstract

We seek evidence of a link between accruals-based earnings quality (EQ) and cost of capital by examining two classes of shares traded in China’s segregated markets during 1995-2000. The A- and B-shares introduced respectively for domestic and foreign investors carry identical cash flow rights, but B-shares are traded at deep discounts relative to A-shares. We predict that whereas differential information access by foreign versus domestic investors through their own private channels causes A- and B-share prices to diverge, high-quality public reporting serves to narrow the information and hence price gaps. Consistent with our predictions, we find that EQ is negatively related to the A-B share price differential, and that the negative effect is more pronounced for firms with large information disparities between the markets. We further find that this EQ effect vanishes after the new policy in 2001, which permits domestic investors to also trade B-shares, and consequently reduces the inter-market information gap. By employing this unique setting, the study circumvents some of the research design limitations in prior studies, which enables us to better identify the pricing effect of accruals quality.

Keywords: Accruals Quality, Cost of Equity, Investor Informedness, Domestic and Foreign Investors, Chinese Stock Market

JEL Classification: M41, G12