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

Abstract

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 prior to 2001.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 the differential informedness of domestic versus foreign investors 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 disparities in informedness between the markets. We further find that this EQ effect vanishes after the new policy in 2001, which permits domestic investors also to 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. JEL Classifications: M41; G12.