Mediators Linking Information Quality and the Cost of Equity Capital*

• DOI: http://doi.org/10.1111/ajfs.12299
• Published date: 01 June 2020
• Author: Seong Mi Bae,Hyoung‐Tae An,Jong Dae Kim
• Date: 01 June 2020

Mediators Linking Information Quality and

the Cost of Equity Capital*

Seong Mi Bae

College of Business Administration, Inha University, Republic of Korea

Hyoung-Tae An

Division of Business Administration, Daelim University College, Republic of Korea

Jong Dae Kim**

College of Business Administration, Inha University, Republic of Korea

Received 22 April 2019; Received in current form (3

rd

revision) 23 February 2020; Accepted 25 February

2020

Abstract

This study investigates the mechanisms underlying the relationship between accounting infor-

mation quality and the cost of equity capital. Information quality is negatively correlated with

the cost of equity capital, with the relationship possibly driven by mediators linking the two

variables. The empirical results indicate that about 42% of the total effects of information

quality on the cost of equity capital is attributable to the indirect effects mediated by informa-

tion asymmetry, market risk, and liquidity risk in that order, although the relative magnitude

of the mediation depends on which mediator is considered first in the model. This study is

the first to examine the mediating effect of liquidity risk using path analysis. Furthermore, no

previous study has examined and compared the relative impact of the three mediators. In par-

ticular, liquidity risk mediates the relationship between information quality and the cost of

equity capital, and the mediating effect of liquidity risk is almost as significant as information

asymmetry and market risk with a marginal difference when considered individually.

Keywords Information quality; The cost of equity capital; Information asymmetry; Liquidity

risk; Mediating effect

JEL Classification: M41

1. Introduction

This study investigates mechanisms underlying the relationship between accounting

information quality and the cost of equity capital. Prior research argues that infor-

mation quality affects the cost of equity capital. In particular, Bhattacharya et al.

*This research was supported by the Inha University.

**Corresponding author: College of Business Administration, Inha University, 100 Inha-ro,

Nam-gu, Incheon, Republic of Korea. Tel: +82-32-860-7757, email: jdk@inha.ac.kr.

Asia-Pacific Journal of Financial Studies (2020) 49, 410–437 doi:10.1111/ajfs.12299

410 ©2020 Korean Securities Association

(2012) find that improved information quality decreases the cost of capital and that

the relationship is mediated by information asymmetry and market beta. As such,

accounting information quality could affect the cost of capital through various

mediating variables.

Many researchers investigate whether earnings quality, particularly accruals qual-

ity, is a priced risk factor in addition to traditional systematic risk factors in the

asset-pricing model. Information quality, a proxy for information risk, is one of the

systematic risks that determine individual stock returns. Francis et al. (2004) find

that, among all earnings quality proxies, accrual quality has the greatest effect on

the implied cost of equity capital. Although Johnstone (2015) argues that informa-

tion quality could decrease or increase the cost of capital depending on the esti-

mates of future cash payoffs rather than merely on its precision, most prior stud ies

find a negative association. Thus, information quality decreases the cost of capital

as represented by the significant negative correlation between the two variables.

Information quality can also affect the cost of capital through mediating vari-

ables. For example, Lambert et al. (2007) argue that an increase in information

quality reduces market risk and, thus, the cost of capital, suggesting that market risk

plays a mediating role between information quality and the cost of capital. Extend-

ing Lambert et al. (2007), Ng (2011) tests the effect of information quality on liq-

uidity risk and the cost of capital. Using the liquidity measure defined by Pastor

and Stambaugh (2003), Ng (2011) compares the effects of information quality on

market and liquidity risks, finding that information quality lowers liquidity risk by

a greater amount than it decreases market risk. However, Ng (2011) does not test

the mediating effects of liquidity risk or market risk using a standard path analysis

framework. Recent evidence on the effect of liquidity on the cost of capital finds

that firms whose stocks have a greater potential for extreme illiquidity realizations

suffer from a higher cost of capital (Belkhir et al., 2018).

While Lambert et al. (2007) and Ng (2011) theoretically suggest the mediating

effects of market and liquidity risks, Bhattacharya et al. (2012) empirically show

that information asymmetry also mediates the effect of information quality on the

cost of capital. Thus, information asymmetry is an additional mediating variable

representing the information environment distinct from market and liquidity risks.

While information quality, or the precision of information, proxies for the level

of information risk, information asymmetry is measured by the distribution of

information between well-informed and poorly informed investors (Bhattacharya

et al., 2012). Lambert et al. (2011) suggest an indirect link between information risk

and the cost of capital through information asymmetry. Unlike Lambert et al.

(2007) and Ng (2011), Bhattacharya et al. (2012) explicitly test the mediating effects

using path analysis. Path analysis is used to decompose inter-variable relationships

into direct and mediated ones, which can be considered a new challenge in

accounting research (Bushee and Noe, 2000; Bhattacharya et al., 2012).

To sum up previous research, the mechanisms linking information quality and

the cost of capital could be reductions in market or liquidity risks, or lower

Mediators between information and the cost

©2020 Korean Securities Association 411