Real versus Accrual-based Earnings Management and the Cost of Equity: Evidence from Hong Kong and Chinese Firms

In this study, we investigate whether and how a firm’s cost of equity capital is influenced by the extent of a firm’s real earnings management (REM) and accrualbased earnings management (AEM). Using a large sample of Hong Kong and Chinese listed firms, we study whether our implied cost of equity estimates are positively associated with both the extent of REM and AEM, and whether the positive association is stronger for REM than for AEM. We also investigate whether this cost-of-equityeffect is stronger in Hong Kong market than in Chinese market, and whether this effect changes temporally in Chinese market. To provide a theoretical link between earnings management and cost of capital before the formal hypothesis tests, we investigate the effect of REM and AEM on the variance and level of future cash flows. As robustness checks, we repeat the above analyses using realized returns and REM/AEM factor returns to address possible concerns on the implied cost of equity estimate as a noisy proxy for the expected return. We also differentiate the component of REM representing optimal business decisions from that representing manager’s opportunistic incentives. We expect that the cost of equity has a positive relation with REM and AEM, and that this positive relation is stronger for REM than for AEM. We posit that this positive and stronger effect comes from the fact that REM increases the variance of future cash flows (direct effect) and decreases the level of future cash flows (indirect effect) to a greater extent than does AEM. We also predict that, due to stronger institutions and their enforcement, this cost-of-equity-effect will be more pronounced in Hong Kong market than in Chinese market, and that, owing to the adoption of new accounting and auditing standards in China, this effect will be larger in post-2007 than in pre-2007 period for Chinese firms.