EFFECT OF ACCRUALS’ QUALITY ON COST OF CAPITAL OF PUBLIC COMPANIES IN KENYA

Abstract

This study uses quantitative research design to evaluate the effects of accruals quality on cost of capital and security market returns of public companies in Kenya. It specifically tests the effects of overall, innate, discretionary and qualitative accruals qualities on cost of capital as well as their market pricing at the Nairobi Securities Exchange (NSE) and its various segments. The study’s purposive sample of 39 companies is derived from a population of 60 companies quoted at the NSE over the period January 1993 through December 2013. It relies on questionnaire-obtained primary qualitative accruals quality data from statutory audit and on secondary quantitative accruals quality data from annual financial statements as well as monthly trading security prices from the NSE. The cost of capital effect is tested by a panel data linear regression of cost of capital on the accruals quality rank factor to establish the statistical significance of the innate, discretionary, overall and qualitative accruals qualities’ coefficients at 95% confidence interval. Accruals quality is estimated as the standard deviation of firm specific residuals obtained from the five-year moving linear regression of working capital on accruals variables. Qualitative accruals quality is established from the accruals quality index of audit analysts’ responses on accruals quality data of the companies they externally audit. The security market pricing effect on the other hand is tested using a panel regression of accruals based portfolio decile premiums on market pricing factors to check the statistical significance of the accruals quality based excess returns over the pricing factors. The study rejects the null hypotheses that accruals qualities have no effect on cost of capital and finds out that the overall, innate, discretionary and qualitative accruals qualities of public companies in Kenya have a negative effect on cost of capital. It further indicates that there exists accruals quality market pricing effect overall, innate and qualitative accruals qualities but not for discretionary accruals quality. In addition, the effect of accruals quality on cost of capital varies widely among the various segments of the NSE in tandem with innate characteristics. The study recommends a test of the effect of accruals quality based on alternative measures of accruals quality to cover a wider scope to include non-listed firms in the wider East African region. .