Bookkeeping, assessment, and the expense of capital

Abstract

This paper investigates the link between accounting and taxation and its implications for the cost of
equity capital. Using a simple model, we characterize the determinants of the cost of capital in a setting
where reporting rules combine accounting and taxation estimations. Accounting and tax rules usually
result in different estimates of true earnings, each one with its own estimation error. The correlation
between these errors and the rule of combination of accounting and tax estimates characterizes the
degree of connection between accounting and taxation. These two variables determine the overall
precision of the public reports issued by the companies and, among other things, influence the cost of
capital. The paper characterizes how the cost of capital varies with precision of accounting and tax
estimates, with the correlation of estimation errors and with the rule of combination between
accounting and tax estimates. The most interesting result is that for low enough or negative levels of
the correlation between estimation errors, more precise accounting/tax estimation principles may result
in higher cost of capital.