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.

Key words: Cost of capital, information, precision, accounting, taxation.