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Comprehensive Income and Cost of Equity Capital

Existing accounting literature on the usefulness of comprehensive income suggests that other comprehensive income is priced by the market but cannot predict future cash flows. Finance theory has long suggested that firm value is determined by present value of expected future cash flows. If a factor is associated with value but does not have an association with (expected) future cash flows, its effect on value must come from its relation with cost of capital (i.e. the discount factor). This argument can be especially true for other comprehensive income since other comprehensive income is mainly change in fair value of long-term financial assets and liabilities caused by market fluctuation.

Market fluctuation affects risk of owning these long-term assets/liabilities but will not have an immediate cash flow impact. Accordingly, we posit other comprehensive income should affect firm's cost of equity capital. We find comprehensive income subsumes net income in explaining firm's cost of equity capital. We also find similar results when we use volatility of stock return to measure risk. We conclude that the value-relevance of comprehensive income is driven by its relation to risk not to future profitability.

Our research builds upon two streams of literature. First, studies examining the value relevance and predictive value of other comprehensive income (e.g. Kanagarentnam et al. 2005; Biddle and Choi, 2006; Chambers et al., 2006) provide evidence indicating that other comprehensive income is value-relevant especially after the introduction of SFAS 130. However, studies (Dhaliwal et al. 1999; Kanagarentnam et al. 2005; Choi et al. 2007) cannot conclude the ability of other comprehensive income in predicting next-period cash flows.

Another strand of research focuses on the risk implication of fair value accounting in banking industry. Studies (Barth, 1994; Barth et al. 1996; Hodder et al, 2006) investigate the association between volatilities of different income measures and firm fundamental risk factors and find that fair value accounting has increased firm risk by including more unrealized gains and losses caused by changes in fair values of certain assets and liabilities in income measures. While other comprehensive income is a product of fair value accounting, studies have not linked the risk explanation of other comprehensive income with its value-relevance.

Comprehensive Income and Cost of Equity Capital