A Reassessment of the Evidence that Accruals Quality is a Priced Risk Factor
Pennsylvania State University
June 15, 2011
Without a theoretical consensus on how information risk affects expected returns, the two-pass methodology widely used to test whether accruals quality (AQ) is a priced risk factor can easily misinterpret mispricing of AQ as evidence of risk. Building on a simple model of asset pricing tests, I predict and confirm that the AQ factor premium estimated from a misspecified two-pass test is mechanically dependent on the correlation between AQ and AQ factor loading. As a result, existing evidence that AQ factor is priced is in fact driven by the mispricing of AQ characteristic. Consistent with the cross-sectional behavior of mispricing, the return regularity on AQ is stronger for firms with greater information uncertainty and imperfect investor competition. In addition, managers seem to strategically exploit market misvaluation by reporting more one-time items when firms with more volatile discretionary accruals earn a higher premium.
Keywords: accruals quality, two-pass asset pricing test, misspecification, mispricing
Date posted: June 16, 2011 ; Last revised: April 14, 2014
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