The Pricing of Accrual Quality

Abstract

Contrary to the recent literature which suggests that accrual quality predicts low returns, we find a strong and long-lasting positive relation between the accrual quality measure of Dechow and Dichev (2002) (DD) and future returns. In decile portfolios that rank on DD, a hedge portfolio that goes long in the lowest decile and short in the highest decile generates an annualized, risk-adjusted return in the order of 10% from one-month to five-year horizons.The findings are robust to common risk factors and return-informative variables and to alternative accrual quality measures, are not subsumed by transaction costs and short-sale constraints, and extend to related measures of accrual volatility. The return premiums related to DD also give rise to a DD-based factor that prices a number of Fama-French portfolios. We show that the pricing of DD is consistent with the convexity valuation of uncertainty of Pastor and Veronesi (2003), in that managers fail to improve the firm's accrual quality over time and thus impose a relatively constant degree of uncertainty for investors to learn about the firm.

Keywords: Accrual quality, Stock returns, Return premium, Pricing factor, Information uncertainty

JEL Classification: G12, G14, M41