The Role of Diversification in the Pricing of Accruals Quality

Abstract

Prior studies suggest that accounting information risk, primarily idiosyncratic in nature, can be diversified away. I show that accounting information risk, proxied by accruals quality, is priced even if it is entirely idiosyncratic. Building on a model developed in the ambiguity literature, I predict that (1) in an under-diversified market, idiosyncratic information risk is priced even if it is diversifiable, and (2) in a well-diversified market, idiosyncratic information risk is priced when information is subject to managers' discretion and thus ambiguous. The empirical results corroborate the predictions from the model. An association is observed between (unambiguous if risky) innate accruals quality and cost of capital. This association can be largely mitigated through diversification. However, diversification has little impact on the association between (ambiguous) discretionary accruals quality and cost of capital.

Keywords: Accruals quality, cost of capital, diversification, ambiguity

JEL Classification: M4, G12, G14