Cross-Firm Return Predictability and Accounting Quality

Abstract

We examine whether cross-firm return predictability is associated with accounting quality (AQ), and find that stock returns of good AQ firms significantly positively predict one-month-ahead stock returns to industry- and size- matched poor AQ firms. In testing a delayed-information-processing mechanism behind the cross-firm return predictability, we find that: (i) Analyst earnings forecast revisions (FR) mimic the return patterns, as FR of good AQ firms significantly positively predict one-month-ahead FR of matched poor AQ firms; (ii) Cross-firm return predictability is concentrated in months with substantial news arrival, but not in no-news months; (iii) Cross-firm return predictability is stronger when the good AQ predictor firms have a richer information environment than poor AQ firms as proxied by analyst following and institutional ownership. Collectively the results uncover a new relation between accounting quality and stock return dynamics.

Keywords: Return predictability, Accounting quality, Information frictions

JEL Classification: G12, M41