IDEAS home Printed from https://ideas.repec.org/a/spr/reaccs/v20y2015i3d10.1007_s11142-015-9331-1.html
   My bibliography  Save this article

The role of diversification in the pricing of accruals quality

Author

Listed:
  • Yu Hou

    (Queen’s University)

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.

Suggested Citation

  • Yu Hou, 2015. "The role of diversification in the pricing of accruals quality," Review of Accounting Studies, Springer, vol. 20(3), pages 1059-1092, September.
    • Handle: RePEc:spr:reaccs:v:20:y:2015:i:3:d:10.1007_s11142-015-9331-1
    DOI: 10.1007/s11142-015-9331-1
    as

    Download full text from publisher

    File URL: http://link.springer.com/10.1007/s11142-015-9331-1
    File Function: Abstract
    Download Restriction: Access to the full text of the articles in this series is restricted.
    File URL: https://libkey.io/10.1007/s11142-015-9331-1?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to

    for a different version of it.

    References listed on IDEAS

    as
    1. Lipe, Robert C. & Bryant, Lisa & Widener, Sally K., 1998. "Do nonlinearity, firm-specific coefficients, and losses represent distinct factors in the relation between stock returns and accounting earnings?," Journal of Accounting and Economics, Elsevier, vol. 25(2), pages 195-214, May.
    2. Francis, Jennifer & LaFond, Ryan & Olsson, Per & Schipper, Katherine, 2005. "The market pricing of accruals quality," Journal of Accounting and Economics, Elsevier, vol. 39(2), pages 295-327, June.
    3. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    4. Larry G. Epstein & Martin Schneider, 2008. "Ambiguity, Information Quality, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 197-228, February.
    5. Judson A. Caskey, 2009. "Information in Equity Markets with Ambiguity-Averse Investors," The Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3595-3627, September.
    6. Peter D. Easton & Gregory A. Sommers, 2007. "Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied by Earnings Forecasts," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 45(5), pages 983-1015, December.
    7. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    8. Stephannie Larocque, 2013. "Analysts’ earnings forecast errors and cost of equity capital estimates," Review of Accounting Studies, Springer, vol. 18(1), pages 135-166, March.
    9. Rakesh K. Sarin & Martin Weber, 1993. "Effects of Ambiguity in Market Experiments," Management Science, INFORMS, vol. 39(5), pages 602-615, May.
    10. H. Henry Cao & Tan Wang & Harold H. Zhang, 2005. "Model Uncertainty, Limited Market Participation, and Asset Prices," The Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1219-1251.
    11. Newey, Whitney K & West, Kenneth D, 1987. "Hypothesis Testing with Efficient Method of Moments Estimation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 777-787, October.
    12. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, vol. 43(2), pages 153-193, February.
    13. William N. Goetzmann & Alok Kumar, 2008. "Equity Portfolio Diversification," Review of Finance, European Finance Association, vol. 12(3), pages 433-463.
    14. Beyer, Anne & Cohen, Daniel A. & Lys, Thomas Z. & Walther, Beverly R., 2010. "The financial reporting environment: Review of the recent literature," Journal of Accounting and Economics, Elsevier, vol. 50(2-3), pages 296-343, December.
    15. Christine A. Botosan & Marlene A. Plumlee & Yuan Xie, 2004. "The Role of Information Precision in Determining the Cost of Equity Capital," Review of Accounting Studies, Springer, vol. 9(2), pages 233-259, June.
    16. David Aboody & John Hughes & Jing Liu, 2005. "Earnings Quality, Insider Trading, and Cost of Capital," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 43(5), pages 651-673, December.
    17. Jones, Jj, 1991. "Earnings Management During Import Relief Investigations," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 29(2), pages 193-228.
    18. James Claus & Jacob Thomas, 2001. "Equity Premia as Low as Three Percent? Evidence from Analysts' Earnings Forecasts for Domestic and International Stock Markets," Journal of Finance, American Finance Association, vol. 56(5), pages 1629-1666, October.
    19. Camerer, Colin & Weber, Martin, 1992. "Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-370, October.
    20. James Jiambalvo & Shivaram Rajgopal & Mohan Venkatachalam, 2002. "Institutional Ownership and the Extent to which Stock Prices Reflect Future Earnings," Contemporary Accounting Research, John Wiley & Sons, vol. 19(1), pages 117-145, March.
    21. William R. Gebhardt & Charles M. C. Lee & Bhaskaran Swaminathan, 2001. "Toward an Implied Cost of Capital," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 39(1), pages 135-176, June.
    22. Merton, Robert C, 1987. "A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    23. Kent Daniel & Sheridan Titman, 2006. "Market Reactions to Tangible and Intangible Information," Journal of Finance, American Finance Association, vol. 61(4), pages 1605-1643, August.
    24. Ball, Ray & Kothari, S. P. & Shanken, Jay, 1995. "Problems in measuring portfolio performance An application to contrarian investment strategies," Journal of Financial Economics, Elsevier, vol. 38(1), pages 79-107, May.
    25. Christine A. Botosan & Marlene A. Plumlee & HE Wen, 2011. "The Relation between Expected Returns, Realized Returns, and Firm Risk Characteristics," Contemporary Accounting Research, John Wiley & Sons, vol. 28(4), pages 1085-1122, December.
    26. Jennifer Francis & Allen H. Huang & Shivaram Rajgopal & Amy Y. Zang, 2008. "CEO Reputation and Earnings Quality," Contemporary Accounting Research, John Wiley & Sons, vol. 25(1), pages 109-147, March.
    27. Fama, Eugene F, 1991. "Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-1617, December.
    28. Daniel Ellsberg, 1961. "Risk, Ambiguity, and the Savage Axioms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 75(4), pages 643-669.
    29. Fama, Eugene F. & French, Kenneth R., 2007. "Disagreement, tastes, and asset prices," Journal of Financial Economics, Elsevier, vol. 83(3), pages 667-689, March.
    30. Christopher S. Armstrong & John E. Core & Daniel J. Taylor & Robert E. Verrecchia, 2011. "When Does Information Asymmetry Affect the Cost of Capital?," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 49(1), pages 1-40, March.
    31. Epstein, Larry G. & Miao, Jianjun, 2003. "A two-person dynamic equilibrium under ambiguity," Journal of Economic Dynamics and Control, Elsevier, vol. 27(7), pages 1253-1288, May.
    32. Partha Mohanram & Dan Gode, 2013. "Removing predictable analyst forecast errors to improve implied cost of equity estimates," Review of Accounting Studies, Springer, vol. 18(2), pages 443-478, June.
    33. Rajgopal, Shiva & Venkatachalam, Mohan, 2011. "Financial reporting quality and idiosyncratic return volatility," Journal of Accounting and Economics, Elsevier, vol. 51(1-2), pages 1-20, February.
    34. Brian J. Bushee, 2001. "Do Institutional Investors Prefer Near†Term Earnings over Long†Run Value?," Contemporary Accounting Research, John Wiley & Sons, vol. 18(2), pages 207-246, June.
    35. Tarun Chordia & Bhaskaran Swaminathan, 2000. "Trading Volume and Cross‐Autocorrelations in Stock Returns," Journal of Finance, American Finance Association, vol. 55(2), pages 913-935, April.
    36. Luzi Hail & Christian Leuz, 2006. "International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 44(3), pages 485-531, June.
    37. Daniel W. Collins & Guojin Gong & Paul Hribar, 2003. "Investor Sophistication and the Mispricing of Accruals," Review of Accounting Studies, Springer, vol. 8(2), pages 251-276, June.
    38. Chen, Changling & Huang, Alan Guoming & Jha, Ranjini, 2012. "Idiosyncratic Return Volatility and the Information Quality Underlying Managerial Discretion," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(4), pages 873-899, August.
    39. John Hughes & Jing Liu & Wei Su, 2008. "On the relation between predictable market returns and predictable analyst forecast errors," Review of Accounting Studies, Springer, vol. 13(2), pages 266-291, September.
    40. Rajgopal, Shiva & Venkatachalam, Mohan, 2011. "Financial reporting quality and idiosyncratic return volatility," Journal of Accounting and Economics, Elsevier, vol. 51(1), pages 1-20.
    41. Yoram Halevy, 2007. "Ellsberg Revisited: An Experimental Study," Econometrica, Econometric Society, vol. 75(2), pages 503-536, March.
    42. Richard Lambert & Christian Leuz & Robert E. Verrecchia, 2007. "Accounting Information, Disclosure, and the Cost of Capital," Journal of Accounting Research, John Wiley & Sons, Ltd., vol. 45(2), pages 385-420, May.
    43. Dimson, Elroy, 1979. "Risk measurement when shares are subject to infrequent trading," Journal of Financial Economics, Elsevier, vol. 7(2), pages 197-226, June.
    44. Bhattacharya, Utpal & Daouk, Hazem & Welker, Michael, 2003. "The World Price of Earnings Opacity," Working Papers 127185, Cornell University, Department of Applied Economics and Management.
    45. Core, John E. & Guay, Wayne R. & Verdi, Rodrigo, 2008. "Is accruals quality a priced risk factor?," Journal of Accounting and Economics, Elsevier, vol. 46(1), pages 2-22, September.
    46. Lawrence, Alastair, 2013. "Individual investors and financial disclosure," Journal of Accounting and Economics, Elsevier, vol. 56(1), pages 130-147.
    47. Barth, Mary E. & Konchitchki, Yaniv & Landsman, Wayne R., 2013. "Cost of capital and earnings transparency," Journal of Accounting and Economics, Elsevier, vol. 55(2), pages 206-224.
    48. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
    49. Todd Kravet & Terry Shevlin, 2010. "Accounting restatements and information risk," Review of Accounting Studies, Springer, vol. 15(2), pages 264-294, June.
    50. Hail, Luzi & Leuz, Christian, 2009. "Cost of capital effects and changes in growth expectations around U.S. cross-listings," Journal of Financial Economics, Elsevier, vol. 93(3), pages 428-454, September.
    51. Jennifer Conrad & Bradford Cornell & Wayne R. Landsman, 2002. "When Is Bad News Really Bad News?," Journal of Finance, American Finance Association, vol. 57(6), pages 2507-2532, December.
    52. Dan Gode & Partha Mohanram, 2003. "Inferring the Cost of Capital Using the Ohlson–Juettner Model," Review of Accounting Studies, Springer, vol. 8(4), pages 399-431, December.
    53. Jeffery S. Abarbanell & Brian J. Bushee & Jana Smith Raedy, 2003. "Institutional Investor Preferences and Price Pressure: The Case of Corporate Spin-Offs," The Journal of Business, University of Chicago Press, vol. 76(2), pages 233-262, April.
    54. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-658, September.
    55. Smith, Michael P, 1996. "Shareholder Activism by Institutional Investors: Evidence for CalPERS," Journal of Finance, American Finance Association, vol. 51(1), pages 227-252, March.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Rjiba, Hatem & Saadi, Samir & Boubaker, Sabri & Ding, Xiaoya (Sara), 2021. "Annual report readability and the cost of equity capital," Journal of Corporate Finance, Elsevier, vol. 67(C).
    2. Ying Cao & James N. Myers & Linda A. Myers & Thomas C. Omer, 2015. "Company reputation and the cost of equity capital," Review of Accounting Studies, Springer, vol. 20(1), pages 42-81, March.
    3. Schreder, Max, 2018. "Idiosyncratic information and the cost of equity capital: A meta-analytic review of the literature," Journal of Accounting Literature, Elsevier, vol. 41(C), pages 142-172.
    4. Terry Shevlin, 2013. "Some personal observations on the debate on the link between financial reporting quality and the cost of equity capital," Australian Journal of Management, Australian School of Business, vol. 38(3), pages 447-473, December.
    5. Suresh Nallareddy & Maria Ogneva, 2017. "Accrual quality, skill, and the cross-section of mutual fund returns," Review of Accounting Studies, Springer, vol. 22(2), pages 503-542, June.
    6. Jang, Soomi & Choi, Heeick & Kim, Hyungtae, 2024. "Managerial ability and cost of equity capital," Advances in accounting, Elsevier, vol. 65(C).
    7. Hou, Kewei & van Dijk, Mathijs A. & Zhang, Yinglei, 2012. "The implied cost of capital: A new approach," Journal of Accounting and Economics, Elsevier, vol. 53(3), pages 504-526.
    8. Najah Attig & Sean Cleary & Sadok El Ghoul & Omrane Guedhami, 2013. "Institutional Investment Horizons and the Cost of Equity Capital," Financial Management, Financial Management Association International, vol. 42(2), pages 441-477, June.
    9. Barth, Mary E. & Konchitchki, Yaniv & Landsman, Wayne R., 2013. "Cost of capital and earnings transparency," Journal of Accounting and Economics, Elsevier, vol. 55(2), pages 206-224.
    10. Sadok El Ghoul & Omrane Guedhami & Yang Ni & Jeffrey Pittman & Samir Saadi, 2012. "Does Religion Matter to Equity Pricing?," Journal of Business Ethics, Springer, vol. 111(4), pages 491-518, December.
    11. Max Schreder & Pawel Bilinski, 2022. "Information Quality and the Expected Rate of Return: A Structural Equation Modelling Approach," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 29(2), pages 139-170, June.
    12. Hwang, Lee-Seok & Lee, Woo-Jong & Lim, Seung-Yeon & Park, Kyung-Ho, 2013. "Does information risk affect the implied cost of equity capital? An analysis of PIN and adjusted PIN," Journal of Accounting and Economics, Elsevier, vol. 55(2), pages 148-167.
    13. Jeff P. Boone & Inder K. Khurana & K.K. Raman, 2009. "Impact of Job Complexity and Performance on CFO Compensation," Working Papers 0098, College of Business, University of Texas at San Antonio.
    14. Shen, Carl Hsin-han & Zhang, Hao, 2020. "What's good for you is good for me: The effect of CEO inside debt on the cost of equity," Journal of Corporate Finance, Elsevier, vol. 64(C).
    15. Pietro Perotti & Alfred Wagenhofer, 2014. "Earnings Quality Measures and Excess Returns," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 41(5-6), pages 545-571, June.
    16. Yu, Huaibing, 2024. "Why isn't composite equity issuance favored by the stock market? A risk-based explanation for the anomaly," International Review of Financial Analysis, Elsevier, vol. 94(C).
    17. Stephanie A. Sikes & Robert E. Verrecchia, 2015. "Dividend tax capitalization and liquidity," Review of Accounting Studies, Springer, vol. 20(4), pages 1334-1372, December.
    18. Sati P. Bandyopadhyay & Alan Guoming Huang & Kevin Jialin Sun & Tony S. Wirjanto, 2017. "The return premiums to accruals quality," Review of Quantitative Finance and Accounting, Springer, vol. 48(1), pages 83-115, January.
    19. Teresa Chu & In-Mu Haw & Bryan Lee & Woody Wu, 2014. "Cost of equity capital, control divergence, and institutions: the international evidence," Review of Quantitative Finance and Accounting, Springer, vol. 43(3), pages 483-527, October.
    20. Wu, Jin (Ginger) & Zhang, Lu, 2010. "Does Risk Explain Anomalies? Evidence from Expected Return Estimates," Working Paper Series 2010-18, Ohio State University, Charles A. Dice Center for Research in Financial Economics.

    More about this item

    Keywords

    ;
    ;
    ;
    ;

    JEL classification:

    • M4 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:spr:reaccs:v:20:y:2015:i:3:d:10.1007_s11142-015-9331-1. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.springer.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.