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Accrual Quality, Realized Returns, and Expected Returns: The Importance of Controlling for Cash Flow Shocks

There is an ongoing debate as to whether the quality of accounting information influences firms’ cost of equity capital. Much of the debate centers around the existence of a priced risk factor related to the quality of accruals. In an influential set of papers, Francis, LaFond, Olsson, and Schipper (2004, 2005) (henceforth, FLOS) argue that accrual quality affects the cost of equity. FLOS base their conclusions in part on a significant positive correlation between the returns on AQ Factor (the accrual quality factor) and contemporaneous stock returns.

However, using conventional two-stage asset pricing tests (e.g., Fama and MacBeth 1973), Core, Guay, and Verdi (2008) (henceforth, CGV) show that the loadings on AQ Factor, although positive on average, do not explain the cross-sectional variation in returns. In addition, CGV document that accrual quality, as a characteristic, does not predict future (one-year-ahead) realized returns. Taken together, the findings in CGV are inconsistent with accrual quality being priced by the market. Resolving the debate on the existence of a priced risk factor related to accrual quality is important given the large number of studies that implicitly or explicitly rely on the existence of AQ factor.

In this paper, I argue that CGV are unable to find an association between accrual quality and future realized returns because their inverse measure of accrual quality—the residual accrual volatility measure proposed by Dechow and Dichev (2002), henceforth the DD Measure—is negatively correlated with future cash flow shocks, that is, firms with low (high) accrual quality experience more negative (positive) cash flow shocks in the future. Due to this correlation, the higher (lower) expected returns associated with poor (good) accrual quality firms are systematically offset by negative (positive) cash flow shocks, thereby leading to no association between future realized returns and accrual quality.

Prior research provides evidence that indirectly supports the conjectures above. Both FLOS and CGV use DD Measure to measure accrual quality. The DD Measure is estimated as the standard deviation of the residuals from a regression of working capital accruals on past, current, and future operating cash flows, so that higher levels of DD Measure represent lower accrual quality. The DD Measure is correlated with several characteristics that are likely to be associated with future cash flow news. For example, high DD Measure (i.e., low accrual quality) stocks have higher sales growth in the past (Doyle et al. 2007), are likely to have higher bankruptcy risk due to a high frequency of losses (Dechow and Dichev 2002), and have more volatile earnings and sales (Dechow and Dichev 2002). Each of these characteristics has been linked to systematic future underperformance in the stock market (Lakonishok et al. 1994; Dichev 1998; Mohanram 2005), possibly as a result of adverse cash flow news.

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Accrual Quality, Realized Returns, and Expected Returns: The Importance of Controlling for Cash Flow Shocks