eThesis - School of Business electronic theses

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ON THE PRICING EFFECT OF EARNINGS QUALITY

PURPOSE OF THE STUDY The purpose of the study is to examine the interplay between earnings quality, information risk and cost of equity capital. Total accruals quality metric which is a numerical estimation based on a firm’s residual accruals is used to depict earnings quality in this thesis. Total accruals quality is further decomposed into innate accruals quality and discretionary accruals quality in order to examine their pricing implications separately. The thesis contributes to the ongoing discussion of whether firm-specific information risk is a priced risk factor, and what is the mechanism through which information risk affects expected returns.

DATA AND METHODOLOGY The thesis employs an extensive sample of data drawn from the US market in 1970–2006. The earnings quality proxies used in the study rely solely on accounting data, which are retrieved from Compustat North America Annual file. These proxies are used to construct factor mimicking portfolios, whose returns represent the exposure to that particular risk factor. The monthly firm returns data are retrieved from CRSP Monthly Stock file and the other return items are retrieved from Wharton Research Data Services (wrds). Asset-pricing methodology is then applied to study the effect of total accruals quality, innate accruals quality and discretionary accruals quality on expected returns.

RESULTS The results provide consistent evidence that total accruals quality is a priced risk factor. The main results from two-stage cross-sectional regressions do not have implications as regards the magnitude of the accruals quality risk premium, but the average positive coefficients indicate that poor accruals quality increase expected returns. The results for innate accruals quality are similar to that of total accruals quality, except that the risk premium implied by the average positive coefficient estimates appears actually larger. This suggests that the pricing effect of total accruals quality may be attributable to the innate components of accruals quality. The results on discretionary accruals quality are somewhat mixed, and the hypothesis that discretionary accruals are just noise in earnings cannot be rejected.

KEYWORDS Earnings quality, accruals quality, information risk, cost of equity, expected returns, risk premium, asset-pricing