The Effect of Fundamental Risk on the Market Pricing of Accruals Quality

30 Pages Posted: 5 Jan 2007 Last revised: 6 Sep 2012

See all articles by Mark A. Trombley

Mark A. Trombley

University of Arizona - Eller College of Management

Dan S. Dhaliwal

University of Arizona - Department of Accounting (deceased)

Linda H. Chen

University of Idaho

Date Written: January 1, 2007

Abstract

Motivated by the theoretical results of Yee (2006), we extend the empirical analysis of Francis et al. (2005) to test the prediction that the effect of accruals quality on cost of capital increases with fundamental risk. In asset pricing tests, we find that there is essentially no relation between accrual quality and cost of capital as measured by future return realizations for firms with the lowest fundamental risk. In contrast, for firms with the highest fundamental risk, there is a strong relation between accrual quality and future return realizations. Using earnings-price ratios and average implied cost of capital as alternative measures of cost of capital, we find that as fundamental risk increases, accrual quality has an increasing effect on cost of capital, and that the effect of accrual quality on cost of capital is reduced for firms with low fundamental risk. Overall, the results in this paper show that that relation depends critically on the level of fundamental risk, consistent with the model of Yee (2006). The results also serve to qualify the findings of Francis et al (2005), who document a relation between accrual quality and cost of capital.

Keywords: of capital, accrual quality, earnings quality, fundamental risk

JEL Classification: G12, M41, M43

Suggested Citation

Trombley, Mark A. and Dhaliwal, Dan S. and Chen, Linda H., The Effect of Fundamental Risk on the Market Pricing of Accruals Quality (January 1, 2007). Journal of Accounting, Auditing and Finance, Vol. 23, No. 4, 2008, Available at SSRN: https://ssrn.com/abstract=954964 or http://dx.doi.org/10.2139/ssrn.954964

Mark A. Trombley (Contact Author)

University of Arizona - Eller College of Management ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States
520-621-4805 (Phone)
520-621-3742 (Fax)

Dan S. Dhaliwal

University of Arizona - Department of Accounting (deceased)

Linda H. Chen

University of Idaho ( email )

Department of Accounting
College of Business and Economics
Moscow, ID 83944-3174
United States

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