The effect of fundamental risk on the market pricing of accruals quality

Motivated by the theoretical results of Yee (2006), we extend the empirical analysis of Francis, LaFond, Olsson, and Schipper (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 accruals 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 accruals 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, accruals quality has an increasing effect on cost of capital and that the effect of accruals 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 accruals quality and cost of capital.