Accruals and the Cross-Section of Expected Stock and Option Returns

• In Event: Accruals and Earnings Quality

Abstract

Interpreting accruals as investment, we use a basic model of optimal investment
to study how accruals are related to the expected returns for holding equity and the
expected returns to holding equity return volatility. In our setting, firms optimally
invest to maximize shareholder value, which, intuitively, leads to firms investing
more when discount rates are low. This allows us to make two predictions: 1)
there is a negative relation between accruals and expected stock returns (equity
risk premia) because firms invest when discount rates are low; and 2) there is a
positive relation between accruals and the expected returns to trading in stock
return variance embedded in option contracts (variance risk premia) because low
discount rates imply low exposure to variance risk premia (which is negative), thus
raising the returns to traded variance embedded in traded options for high accrual
firms. These predictions are borne out in empirical tests and the results hold in
a variety of empirical specifications. Collectively, these findings suggest that the
documented negative relation between accruals and future stock returns may be far
less anomalous than previously thought.

Authors

• Salman Arif, Wharton/University of Pennsylvania

• Matthew Lyle, Northwestern University