Accruals and the Conditional Equity Premium

Abstract

Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.

Predicting Stock Market Returns with Aggregate Discretionary Accruals

“…10 10 As Guo and Jiang [2009] do not tabulate their result, we believe that this notable exception is one evidence that they use to challenge the interpretation of findings in our earlier draft. On page 5, they claim to “ find that the predictive power of discretionary accruals mainly comes from the systematic component of firm‐level discretionary accruals that are positively related to the conditional equity premium .” However, a further analysis, unreported for brevity, illustrates that FDAC obtains the significant return forecasting power in this particular framework of co‐movement regressions mainly through the co‐movement of firm‐level discretionary accruals with IV but not MV .…”

“…Another risk-based explanation is that the set of commonly used control variables in our multivariate analysis are not as powerful as the aggregate discretionary accruals in predicting time-varying equity premiums, so that aggregate discretionary accruals contain information about discount rates above and beyond the control variables used. Building on Guo and Savickas's [2008] finding that market variance and idiosyncratic variance have superior forecasting power relative to commonly used proxies, Guo and Jiang [2009] suggest that aggregate accruals forecast market returns because they co-move with the conditional equity premium that is represented by the two variance variables.…”

“…Predictive Regressions with Alternative Risk Premium Proxies Table 9 reports the estimation results of regressing excess market returns against aggregate normal accruals and/or aggregate discretionary accruals, using the four ICAPM‐motivated risk premium proxies as control variables. As in Guo and Jiang [2009], we also include a time trend in the predictive regressions to accommodate the statistical property of IV . Use of this trend variable also alleviates the concern over a potential time trend in either aggregate normal accruals or aggregate discretionary accruals due to the documented rising conservatism in accounting reporting (Givoly and Hayn [2000]).…”

“…We include the two variance measures in the set of control variables to distinguish our results from those reported inGuo and Jiang [2009]. Please see section 4.4 for our detailed analysis.…”

Aggregate Earnings and Corporate Bond Markets

“…To explain the relation between aggregate earnings changes and corporate bond market returns, I use the return decomposition proposed 1 Studies that examine the macroeconomic role of aggregate accounting numbers include Anilowski, Feng, and Skinner [2007] and Bonsall, Bozanic, and Fischer [2013], who examine the relation between aggregate earnings guidance and stock market returns; Hirshleifer, Hou, and Teoh [2009], who examine the relation of aggregate accruals and aggregate cash flows to stock market returns; Kang, Liu, and Qi [2010], who study the association of aggregate discretionary accruals and aggregate normal accruals with stock market returns; and Guo and Jiang [2011], who examine the relation between aggregate accruals and the conditional equity premium.…”