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Critics on the research paper: The market pricing of accruals quality (Jennifer Francis, Ryan LaFond, Per Olsson, Katherine Schipper)

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  1. Introdction.
  2. Synthesis of strengths.
    1. Accruals quality and its impact on the information risk and the cost of capital.
    2. Innate accruals quality vs discretionary accruals quality.
  3. Methodological weaknesses.
    1. The specific sample that cannot be applied generally.
    2. Questionable hypotheses and methods.
    3. Variances between empirical findings and other results.
  4. Theoretical limitations.
    1. The systematic component of earning quality risk.
    2. The relation between accruals quality and cost of capital.
    3. Accruals quality is neither a priced risk factor nor a determinant of the cost of capital.
  5. Bibliography.

The paper ?The market pricing of accruals quality? sustains that the quality of accruals is priced by the financial markets. We can judge the value of this research by wondering to what extent, from a methodological and theoretical point of view, the accrual quality has an impact on the opportunity cost on capital. In the first place, we will summarize the strengths of the research paper; this point will allow us to come to underline the weaknesses of the empirical method in a second section; eventually, we will notice the limitations of the theoretical approach. According to the authors, accruals quality has an impact on the information risk and subsequently on the cost of capital: the poorer the accruals quality is, the greater the cost on debt and equity is. Nevertheless, innate accruals quality has a larger impact on the cost of capital than discretionary accruals quality has. Unlike cash accounting, in which transactions are registered only when flows are paid or received, accrual accounting respects the matching principle and economic events are recognised when transactions occur and not when payment is made.

[...] Only the systematic components of earnings risk contribute to the equity risk premium, while all the components, either systematic or diversifiable, affect the earnings capitalization factors / The relation between accruals quality and cost of capital depends on the fundamental risk In the paper The effect of fundamental risk on the market pricing of accruals quality, the authors corroborate and quantify the relation, while testing the theoretical model of Yee. The effect of accruals quality on the cost of capital increases with the fundamental risk. [...]

[...] The measure of accruals quality is explained by eight proxies in The quality of accruals and earnings and the market pricing of earnings quality: -the longer the operating cycle, -the smaller the firm -the greater the magnitude of sales volatility -the greater the magnitude of cash flows volatility ( the lower accruals quality -the greater the magnitude of accruals volatility -the greater the magnitude of earnings volatility -the greater the frequency of reporting negative net earnings -the greater the magnitude of accruals These results have been already announced by the authors in a former paper The market pricing of earnings quality. [...]

[...] The amount and the quality of public information supplied by financial reports affect the investor's non diversifiable information risk and consequently the required return or cost of capital .2/ Accruals quality has an impact on the cost of debt: The authors try to highlight the cause-and-effect relation between poor accruals quality and high cost of debt. Accruals quality is negatively correlated with the cost of debt, which depends also on several others factors: risk free rate, financial leverage, firm size, and return on assets, interest coverage and volatility of net income before extraordinary items. [...]

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