| This thesis examines the anomaly, first reported by Sloan (1996), that the market misprices stocks of firms with extreme (high or low) accruals. The thesis proposes a four-factor ICAPM, based on Campbell and Vuolteenaho (2004) and Fama and French (1993), and tests the model using a two-pass cross-sectional regression. Two principal findings are reported. First, the model successfully prices the cross-section of accrual portfolios with an error that is statistically indistinguishable from zero at conventional sizes. In addition, abnormal returns to a variety of hedge portfolios are statistically or economically insignificant. These results do not hold for the CAPM and the Fama-French three-factor model. Secondly, tests based on Chan and Chen (1991) reveal that the return behavior of the low accrual portfolio mimics the return behavior of a portfolio of firms with high bankruptcy risk. In sum, the evidence suggests that (i) cross-sectional variation in average returns to high and low accrual firms is due to differences in risk rather than mispricing, and (ii) these differences in risk are not due to accruals per se, but rather, to well-known economic and financial distress characteristics that are correlated with accruals. |
