Cross-firm return predictability and accounting quality

We test the hypothesis that if poor accounting quality (AQ) is associated with poor investor understanding of firms’ revenue and cost structures, then poor AQ stocks likely respond more slowly than good AQ stocks to new non-idiosyncratic information that affects both sets of firms. Consistent with this, results indicate that stock returns of good AQ firms significantly positively predict one-month-ahead stock returns to industry- and size-matched poor AQ firms. In testing a delayed-information-processing mechanism behind the cross-firm return predictability, we find that: (i) analyst earnings forecast revisions (FR) mimic the return patterns, as FR of good AQ firms significantly positively predict one-month-ahead FR of matched poor AQ firms; (ii) cross-firm return predictability is concentrated in months with substantial news arrival, including months with Federal Open Market Committee (FOMC) rate announcements, but not in no-news months; (iii) cross-firm return predictability is stronger when the good AQ predictor firms have a richer information environment than poor AQ firms as proxied by analyst following, institutional ownership, and the presence of a Big 4 auditor. Collectively, the results uncover a new relation between accounting quality and stock return dynamics.