The role of market frictions, such as incomplete information and asymmetric information, in explaining asset prices has attracted much attention in prior research (e.g., Merton, 1987; Easley, Hvidkjaer and O'Hara, 2002; Aboody, Hughes and Liu, 2005; Francis, LaFond, Olsson and Schipper, 2005; Hou and Moskowitz, 2005; Lambert, Leuz and Verrecchia, 2007). This study examines the role of accounting quality in explaining stock market frictions, and the consequences of such association for future stock returns.
We reason that poor accounting quality can contribute to a variety of market frictions such as asymmetric information, incomplete information, parameter uncertainty, illiquidity and short sale constraints. These frictions hinder timely price discovery, and their effect is parsimoniously characterized in Hou and Moskowitz (2005) as the average delay with which information is incorporated into stock prices. Stock price delay can thus be seen as an 'outcome-based' measure of market frictions. We use the summary price delay measure of Hou and Moskowitz (2005) and examine the association between accounting quality, price delay and future returns.
Our notion of accounting quality is broadly the degree of bias and noise in financial statements that results from unusual firm circumstances, managerial opportunism and general business uncertainty. Financial statements incorporate considerable managerial judgment and estimation in a variety of financial accounts. Estimation is much more difficult, and the estimates more noisy, when the firm faces greater business uncertainty or is in unusual circumstances (for example, restructurings).
Estimates could also be biased due to managerial opportunism resulting from agency problems. We do not distinguish between the sources or causes of poor accounting quality. Rather, our goal is to examine the consequences of poor accounting quality for stock price delay and future stock returns.
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Accounting Quality, Stock Price Delay and Future Stock Returns
