Accounting Fundamentals and Systematic Risk: Corporate Failure over the Business Cycle
Forthcoming, The Accounting Review; DOI: 10.2308/accr-52638
Chicago Booth Research Paper No. 14-31
Stanford University Graduate School of Business Research Paper No. 14-37
90 Pages Posted: 1 Oct 2014 Last revised: 24 Oct 2019
Date Written: October 17, 2019
Abstract
In this paper, we use accounting fundamentals to measure systematic risk of distress. Our main testable prediction—that this risk increases with the probability of recessionary failure, P(R|F)—is based on a stylized model that guides our empirical analyses. We first apply the lasso method to select accounting fundamentals that can be combined into P(R|F) estimates. We then use the obtained estimates in asset-pricing tests. This approach successfully extracts systematic risk information from accounting data—we document a significant positive premium associated with P(R|F) estimates. The premium covaries with the news about the business cycle and aggregate failure rates. Additional tests underscore the importance of the “structure” imposed through recessionary-failure-probability estimation. The “agnostic” return predictor that relies only on past correlations between the same fundamental variables and returns exhibits markedly different properties.
Keywords: Systematic risk, distress, business cycle, expected returns, accounting fundamentals
JEL Classification: G12, G32, G33, M41
Suggested Citation: Suggested Citation