Accounting Fundamentals and Systematic Risk: Corporate Failure over the Business Cycle
Forthcoming, The Accounting Review; DOI: 10.2308/accr-52638
90 Pages Posted: 1 Oct 2014 Last revised: 24 Oct 2019
Date Written: October 17, 2019
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