The Role of Accounting Quality During Mutual Fund Fire Sales

We study the ex ante role of accounting quality in mitigating the undervaluation generated by mutual fund fire sales. Asymmetric information between distressed mutual funds and potential buyers of the securities being fire sold leads to an adverse selection problem resulting in an equilibrium in which buyers only trade at prices below intrinsic value. Sellers accept these lower prices only because they have severe liquidity needs. To the extent that accounting quality helps market participants better estimate the intrinsic value of securities being fire sold, we expect the adverse selection problem to be less severe for firms with better accounting quality. Consistently, we find that high accounting quality is associated with smaller fire sale discounts. This result is explained by two complementary mechanisms. Analysts are more likely to provide price-correcting recommendations and arbitrageurs trade more heavily on high accounting quality firms during mutual fund fire sales. Overall, our results show that accounting quality mitigate stock underpricing caused by non-fundamental reasons.