Earnings Management and the Predictive Ability of Accruals with Respect to Future Cash Flows

Abstract:     
There are two widely held views in the literature regarding management's motivations to manage earnings, and each has quite different implications for the resulting numbers' ability to predict future firm operating cash flows. One view is that earnings management is motivated by mangers' attempt to sustain the overvaluation of the firm's stock price and to enhance managers' personal welfare by disguising the true underlying economic performance of the firm (opportunistic perspective). An alternative view is that managers manage earnings to reveal private value-relevant information about the future prospects of a firm (informational perspective). Using a sample of firms that have restated earnings, we show that originally reported (managed) earnings of firms classified as managing earnings for opportunistic reasons are less predictive of future cash flows relative to the restated (unmanaged) numbers. Conversely, we find that originally reported (managed) earnings of firms classified as managing earnings for informational reasons exhibit greater predictive ability with respect to future cash flows relative to restated (unmanaged) numbers. Returns analysis corroborates our classification of firms into opportunistic and informational subsamples and provides evidence that supports Jensen's (2005) conjecture that overvaluation leads to value-destroying opportunistic earnings management. To the best of our knowledge, this study is the first to show that managed earnings exhibit different predictive ability of future cash flows depending on the apparent motivation behind the earnings management.

Keywords: Overvaluation, Earnings Management, Restatements, Cash Flows, Accruals

JEL Classifications: M41, M43, G12, G14

Working Paper Series