Discretionary Accruals, Earnings Management and the Valuation of Earnings

Abstract

This study investigates how discretionary accruals affect earnings valuation (or price-earnings) multiples to provide indirect evidence on whether managers use their discretion over accruals to communicate their private information or to obtain private benefits. I find that earnings multiples are significantly higher when earnings contain large income increasing discretionary accruals than when earnings contain small discretionary accruals. Furthermore, in periods of high performance earnings multiplies are significantly lower when earnings contain large income decreasing discretionary accruals than when earnings contain small discretionary accruals. These results are consistent with the communication hypothesis. The effect of large income decreasing discretionary accruals in periods of moderate performance is mixed and in periods of low performance is not significant. The study (i) extends the literature on earnings multiples, (ii) suggests that effects of discretionary accruals depend on the context in which they are reported, and (iii) suggests that reduction of managerial discretion via accounting standards is costly because it eliminates the opportunity to communicate.

JEL Classification: M41, M43, G12