The Effect of Investment Opportunity Set and Debt Level on Earnings-Returns Relationship and the Pricing of Discretionary Accruals

38 Pages Posted: 12 Sep 2000

See all articles by Ferdinand A. Gul

Ferdinand A. Gul

Monash University Sunway Campus

Sidney Leung

City University of Hong Kong (CityUHK) - Department of Accountancy

Bin Srinidhi

University of Texas at Arlington - Department of Accounting; City University of Hong Kong (CityUHK) - Department of Accountancy

Date Written: July 12, 2000

Abstract

This study examines whether the informativeness of earnings and the pricing of discretionary accruals by the market are associated with investment opportunity set (IOS) and debt levels. We show that the earnings-returns relationship is impacted positively by IOS but negatively by debt after controlling for other confounding variables such as size, beta, persistence of earnings and regulatory environment. We then show that the market prices discretionary accruals at a higher level for high-IOS firms than for low-IOS firms. The evidence on the effect of debt on the pricing of discretionary accruals is weaker but negative. We show further that the positive association of discretionary accruals with future profits is further improved in high-IOS firms but weakened in high-debt firms. This is consistent with the view that managers use discretionary accruals as a means to signal future opportunities for growth. In effect, this efficient earnings management can be significant, especially in high-IOS firms. More interestingly, opportunistic earnings management is not the only motivation for earnings management under all circumstances.

Key Words: Earnings management; Investment opportunity set; Capital markets; Valuation; Discretionary accruals

JEL Classification: M41, M44, G12

Suggested Citation

Gul, Ferdinand A. and Leung, Sidney and Srinidhi, Bin, The Effect of Investment Opportunity Set and Debt Level on Earnings-Returns Relationship and the Pricing of Discretionary Accruals (July 12, 2000). Available at SSRN: https://ssrn.com/abstract=236080 or http://dx.doi.org/10.2139/ssrn.236080

Ferdinand A. Gul

Monash University Sunway Campus ( email )

Jalan Lagoon Selatan
Selangor Darul Ehsan
Bandar Sunway, 46150
Malaysia

Sidney Leung

City University of Hong Kong (CityUHK) - Department of Accountancy ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
China
+852 2788-7924 (Phone)
+852 2788-7944 (Fax)

Bin Srinidhi (Contact Author)

University of Texas at Arlington - Department of Accounting ( email )

Arlington, TX 76013
United States

City University of Hong Kong (CityUHK) - Department of Accountancy ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
China

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