Understanding the Relation between Accruals and Volatility: A Real Options-Based Investment Approach

60 Pages Posted: 12 Dec 2013 Last revised: 16 Jun 2016

See all articles by Salman Arif

Salman Arif

Indiana University - Kelley School of Business - Department of Accounting

Nathan T. Marshall

University of Colorado at Boulder - Department of Accounting

Teri Lombardi Yohn

Indiana University - Kelley School of Business - Department of Accounting

Date Written: April 22, 2016

Abstract

Accruals are fundamental to financial reporting and are the underlying innovation of accounting. Despite this, accounting research has provided little understanding of how economic forces affect a firm’s level of accruals and limited guidance for forming expectations of accruals based on ex ante firm characteristics. We consider accruals as a form of investment and examine whether theoretical predictions from a real options-based investment framework provide insight into the relation between accruals and the ex ante expected volatility faced by the firm. Specifically, the theory predicts that higher volatility dampens investment because firms prefer to ‘wait and see’ instead of investing immediately. Consistent with this theory, we document a robust negative relation between year-ahead net working capital accruals and expected volatility. We also predict and find that the negative association between year-ahead net working capital accruals and expected volatility is less pronounced for distressed firms and more pronounced for firms with a longer operating cycle, and that current asset accruals are more sensitive to volatility than current liability accruals. Finally, we find that the residuals from an investment-based expected accrual model outperform those from the widely-used performance-adjusted modified Jones model in identifying companies that just meet or beat analysts’ earnings forecasts. Collectively, our findings suggest that the investment perspective of accruals, and in particular the real options-based investment framework, provide useful insights for forming expectations of accruals.

Keywords: Accruals, Volatility, Real Options, Financial Accounting

JEL Classification: M41

Suggested Citation

Arif, Salman and Marshall, Nathan T. and Yohn, Teri Lombardi, Understanding the Relation between Accruals and Volatility: A Real Options-Based Investment Approach (April 22, 2016). Forthcoming, Journal of Accounting & Economics (JAE), Vol. 62, No. 1, 2016; Kelley School of Business Research Paper No. 2014-26. Available at SSRN: https://ssrn.com/abstract=2365998 or http://dx.doi.org/10.2139/ssrn.2365998

Salman Arif (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States

Nathan T. Marshall

University of Colorado at Boulder - Department of Accounting ( email )

419 UCB
Boulder, CO 80309-0419
United States

Teri Lombardi Yohn

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
(812) 855-0430 (Phone)

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