Extreme Accruals, Earnings Quality, and Investor Mispricing

50 Pages Posted: 11 May 2004

See all articles by Anwer S. Ahmed

Anwer S. Ahmed

Texas A&M University - Mays Business School

Bruce K. Billings

Florida State University - Department of Accounting

Richard M. Morton

Florida State University - Department of Accounting

Date Written: April 30, 2004

Abstract

Extreme accruals are commonly viewed as tainted by earnings management, contributing to lower quality earnings. We refer to this presumption as the earnings management/quality hypothesis. We directly examine three aspects of the presumed relation between the level of accruals and earnings management/quality: (i) the implications of earnings management for earnings persistence, (ii) the implications of earnings management for accrual mispricing, and (iii) the likelihood of greater opportunistic management to achieve earnings targets.

We find (i) no evidence that extreme income-increasing accruals have lower persistence for year-ahead earnings, (ii) no evidence that investors systematically overweight extreme accruals, and (iii) no evidence that extreme accrual firms fall into the interval of firms just avoiding losses or earnings decreases more than other firms. We do find evidence that extreme income-decreasing accruals have lower persistence, but the evidence suggests this results from poor economic performance rather than accrual manipulation. We also document that investors consistently underestimate the persistence of cash flows for all firms, and that predictable year-ahead abnormal returns to extreme total or abnormal accrual portfolios documented in prior work appear to be driven by cash flow mispricing rather than accrual mispricing. Overall, our findings cast doubt on using extreme accruals to proxy for earnings management and/or low earnings quality.

Keywords: Extreme accruals, earnings management, earnings quality, persistence

JEL Classification: M41, M43, G12, G14

Suggested Citation

Ahmed, Anwer S. and Billings, Bruce K. and Morton, Richard M., Extreme Accruals, Earnings Quality, and Investor Mispricing (April 30, 2004). Available at SSRN: https://ssrn.com/abstract=544984 or http://dx.doi.org/10.2139/ssrn.544984

Anwer S. Ahmed

Texas A&M University - Mays Business School ( email )

430 Wehner
College Station, TX 77843-4353
United States

Bruce K. Billings (Contact Author)

Florida State University - Department of Accounting ( email )

Rovetta Business Bldg. (RBA)
College of Business
Tallahassee, FL 32306-1110
United States
850-644-7889 (Phone)
850-644-8234 (Fax)

Richard M. Morton

Florida State University - Department of Accounting ( email )

Room No. 421
Tallahassee, FL 32306-8234
United States
850-644-7877 (Phone)

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