The Pricing of Discretionary Accruals
Posted: 31 Jul 1995
This paper examines if the market attaches value to discretionary accounting choices. Discretionary accruals are computed by using a cross-sectional variation of the Jones  technique. The results of return association tests and tests using P/E ratios indicate that under the maintained hypothesis that the Jones technique is able to correctly decompose accruals into the discretionary and non- discretionary components the market attaches value to discretionary accruals. This is consistent with two alternative scenarios: (1) discretionary accounting choices arise from managerial opportunism and are value irrelevant and the pricing of discretionary accruals connotes market mispricing arising either because of functional fixation or information asymmetry (2) managers convey private information through discretionary accruals and the market properly prices them. Further tests are undertaken to investigate if management uses its discretion to improve the value relevance of earnings. There is evidence of pervasive income smoothing which improves the ability of reported earnings to approximate the long-term trend in profitability. There is also evidence that discretionary accruals predict future earnings/cash-flows individually and collectively with other components of income.
JEL Classification: M40, G12
Suggested Citation: Suggested Citation