Earnings Management, Corporate Investments, and Stock Returns

Abstract

In this paper, we investigate the relation between accounting accruals and abnormal corporate investments and if the accrual-based anomaly documented by Sloan (1996) is distinct from the investment-based anomaly documented by Titman, Wei, and Xie (2004). Our results indicate that abnormal capital investments are positively associated with accounting accruals and that the mispricing of abnormal capital investments is distinct from the mispricing of discretionary current accruals. In addition, investors can earn substantially higher size-adjusted returns by exploiting both strategies at the same time than by exploiting each individual strategy alone. Finally, our result suggests that the stock market appears to overvalue both discretionary current accruals and abnormal capital expenditures.

Keywords: Discretionary accruals, earnings management, abnormal capital investment, market efficiency

JEL Classification: G14, G31, M41, M42