Earnings Quality and Future Returns: The Relation between Accruals and the Probability of Earnings Manipulation

60 Pages Posted: 19 May 2005

See all articles by Messod Daniel Beneish

Messod Daniel Beneish

Indiana University - Kelley School of Business - Department of Accounting

Craig Nichols

Syracuse University

Date Written: May 17, 2005

Abstract

The paper examines the relation between the probability of manipulation, accruals, and future returns. We show that firms that have a high likelihood of earnings manipulation (as measured by the Beneish (1999)'s M-Score) experience lower future earnings, but that investors expect these firms to have higher future earnings. Indeed, we find that investors overestimate next-period return on assets by 490 to 690 basis points (this is significant as the median ROA in the sample 4.6%). We also show that the probability of manipulation is a correlated omitted variable for the earnings forecasting models used in prior research on accrual mispricing and that including the probability of manipulation greatly attenuates the mispricing of accrual persistence. Finally, we show that the probability of earnings manipulation predicts economically significant abnormal returns of approximately 15% per year after controlling for accruals and various controls for risk factors, including a factor compensating for earnings quality differences (Easley and O'Hara (2004), Francis et al. (2005)). We interpret our results that the predictive ability of accruals for returns is greatly diminished in the presence of the M-Score as indicating that accrual mispricing arises because investors are misled by managers' opportunistic management of earnings.

Keywords: Earnings manipulation, accrual mispricing, future returns

JEL Classification: M41, M43, G12, G14

Suggested Citation

Beneish, Messod Daniel and Nichols, Craig, Earnings Quality and Future Returns: The Relation between Accruals and the Probability of Earnings Manipulation (May 17, 2005). Available at SSRN: https://ssrn.com/abstract=725162 or http://dx.doi.org/10.2139/ssrn.725162

Messod Daniel Beneish (Contact Author)

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

1309 E. 10th Street
Bloomington, IN 47405
United States
812-855-2628 (Phone)
812-855-4985 (Fax)

Craig Nichols

Syracuse University ( email )

900 S. Crouse Avenue
Syracuse, NY 13244-2130
United States

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