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Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly

CentER Discussion Paper Series No. 2006-103

64 Pages Posted: 28 Dec 2005  

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Elena Loutskina

University of Virginia - Darden School of Business

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: October 2006

Abstract

We show that the agency theory of overvalued equity (see Jensen, 2005) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996).Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation.Thus, high-accrual portfolios are likely to be over-represented with over-valued firms.Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms.In contrast, undervalued firms do not face incentives to report low accruals, so undervalued firms are not concentrated in low accrual decile portfolios.Therefore, across the accrual decile portfolios, we predict and find an asymmetric relation between accruals and both prior and subsequent returns.In addition, consistent with the predictions of the agency theory of overvalued equity, we find high, but not low, accrual firms' investment-financing decisions and insider trading activity are distorted, and analyst forecast optimism is concentrated among the high-accrual decile portfolios.Overall, return behavior, analyst optimism, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity, but do not support investor fixation on accruals.

Keywords: accrual anomaly; earnings management; agency theory of overvalued equity

JEL Classification: G31, G32, G34, G14, M41, M43

Suggested Citation

Kothari, S.P. and Loutskina, Elena and Nikolaev , Valeri V., Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly (October 2006). Available at SSRN: https://ssrn.com/abstract=871750 or http://dx.doi.org/10.2139/ssrn.871750

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

Elena Loutskina

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-243-4031 (Phone)

Valeri V. Nikolaev (Contact Author)

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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