Earnings Management and Mispricing of Allowance for Funds During Construction in the Electric Utility Industry

Abstract

The deregulation experienced by the electric utility industry in recent years has dramatically increased the competition from new suppliers of electric power. This changing environment puts managers in the electric utility industry under increasing pressure to improve financial performance. We hypothesize and find that there is an indication of earnings management in a discretionary income account, Allowance for Funds Used During Construction (AFUDC). The level of AFUDC increases with the magnitude of discretionary accruals. In addition, the stock market overestimates the impact of AFUDC in predicting one-year-ahead earnings. A subsequent hedge-portfolio test based on the mispricing insight earns significant abnormal returns, and these abnormal returns cannot be fully explained by either the three Fama-French (1992) risk factors, or the earnings-price anomaly (Basu, 1977). The results stay robust through various sensitivity tests.