Extreme Accruals, Earnings Quality, and Investor Mispricing

Abstract

Extreme accruals are commonly viewed as tainted by earnings management, contributing to lower quality earnings. We refer to this presumption as the earnings management/quality hypothesis. We directly examine three aspects of the presumed relation between the level of accruals and earnings management/quality: (i) the implications of earnings management for earnings persistence, (ii) the implications of earnings management for accrual mispricing, and (iii) the likelihood of greater opportunistic management to achieve earnings targets. We find (i) no evidence that extreme income-increasing accruals have lower persistence for year-ahead earnings, (ii) no evidence that investors systematically overweight extreme accruals, and (iii) no evidence that extreme accrual firms fall into the interval of firms just avoiding losses or earnings decreases more than other firms. We do find evidence that extreme income-decreasing accruals have lower persistence, but the evidence suggests this results from poor economic performance rather than accrual manipulation. We also document that investors consistently underestimate the persistence of cash flows for all firms, and that predictable year-ahead abnormal returns to extreme total or abnormal accrual portfolios documented in prior work appear to be driven by cash flow mispricing rather than accrual mispricing. Overall, our findings cast doubt on using extreme accruals to proxy for earnings management and/or low earnings quality.