Investment Opportunity Set, Accounting Policy, and Discretionary Accruals

Abstract

This study analyzes the effect of the investment opportunity set (IOS) on management's use of discretionary accruals to increase or decrease income. We argue that the relation between the IOS and the managerial decision to select accounting methods to maximize or minimize reported results is based upon the level of firm information asymmetry. First, given the information asymmetry, managers engage in income-increasing earnings management to signal firm performance or to achieve personal gains. Second, given their greater information asymmetry, firms with high investment opportunity set are more likely to select income-increasing accounting procedure. Third, we argue that discretionary accruals are a global measure of corporate accounting choices. The results of this paper show that firms with more investment opportunities are more likely to use discretionary accruals to maximize reported earnings. These results are robust to various discretionary accruals models and other sensitivity tests.