Overvalued Equity and Discretionary Accruals

Abstract

This paper provides evidence consistent with the overvaluation hypothesis (Jensen 2005). We categorize firms as overvalued if they are in the top quintile based on beginning of year price-earnings ratio, prior year abnormal return, or a classification technique that uses both the lagged price-earnings ratio and abnormal return. Under the overvaluation hypothesis, overvalued equity provides a strong incentive for managers to present an earnings number that does not disappoint the market. Using annual data from 1990 to 2005, we find that overvalued firms have significantly higher discretionary current accruals in the year following their classification as overvalued. Moreover and again consistent with the overvaluation hypothesis, we find that (a) the negative association between discretionary accruals and operating cash flows is more pronounced for overvalued firms and (b) the positive association between discretionary accruals and an indictor variable that captures whether discretionary accruals were necessary to beat last year's earnings target is also more pronounced for overvalued firms. To reinforce our interpretation of the findings as evidence of reduced earnings quality for overvalued firms, we show that audit quality proxied by whether a firm uses one of the Big N auditors has the effect of diminishing rather than reinforcing the negative (positive) association between discretionary accruals and operating cash flows (earnings target indicator variable).