Pricing Discretionary Accruals: Code vs. Common Law Firms

Abstract

The purpose of this study is to investigate whether the U.S. stock market differentially and rationally prices discretionary accrual components of earnings of U.S.-traded foreign companies from different legal systems – code and common law. The study covers 1,426 U.S.-traded nonfinancial foreign firm-years (265 firms) from 1981 to 2000 including 686 common law firm-years (126 firms) and 740 code law firm-years (139 firms). Both Mishkin (1983) and hedge portfolio tests are performed to conduct our investigation. Hedge portfolio tests show that the market overprices the discretionary accruals for code law firms than those for common law firms. At the same time, the Mishkin (1983) tests show that U.S. market may, on average, rationally prices discretionary accruals for the full sample size of code and common law firms, but the hedge portfolio tests indicate that market may not rationally price discretionary accruals for every firm, especially for with extreme on discretionary accruals. The major limitation of this study is small size of sample. Future research can conduct a large-sample study by using code law and common law firms listed in their domestic markets rather than in the U.S. markets. Because of finding of this paper, investors can identify mispriced foreign firms publicly traded in the U.S. stock market by focusing more on code law firms than common law firms.