The Value of Long-Term Accrual Management

Abstract

In this paper, we examine both value-enhancing and value-detrimental effects of smooth earnings on forward-looking value proxies of future returns from one-month to five-year horizons. Some prior studies, on one hand, find that smoothed earnings signal superior performance, enhancing thereby firm value; some others, on the other hand, argue that smooth earnings achieved through managerial intervention are noisy. We capture the potentially harmful long-term managerial intervention aspects of earnings smoothing by multi-period accruals volatility that increases with smooth earnings. Consistent with previous literature, we treat the correlation (“correlation”) between cash flows and accrual as the value enhancing aspect of earnings smoothing. In multivariate regressions that control for a battery of risk factors, future returns are positively related to earnings smoothing of the correlation variable but negatively associated with accrual volatility. Moreover, economic significance tests performed in this paper show that the value detrimental effects of accrual volatility completely wipe out future returns increases associated with any increase in correlations. These results are particularly pronounced in discretionary accruals and in firms with high information asymmetry and underlying operating uncertainty. The evidence suggests that due to its large accrual volatility effect, excessive long-term accrual management, whether voluntary or involuntary, is valuedetrimental.