Trends in Earnings Volatility, Earnings Quality and Idiosyncratic Return Volatility: Managerial Opportunism or Economic Activity

Abstract

We establish a link between earnings volatility and earnings quality, and show that both earnings volatility and earnings quality contribute to the trend in idiosyncratic return volatility. We examine the trend in earnings volatility and its components during the period 1978-2006 and find that both cash flow volatility and accruals volatility have been increasing and that the contemporaneous correlation between cash flow and accruals has become less negative. The key driver for the deteriorating earnings quality measure is the less negative contemporaneous correlation between cash flow and accruals. We view cash flow volatility as reflecting the uncertainty in firms' real operating activities, accruals volatility as reflecting firms' absolute financial reporting uncertainty, and the cash flow-accruals correlation as reflecting firms' relative degree of earnings management. We find that both the marginal contribution and overall contribution of the cash flow volatility trend to the earnings volatility trend dominate those of accrual volatility and those of correlation. The cash flow volatility trend is positively associated with the idiosyncratic return volatility trend, reflecting the impacts of firms' economic operations. On the financial reporting side, the return volatility trend is positively associated with the earnings quality trend yet negatively associated with the accrual volatility trend. Collectively, the trends in earnings volatility and its components and the trend in earnings quality help explain the documented increasing idiosyncratic stock return volatility. In sum, this paper contributes to the literature in a number of ways. First, we identify the drivers for the trend in earnings volatility. While a few papers have separately identified the trend either in earnings or cash flow volatilities, this paper brings these strands of literature together. Our main finding is that cash flow volatility is the primary but not the only driver for earnings volatility. We also document the role of management opportunism in contributing to the earnings volatility trend. Second, we find that earnings quality, financial reporting volatility, and cash flow volatility coexist in explaining idiosyncratic stock return volatility. Our results highlight the roles of both operating volatility (economic forces) and financial reporting quality (managerial opportunism) in explaining earnings volatility and idiosyncratic return volatility, with economic forces dominating managerial opportunism.