Understanding the relation between accruals and volatility: A real options-based investment approach

Abstract

Accruals are fundamental to financial reporting and are the underlying innovation of accounting. Despite this, accounting research has provided little understanding of how economic forces affect a firm׳s level of accruals and limited guidance for forming expectations of accruals based on ex ante firm characteristics. We consider accruals as a form of investment and examine whether theoretical predictions from a real options-based investment framework provide insight into the relation between accruals and the ex ante expected volatility faced by the firm. Specifically, the theory predicts that higher volatility dampens investment because firms prefer to ‘wait and see’ instead of investing immediately. Consistent with this theory, we document a robust negative relation between year-ahead net working capital accruals and expected volatility. We also predict and find that the negative association between year-ahead net working capital accruals and expected volatility is less pronounced for distressed firms and more pronounced for firms with a longer operating cycle, and that current asset accruals are more sensitive to volatility than current liability accruals. Finally, we find that the residuals from an investment-based expected accrual model outperform those from the widely-used performance-adjusted modified Jones model in identifying companies that just meet or beat analysts’ earnings forecasts. Collectively, our findings suggest that the investment perspective of accruals, and in particular the real options-based investment framework, provide useful insights for forming expectations of accruals.