Poor Accruals Quality Research Articles

How Do Regulation and Deregulation of Audit Fees Influence Audit Quality?: Empirical Evidence from Japan

The Japanese Institute of Certified Public Accountants (JICPA) formerly issued a standard audit fees table in accordance with the Certified Public Accountants Law. This table was intended to serve as a reference for the determination of audit fees, but in practice, the standard fees were applied frequently as substantive upper limits. The table was criticized and blamed for low fees and, thus, inefficient audit services. In response to this criticism, the Certified Public Accountants Law was amended in 2004, and the JICPA discontinued the issuance of the table, and audit fee pricing was no longer quasi-regulated in Japan. In this work, we examine the effects of (de)regulation on audit quality in this institutional setting. We specifically investigate the effects of low audit fees on audit quality prior to deregulation and the effects of higher fees on audit quality after deregulation. We use the accrual quality measure of Dechow and Dichev to capture audit quality. The results show that high fees, not low fees, correlate with poor accrual quality during the period of regulation and accrual quality decreases when audit fees increase after implementing deregulation.

Connecting the dots: the accruals quality premium vs the value premium

PurposeThe purpose of this paper is to investigate the connection between the accrual quality and the growth/value characteristics (and their return premia) at firm level.Design/methodology/approachThe paper employs a battery of univariate and multivariate cross‐sectional tests. Fama‐MacBeth regressions with main effects and interaction effects are used to identify the relation between accrual quality, book‐to‐market and returns. The analysis is conducted on the overall sample, as well as after conditioning on up and down markets.FindingsValue (growth) stocks are more likely to be associated with high (low) accrual quality. Value stocks earn higher returns mainly in down markets, while poor accrual quality firms have significantly higher returns during up markets, but significantly lower returns during down markets. There is a significant interaction effect between accrual quality and the value premium, which only exhibits in the down markets (i.e. stocks with poor accrual quality earn a higher value premium in down markets than stocks with good accrual quality).Originality/valueResults in this paper help disentangle between various explanations proposed for the accrual quality premium and the value premium. These findings are consistent with the idea that the same underlying risk factor generating the value premium also generates the cross‐sectional variation in accrual quality responsible for the accrual quality premium. From the corporate managers' perspective, the results imply that value firms can mitigate their higher costs of capital by providing high quality of accounting information. From an analyst's perspective, the study suggests that considering both accrual quality and growth characteristics can help make better portfolio allocation decisions than when these are considered separately.

Accrual Quality, Realized Returns, and Expected Returns: The Importance of Controlling for Cash Flow Shocks

ABSTRACTThis paper develops a simple methodology based on the earnings response coefficient framework that allows decomposing realized returns into cash flow shocks and returns excluding cash flow shocks. I find that stocks with poor (good) accrual quality were on average subject to relatively lower (higher) cash flow shocks over the past 37 years. These lower (higher) cash flow shocks offset the higher (lower) expected returns of poor (good) accrual quality firms. After excluding cash flow shocks, future realized returns are negatively associated with accrual quality. The premiums pertaining to accrual quality are both statistically and economically significant in standard asset-pricing tests when cash flow shocks are excluded by firm-specific return decomposition. Overall, this paper provides evidence on the existence of a priced accrual quality risk factor, and underscores the importance of controlling for cash flow shocks in asset-pricing tests that use realized returns.

Discretionary Accruals Quality, Cost of Capital, and Diversification

This study examines the discretionary accruals quality of single- and multiple-segment firms. The authors hypothesize and find that the discretionary accruals quality is lower for multiple-segment firms than single-segment firms, and for the same level of discretionary accruals quality, the cost of capital is higher for multiple-segment firms than single-segment firms. These findings suggest that more severe agency problems in multiple-segment firms compared with single-segment firms may lead to poor discretionary accruals quality and agency risk is priced-in as a higher cost of capital.

Accruals quality and corporate cash holdings

AbstractThis Work Uses Panel Data For Firms Listed In The Spanish Stock Exchange Over The Period From 1995 To 2001 To Analyse The Effect Of Accounting Quality On Cash Holdings. The Results Show That Firms With Good Accruals Quality Hold Lower Cash Levels Than Firms With Poor Accruals Quality. This Finding Suggests That The Quality Of Accounting Information May Reduce The Negative Effects Of Information Asymmetries And Adverse Selection Costs, Allowing Firms To Reduce Their Level Of Corporate Cash Holdings. The Results Also Show That Cash Holdings Decrease When Firms Increase Their Use Of Bank Debt And In The Presence Of Cash Substitutes. In Contrast With This, Firms With Higher Cash Flow Hold Higher Levels Of Cash.

Can Accruals Quality Explain Auditors' Decision Making? The Impact of Accruals Quality on Audit Fees, Going Concern Opinions and Auditor Change

In this paper we investigate whether auditors' decisions can be explained by accruals quality. Using alternative measures of accruals quality developed by prior researchers, we find that a firm with poorer accruals quality is associated with higher audit fees, a greater likelihood of receiving a going concern audit opinion and a greater likelihood of auditor turnover. Recent studies have used accruals quality to proxy for a firm's information risk. Our study contributes to the literature by showing that information risk can be useful in explaining auditors' decisions. Accruals quality measures have also been suggested as a means of identifying earnings management. Existing studies exploring the effects of earnings management on auditors' decisions primarily use discretionary accruals and provide conflicting results. In contrast we find fairly consistent evidence that the likelihood of earnings management affects auditors' decisions adversely.

Accrual Quality and Expected Returns: The Importance of Controlling for Cash Flow Shocks

This paper develops a simple methodology based on the earnings response coefficient framework that allows decomposing realized returns into cash flow shocks and returns excluding cash flow shocks. I find that stocks with poor (good) accrual quality were on average subject to relatively lower (higher) cash flow shocks over the past 37 years. These lower (higher) cash flow shocks offset the higher (lower) expected returns of poor (good) accrual quality firms. After excluding cash flow shocks, future realized returns are negatively associated with accrual quality. The premiums pertaining to accrual quality are both statistically and economically significant in standard asset-pricing tests when cash flow shocks are excluded by firm-specific return decomposition. Overall, this paper provides evidence on the existence of a priced accrual quality risk factor, and underscores the importance of controlling for cash flow shocks in asset-pricing tests that use realized returns.

The Long-Term Price Effect of S&P 500 Index Addition and Earnings Quality

A positive price response has been found to follow a company's addition to the SP index inclusion would provide information even though Standard & Poor's assures investors that the investment merits of a company do not influence its selection. My study examined the quality of earnings data before and after index listing for 202 companies added to the S&P 500 in the 1990-2005 period. I find that the addition of a company to the S&P 500 does not necessarily reveal new information but does strengthen managerial incentives to provide high-quality financial disclosures. Discretionary accruals, a measure of earnings quality, are significantly larger in magnitude before index listing than after listing. The change signals a reduction in information risk. The addition of a company to the S&P 500 may increase investors' and media awareness and, in that way, change managerial incentives to release high-quality earnings data. The change is somewhat permanent: Five years after addition to the S&P 500, discretionary accruals are about one-half their magnitude at the time of inclusion. The price response to S&P 500 addition may come from the change in earnings quality. If investors anticipate an increase in earnings quality, they will reduce the return they demand because of the lower information risk, thus causing the price to rise. Results of my study support the hypothesis that the change in discretionary accruals contributes to the observed S&P 500 effect. The results of this study support the role of information risk and accruals in pricing, which is also consistent with recent findings that companies with poor accruals quality have higher costs of capital.

The market pricing of accruals quality

We investigate whether investors price accruals quality, our proxy for the information risk associated with earnings. Measuring accruals quality ( AQ) as the standard deviation of residuals from regressions relating current accruals to cash flows, we find that poorer AQ is associated with larger costs of debt and equity. This result is consistent across several alternative specifications of the AQ metric. We also distinguish between accruals quality driven by economic fundamentals (innate AQ) versus management choices (discretionary AQ). Both components have significant cost of capital effects, but innate AQ effects are significantly larger than discretionary AQ effects.

Call Options and Accruals Quality

We investigate whether greater use of call options in compensation and financing arrangements is associated with financial reporting choices that affect accruals quality, which previous research has shown to be a priced measure of information risk. Consistent with prior research documenting an association between the use of call options in compensation arrangements (in the form of employee stock options or ESOs) and increased returns and/or income volatility, we find that ESOs are also associated with poorer accruals quality, which has been shown to be related to increased returns volatility. However, call options used in financing arrangements (in the form of convertible debt and convertible preferred stock) provide no post-issuance incentives to worsen accruals quality, and may encourage the opposite behavior. We predict and find that the use of these instruments is associated with better accruals quality.