The Effect of the Determinants of Accounting Discretion on the Relationship Between Earnings Management and Stock Returns

Abstract

This research investigates the effect of the determinants of accounting discretion (beating last year’s earnings, overinvestment problems, growth options, debt, and financial risk) on the relationship between earnings management and stock returns. We use discretionary accruals as a proxy of earnings management.

Based on a sample of 486 American firms for the period 2002-2010, our results show that discretionary accruals are positively priced by the market. This relation is even stronger when firms beat last year’s earnings, have higher growth options and increase their debt ratio. Indeed, firms’ accounting manipulations are used, in these circumstances, to convey private information about future prospects and signal good financial situation to external investors. However, discretionary accruals are negatively priced by investors in distressed firms and when overinvestment problems are intense. These firms have greater motivation to use opportunistic earnings management to camouflage the fall of firm value.