Accruals quality, managers’ incentives and stock market reaction: evidence from Europe

ABSTRACT

We investigate if accruals quality is a valuable indicator of earnings quality for stock market investors. Our particular focus is on the incremental informative value of taking into account managers’ incentives for using accruals. We propose a market-based approach for assessing the usefulness of this indicator to improve investors’ decisions. Specifically, we examine the association between accruals quality and information asymmetry among stock market participants. Our empirical study uses data on European firms and our results are consistent with a positive association between poor earnings quality and high information asymmetry. However, given some previous studies suggesting that accruals-based measures may be noisy indicators of earnings quality, we develop a method to increase the informational content of the accruals quality measure. Based on our results, we find that combining accruals quality with the dispersion in analysts’ forecasts provides a better indicator of earnings quality rather than only accruals quality.

KEYWORDS:

• Earnings management
• accruals quality
• information asymmetry
• high-low spread estimator

JEL CLASSIFICATION:

• D80
• G14
• M41

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ We assume an endogenous relation between earnings quality and voluntary disclosure (Francis, Nanda, and Olsson 2008).

² In the case of good private information, managers are encouraged to disclose that information to distinguish it from the worst information that they could possibly have. However, managers may suppress bad information because investors’ knowledge of managers’ information is incomplete (Dye 1985).

³ Managers holding high-quality private information tend to disclose more information (Verrecchia 1990).

⁴ Information precision is the reciprocal of the variance of beliefs about a firm’s future cash flows (Lambert, Leuz, and Verrecchia, 2012).

⁵ Persistence refers to sustainable earnings and predictability is the ability to predict future cash flows.

⁶ Specifically, Perotti and Wagenhofer (2014) propose a stock-price-based measure for assessing the quality of several proxies for earnings quality.

⁷ The adverse selection component of the quoted spread is equal to the revision in the expectations of the market maker conditional on the precision of private information and on the probability that the trader is an informed investor. Hence, such proxy is expected to capture both information precision and information asymmetry.

⁸ Dechow, Sloan, and Sweeney (1995), in the modified Jones model, assume that changes in credit sales are the result of Earnings Management.

⁹ Even if the term quintile refers to a cut-off point, hereafter, quintile denotes a group of firms, for example the first quintile corresponds to firms whose magnitude of AQ is lower than the twentieth percentile.