Managerial Discretion in Accruals and Informational Efficiency

• Author: Pietro Perotti,David Windisch
• Published date: 01 March 2017
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/jbfa.12241

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(3) & (4), 375–416, March/April 2017, 0306-686X

doi: 10.1111/jbfa.12241

Managerial Discretion in Accruals and

Informational Efficiency

Pietro Perotti∗and David Windisch

Abstract: In this paper, we examine the relation between managerial discretion in accruals

and informational efficiency. We measure managerial discretion in accruals by the absolute

value of abnormal accruals. Assuming that efficient prices follow a random walk, we measure

informational efficiency by using stock return variance ratios. We find that the absolute value

of abnormal accruals is negatively associated with the price deviation from a random walk

pattern, estimated in the 12-month period subsequent to the accrual reporting; hence, future

informational efficiency increases with the extent to which managers exercise discretion over

accruals. The results are consistent with the view that discretionary accruals, on average, convey

useful information to investors and facilitate the price convergence to its fundamental value.

Our findings are robust to a battery of tests, including tests to validate both our measures of

informational efficiency and our measure of managerial discretion in accruals.

Keywords: managerial discretion, abnormal accruals, informational efficiency, stock return

variance ratios

1. INTRODUCTION

Informational efficiency is a fundamental aspect of market quality. The extent to which

prices reflect available information has been shown to affect both capital allocation

and real investment decisions (Wurgler, 2000; Subrahmanyam and Titman, 2001;

and Chen et al., 2006). The accounting process, as a major source of firm-specific

∗The first author is affiliated with the University of Bath School of Management, Bath, UK. The second

author is from the University of Graz, Center for Accounting Research, Graz, Austria. The authors thank

Lucie Courteau, Joshua Coyne, Steve Crawford, Florian Eugster (discussant), Igor Goncharov (discussant),

Christian Gross, Joanne Horton, Roland Koenigsgruber, Sonia Konstantinidi, Wayne Landsman, Garen

Markarian, Bo Qin, Bryce Schonberger (discussant), Catherine Schrand, Andrew Stark (the editor), Steve

Stubben, David Veenman, Alfred Wagenhofer, and an anonymous referee for helpful comments. The

authors further thank participants at the 2012 AAA Annual Meeting, the 2013 AAA IAS Midyear Meeting,

the 2013 EAA Annual Meeting, the 2013 WHU FAccT Center Workshop, the 2016 JBFA Capital Markets

Conference, and at the workshops at University of Graz, Bocconi University, University of North Carolina

at Chapel Hill, Free University of Amsterdam, Erasmus University Rotterdam, University of Bath, Free

University Bozen, and University of Essex. Part of this research was conducted while Pietro Perotti and

David Windisch were visiting scholars at the University of Mannheim and the University of Chicago Booth

School of Business, respectively. Financial support of the Austrian Science Fund (P 24911-G11) and the

Austrian Academy of Public Accountants is gratefully acknowledged. (Paper received August 2014, revised

revision accepted February 2017).

Address for correspondence: University of Bath School of Management, Claverton Down, Bath BA2 7AY,

UK.

e-mail: p.perotti@bath.ac.uk

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376 PEROTTI AND WINDISCH

information, is likely to play a crucial role in the determination of informational

efficiency. On a related note, more research on how accounting affects informational

efficiency has been called for by Kothari (2001) in his survey on accounting-based

capital market research; by Lee (2001) in his commentary;1andbyRichardsonetal.

(2010) in their review of the literature on accounting anomalies.

In this paper, we examine the relation between a central feature of the accounting

process, namely managerial discretion in accruals, and informational efficiency. Gen-

erally Accepted Accounting Principles (GAAP) give managers considerable discretion

in determining accruals through accounting policy choices and implementation

decisions. This flexibility should enable them to convey relevant private information

and improve earnings as a measure of firm performance (Guay et al., 1996; and

Francis et al., 2005). More informative financial statements (i.e., giving more precise

information about the financial position and performance of a firm) allow investors to

improve their cash flow forecasts and help them to better process new information

coming to the market by providing context for subsequent events and disclosures

(Drake et al., 2015, 2016). Therefore, ideally, managers’ discretionary choices in

accrual reporting enhance investors’ ability to assess a firm’s fundamental value and,

consequently, increase informational efficiency.2However, managers can use the flexi-

bility in accrual-based accounting not only as a tool to convey private information, but

also to conceal the firm’s true underlying economic performance (e.g., Holthausen

and Leftwich, 1983; Watts and Zimmerman, 1986; Guay et al., 1996; and Healy

and Wahlen, 1999). Because managers’ accrual choices are influenced by manifold

unobservable financial reporting motivations, understanding what is the prevailing

effect of their use of discretion over accruals on informational efficiency is an empirical

question.

In contrast to many prior works that focus on idiosyncratic samples where managers

have specific incentives to exercise discretion over accruals, we focus on a general sam-

ple of firms. This allows us to examine the prevailing effect of managerial discretion

exercised over accruals on informational efficiency in the whole population of firms.

If the prevailing effect of managerial discretion in accruals on the informativeness

of financial statements is beneficial (detrimental), we expect to observe a positive

(negative) association between the extent to which managers use their discretion to

manage earnings and the informational efficiency of a firm’s stock price in the period

after the earnings release.

We measure the extent to which managers exercise discretion over accruals by the

absolute value of abnormal accruals;3the main analysis uses the specification proposed

by Kothari et al. (2005) to identify the discretionary portion of a firm’s total accruals.

Our tests of informational efficiency are based on the assumption that informationally

1 ‘Rather than remaining agnostic about the role of market prices, I advocate a more proactive approach.

Rather than assuming market efficiency, we should study how,when, and why price becomes efficient (and

why at other times it fails to do so). Rather than ignoring the current market price, we should seek to

improve it’ (Lee, 2001, p. 251).

2 By fundamental value we refer to the present value of all expected future payoffs, discounted by the

appropriate risk factor (Christensen and Feltham, 2003; and Penman, 2013). A widely accepted definition

of informational efficiency states that at any time informationally efficient prices fully reflect all available

information (Fama, 1970). Therefore, informationally efficient prices equal, at any time, an unbiased

estimate of the fundamental value (e.g., Jensen, 2005).

3 We use the term ‘abnormal accruals’ to refer to the empirical proxy used to estimate the discretionary

portion of accruals.

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efficient prices follow a random walk.4Specifically, following a standard approach in

the informational efficiency literature (e.g., Campbell et al., 1997), we focus on firm-

specific stock return variance ratios to investigate the deviation of prices from the

random walk benchmark.

Using a large sample of US firms over 20 years, we find that, after controlling for

other cross-sectional determinants of informational efficiency (i.e., firm size, liquidity,

trading volume, and institutional ownership), the deviation of the price pattern

from a random walk process decreases as the absolute value of abnormal accruals

increases; thus, informational efficiency in the period after the publication of the

financial statements increases with the extent to which managers exercise discretion

over accruals. In particular, a one standard deviation change in the absolute value of

abnormal accruals is associated with approximately a 3% change in the measures of

informational efficiency.

We run a battery of tests to validate both our measures of informational efficiency

and our measure of managerial discretion in accruals. Specifically, we show that our

results are not driven by sub-samples where potentially extremely slow incorporation

of information into stock prices may lead to a reversed interpretation of the infor-

mational efficiency measures (see Griffin et al., 2010); furthermore, we show that

the results are not attributable to cross-sectional differences in operating volatility or

business model shocks, which can impair the ability of accrual expectation models

to estimate the magnitude of managerial discretion in accruals (Hribar and Nichols,

2007; and Owens et al., 2016).

The results are robust to using alternative specifications that introduce additional

control variables potentially related to informational efficiency (e.g., analyst coverage,

growth opportunities, financial distress). Inference is also unchanged for alternative

accrual expectation models, across different time periods, and sub-samples of profit

vs. loss firms. The positive association between managerial discretion in accruals

and informational efficiency persists over each quarter of the examined 12-month

period. In the main analysis, we concentrate on annual discretionary accruals; we

obtain similar results examining quarterly discretionary accruals. Controlling for the

non-discretionary portion of accruals and for the perceived reliability of financial

statements does not change the results.

We also examine the cross-sectional variation in our results. We find that the

richness of the information environment has a mitigating effect on the strength of the

association between managerial discretion in accruals and informational efficiency;

this result is consistent with managers’ reduced need of using accruals to convey

information in richer information environments (Arya et al., 2003; and Louis and

Robinson, 2005). Furthermore, we identify a sub-sample of restated financial state-

ments in which the primary reason for restatement is related to accrual accounting;

in this setting, a greater use of discretion in accrual reporting presumably makes

accounting numbers less informative for market participants. Accordingly, we find a

negative association between the absolute value of abnormal accruals and informa-

tional efficiency in this sub-sample. Our cross-sectional evidence further supports the

4 We note that our objective is not to test whether prices follow a random walk; we instead seek to explain

cross-sectional differences in the extent to which prices deviate from an informationally efficient bench-

mark. Therefore, similar to prior literature (Boehmer and Kelley, 2009), we take a ‘relative informational

efficiency’ approach.

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