Discretionary Accruals, Earnings Management and the Valuation of Earnings

This study investigates how discretionary accruals affect earnings valuation (or price-earnings multiples) to provide indirect evidence on whether managers use their discretion over accruals to communicate their private information or to obtain private benefits. The results indicate that earnings multiples are significantly higher when earnings contain large income increasing discretionary accruals than when earnings contain small discretionary accruals. Furthermore, the effect of income decreasing discretionary accruals depends on current performance (measured before discretionary accruals). In periods of high performance, earnings multiples are significantly lower when earnings contain large income decreasing discretionary accruals than when earnings contain small discretionary accruals. This is consistent with the communication hypothesis. In periods of low performance, earnings multiples are significantly higher when earnings contain large income decreasing discretionary accruals than when earnings contain small discretionary accruals. This is consistent with investors viewing income decreasing discretionary accruals as being transitory