Investor Sentiment and the (Discretionary) Accrual-Return Relation

Discretionary accruals are positively associated with stock returns at the aggregate level but negatively so in the cross section. Using Baker-Wurgler investor sentiment index, we find that a significant presence of sentiment-driven investors is important in accounting for both patterns. We document that the aggregate relation is only prominent during periods of high investor sentiment. Similarly, the cross-section relation is considerably stronger in high-sentiment periods in both economic magnitude and statistical significance. We then embed investor sentiment into a stylized model of earnings management, and illustrate that a positive (negative) relationship between stock returns and earnings management can endogenously emerge in the aggregate (cross section). Our analysis suggests that the (discretionary) accrual-return relation at both the aggregate and firm levels at least partially reflects mispricing that is related to market-wide investor sentiment