Do managers credibly use accruals to signal private information? Evidence from the pricing of discretionary accruals around stock splits

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Abstract

Prior studies suggest that managers use their reporting discretion to signal private information. However, because managers are often assumed to use their discretion to mislead investors, discretionary accruals might be regarded as opportunistic. We posit that combining the accrual signal with other signals may be an effective means of communicating private information. One such signal is stock splits. The stock split signal lends credibility to the accrual signal whereas the accrual signal reinforces the split signal. Accordingly, we find that, at the split announcement, the market construes the pre-split abnormal accrual as a signal of managerial optimism rather than managerial opportunism.

Introduction

Prior studies suggest that managers use their reporting discretion to signal their private information through accruals.1 However, because managers are often assumed to use their discretion to mislead investors, discretionary accruals might be regarded as opportunistic. To enhance the credibility of accruals as a means of signaling favorable private information, managers can use discretionary accruals in conjunction with other corroborating signals. One signal suggested by prior studies is stock splits. We therefore examine whether managers credibly use accruals to signal their private information by analyzing firms’ reporting behavior prior to stock splits and the effect of pre-split abnormal accruals on the market reaction to split announcements.

Subramanyam (1996) finds a positive correlation between stock returns and unexpected accruals. He interprets this result as evidence that discretionary accruals are signals of managers’ private information. However, Guay et al. (1996) (henceforth GKW) show analytically that a positive correlation between returns and discretionary accruals is consistent with both the opportunistic behavior hypothesis and the signaling hypothesis. GKW also conclude that researchers should take managers’ incentives into account when selecting samples to identify discretionary accruals. Consistent with this recommendation, Healy and Wahlen (1999) observe that some researchers employ research designs aimed at increasing the validity of their inferences by identifying conditions under which managers’ incentives to manage earnings are likely strong, and then testing whether patterns of unexpected accruals are consistent with the incentives.2 However, in general, existing studies analyze earnings management in settings where management is most likely to display opportunistic behavior. Few studies examine discretionary accruals in corporate settings where managers might use accruals to signal their private information.3

Because of the litigation risk associated with inflating earnings,4 we conjecture that firms are more likely to use discretionary accruals to signal their private information when they are confident that future performance will meet the expectations raised by the discretionary accruals. In addition, because managers are often assumed to use their discretion to mislead investors, we also conjecture that, without a second corroborating signal, discretionary reporting might be regarded as opportunistic. Prior studies strongly suggest that managers split their stocks when they have favorable private information (see, e.g., Ikenberry et al., 1996). Existing studies also find that the market under-reacts to the signal conveyed by a stock split (see, e.g., Ikenberry and Ramnath, 2002). Hence, we posit that combining the discretionary accrual signal with the stock split signal is likely to be an effective means of communicating favorable private managerial information. The reporting signal reinforces the stock split signal whereas the stock split signal lends credibility to the reporting signal.

Many studies document a reversal of the price effects of discretionary accruals at the announcements of events that reveal management's past opportunistic behavior (Teoh et al., 1998a, Teoh et al., 1998b; Shivakumar, 2000; Louis, 2004). These studies find that the market reaction to the announcements of events such as initial public offerings (IPOs), seasoned equity offerings (SEOs), and stock-for-stock mergers is negatively correlated with the pre-event abnormal accruals, which suggests that investors were misled by the pre-event discretionary accruals. Positive abnormal accruals prior to IPOs, SEOs, and stock-for-stock mergers are likely to be associated with management's opportunistic behavior. Positive abnormal accruals prior to stock splits, on the other hand, are more likely to be related to management's attempt to signal favorable private information to the market. Thus, assuming that discretionary accruals serve as complements to stock splits,5 we postulate that the pre-split abnormal accruals and the abnormal split announcement returns will be positively correlated.

The results of the study are consistent with the signaling hypothesis. We find that managers report significantly positive abnormal accruals in the quarter prior to stock splits and that the market positively prices the pre-split abnormal accruals at the split announcement. We also find no evidence that the pre-split abnormal accrual is associated with the post-split long-term abnormal return. The results suggest that, on average, at the split announcement, the market construes the pre-split abnormal accrual as a signal of managerial optimism rather than managerial opportunism.6

Consistent with Arya et al. (2003), we conjecture that managerial incentives to signal private information depend on a firm's information environment and managers’ ability to use other means of communication. Following Lys and Soo (1995) and Lang et al. (2003), among others, we use analyst coverage to proxy for the richness of a firm's information environment. We conjecture that limitations on managers’ ability to communicate are more severe for firms that have low analyst coverage. Hence, we expect these firms’ managers to have stronger incentives to signal their private information. Consistent with the signaling hypothesis, we find that low analyst coverage firms report significantly more abnormal accruals than high analyst coverage firms prior to stock splits. In addition, we find that the positive association between the split announcement abnormal stock return and the pre-split abnormal accrual is driven mainly by low analyst coverage firms.7

The remainder of the study is organized as follows. We formulate the research hypotheses and describe the research method and sample selection process in Section 2. We report the results in Section 3 and conclude the paper with a summary in Section 4.

Section snippets

Hypothesis development

Prior studies conclude that managers use stock splits to signal their optimism about firms’ prospects.8 Existing studies suggest that the costs associated with a stock split make it a credible signaling device. Brennan and Copeland (1988) argue that a stock split is costly because, in particular, brokerage commissions increase in the number

Descriptive statistics

Descriptive statistics are reported in Table 1. They indicate that the splitting firms are generally profitable and have relatively low book-to-market ratios.15 If a low book-to-market ratio is an indication of overvaluation, the observed low

Summary

The extant literature suggests two reasons why managers may want to manage their earnings reports. First, earnings management may be part of managers’ attempts to mislead investors. Alternatively, managers may use their reporting discretion to signal their private information to the market. Many empirical studies have provided evidence consistent with the opportunistic hypothesis. In this study, we provide evidence consistent with the signaling hypothesis.

Prior studies document that managers

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    This paper benefits from comments by Anwer Ahmed (the referee), Orie Barron, Neil Bhattacharya (discussant at the 2003 AAA annual conference), Sanjay Gupta, Steve Kaplan, Bin Ke, S. P. Kothari (the editor), James McKeown, Karl Muller, Casey Rowe, Bill Schwartz, and workshop participants at Columbia University, MIT, Ohio State University, Penn State University, Southern Methodist University, University of Arizona, and University of Georgia.

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