Does Investors’ Sophistication Affect Persistence and Pricing of
Department of Finance
National University of Kaohsiung
No. 700, Kaohsiung University Road,
Nan-Tzu District, Kaohsiung 811, Taiwan.
Does Investors’ Sophistication Affect Persistence and Pricing of
This paper examines whether the sophistication of market investors
influences management’s strategy on discretionary accounting choice, and thus
changes the persistence of discretionary accruals. The results show that the
persistence of discretionary accruals for firms face with naive investors is lower than
that for firms face with sophisticated investors. The results also demonstrate that
sophisticated investors indeed incorporate the implications of current earnings
components into future earnings in a more sufficient manner than naïve investors do.
Keywords: Managerial discretion, Discretionary accruals, Investors’ sophistication
The role of accruals is an important issue in accounting research. Dechow
(1994) points out that accrual-based earnings is a superior measure of firm
performance than cash flows because it mitigates timing and mismatching problems
inherent in measuring cash flows over short intervals. However, because of the
flexibility provided by Generally Accepted Accounting Principles (GAAP),
accrual-based earnings is subject to managerial discretion. Managements use
discretionary accounting choices in two different scenarios. On one hand,
managerial discretion could enhance earnings’ informativeness by communicating
private information. On the other hand, misalignment of managers’ and
shareholders’ incentives could induce managers to use the flexibility provided by
GAAP to manage income opportunistically, thereby creating distortions in the
reported earnings (Watts and Zimmerman, 1986; Healy and Palepu, 1993).
Recently, researchers investigate the link between management’s discretionary
accounting choice and the pricing of earnings. They test (1) whether the market
attaches value to accruals or discretionary accruals (e.g., Dechow, 1994;
Subramanyam, 1996) and (2) whether the market misprices the accruals or
discretionary accruals (e.g., Sloan, 1996; Collins and Hribar, 2000; Xie, 2001).
Subramanyam (1996) shows that the market attaches value to discretionary accruals
and that the pricing of discretionary accruals arises because managers use their
discretion to improve the ability of earnings to reflect fundamental value.
Xie (2001) extends Subramanyam (1996) by demonstrating that the market not
only prices, but also overprices discretionary accruals. Xie (2001) examines the
market pricing of earnings components to test whether stock prices rationally reflect
the one-year-ahead earnings implications of cash flow from operations,
nondiscretionary accruals and discretionary accruals components of accounting
earnings. He finds that cash flow component of earnings is more persistence than the
nondiscretionary accrual component, and the nondiscretionary accruals component is
more persistent than the discretionary accrual component. His results indicate that
discretionary accruals are the least persistent among the three earnings components.
In addition, Xie (2001) shows that the market underestimates the persistence of, thus
underprices, cash from operations. In contrast, the market overestimates the
persistence of, and thus overprices, both nondiscretionary and discretionary accruals.
He also finds that the market appears to overprice discretionary accruals to a greater
extent than it does nondiscretionary accruals.
Managerial discretion could be opportunistic or could improve the ability of
earnings to reflect economic value (Watts and Zimmerman, 1986; Healy and Palepu,
1993). Most recent studies focus on the opportunistic role of discretionary accruals
(e.g., Rangan, 1998; Teoh et al., 1998a, 1998b; Healy and Wahlen, 1999). They
show that managers choose positive discretionary accruals to opportunistically
increase earnings prior to IPOs or SEOs for the purpose of misleading the market and
that the market overprices these discretionary accruals. The results imply that
managers believe that investors are too naïve to comprehend the informational content
of earnings and will pay higher prices for the securities with inflated earnings.
However, some researchers argue that accounting choice may provide a
mechanism by which better informed insiders can convey information to less
informed parties about the timing, magnitude, and uncertainty of future cash flows
(Field et al. 2001). For example, Beaver and Engel (1996) find that the capital market
is able to decompose the allowance for loan losses in the banking industry into two
components, a nondiscretionary component which is negatively priced and a
discretionary component whose incremental pricing coefficient is positive.
Subramanyam (1996) also provides evidence that, on average, the market attaches
value to discretionary accruals because managerial discretion improves the ability of
earnings to reflect economic value.
The interesting issue arising from those incongruous empirical findings is thus to
investigate why firms engaged in earnings management: Do they intend to mislead the
market or to convey inside information to outside investors through discretionary
accruals? It would make no sense for managers to manipulate earnings numbers if
the investors are capable to tell the quality of earnings. Sophisticated investors may
raise doubts about not only the integrity of the management, but also the prospective
of the firm’s future performance. It is likely that the market would assess a larger
discount factor in valuing the stock prices because of the greater uncertainty for firms
that engaged in earnings managements. Accordingly, the stock prices may not be
inflated as expected by the managers who manipulated earnings, but contrary to their
expectations, would eventually be undervalued due to the enlargement of discount
factor that was assessed by sophisticated investors for their valuation of stock prices.
Thus, the question is, “would firms engage in earnings management when the
investors they faced are sophisticated?” If so, then there must be motivations other
than misleading the market.
Kao and Chien (2003) have already explored how SEO firms develop their
strategies of earnings management in the face of investors with different levels of
sophistication. They find that firms faced with less sophisticated investors will
engage in earnings management with discretionary accruals years before SEOs
issuance. The discretionary accruals then decline dramatically subsequent to the
issuance. The results provide strong evidence that firms engaged in earnings