Informative and Opportunistic Earnings Management and the Value

Relevance of Earnings: Some Evidence on the Role of IOS

Ferdinand A Gul
&
Sidney Leung
&
Bin Srinidhi*
City University of Hong Kong
Department of Accountancy
83 Tat Chee Avenue
Kowloon Tong
Hong Kong
Tel: 852 2788 7962
Fax: 852 2784 4498
Email: acbin@cityu.edu.hk

July 2003

_________________________
Acknowledgement: We gratefully acknowledge the comments received from the
participants of the 2000 AAA conference, the 2000 AAANZ conference and accounting
seminars at City University of Hong Kong, Chinese University of Hong Kong, Rutgers
University and State University of New York at Albany on earlier versions of this paper.
* Corresponding author

Informative and Opportunistic Earnings Management and the Value

Relevance of Earnings: Some Evidence on the Role of IOS

Abstract
In this paper, we first recognize that managers manage earnings for either
informational purposes or for opportunistic purposes. We then explore whether a firms
growth opportunities, as measured by its investment opportunity set (IOS), an exogenous
variable, is associated with this choice. In particular, this study examines whether IOS
affects managers choice to report opportunistically to hide performance or to report
more informative earnings. Our results show that discretionary accruals improve the
value relevance of earnings measured in terms of the earnings-return relationship (ERR)
in firms with higher IOS. This is consistent with the notion of a higher proportion of
informative earnings management (IEM) in high-IOS firms.

Keywords: Capital markets; Valuation; Opportunistic and informative earnings

management; Discretionary accruals; Investment opportunity set.

1. INTRODUCTION
This paper integrates two streams of the literature to explore whether a firms
growth opportunities as measured by its investment opportunity set (IOS), an exogenous
variable, is associated more with managers choice of Informative Earnings
Management (IEM) or Opportunistic Earnings Management (OEM). The first stream
suggests that IOS affects contracts-in-place which, in turn, affect managers choice of
accounting methods (see, for example, Watts and Zimmerman, 1986; Zimmer, 1986).
More specifically, Skinner (1993) found direct and indirect evidence to show that there
is an association between IOS and choice of accounting methods, even after controlling
for managers contractual incentives (p. 443). The second stream draws on the earnings
management (EM) literature which suggests that managers have different motivations
for managing the reported earnings of the firm. They are closely involved in investment
and operating decisions of the firm which allows them to have much better information
about the future prospects of the firm. Therefore, they are in a better position to estimate
the firms earnings that component which conveys the best available information on the
firms future to the investor. Managers who are motivated to convey this superior
information to the investors might use discretionary accruals to better reflect the
underlying economic performance in reported earnings. We refer to such use of
discretion as IEM. On the other hand, the managers might also mask or obscure true
economic performance by withholding information about current or future (potential)
poor performance1. Such reporting decreases the earnings informativeness and we refer
to this as OEM.

Even though the conceptual difference between these two motivations is quite
clear, it is difficult to decompose any given discretionary accrual into IEM and OEM
components. An example will probably make this clear. For example, let the manager
believe that given the predicted future cash flows of the business, the best estimate of
earnings per share is $2 per share. With no discretionary accrual, let the resulting
earnings be $1.95 per share. If the manager uses income increasing discretionary
accruals to manage the earnings to $2 per share, it would be IEM. On the other hand, if
the manager increases the income to $2.10, in order to partly improve his/her
compensation, part of the increase (5 cents) is driven by IEM and part of the increase (10
cents) is driven by OEM. It is therefore not possible, ex-post, to attribute the
discretionary accruals to a definite mix of IEM and OEM unless the true income is
known (in which case, the whole notion of earnings management is irrelevant).
Even though a clear ex-post distinction between the two motivations is not
possible, we believe that in the long run, a rational investor compares the reported
earnings with actual performance and continually refines his interpretation of the
earnings reported by management. If the managers of a firm are typically motivated by a
desire to inform the investor, the future performance of the firm coincides more closely
with the reported income stream and the investors will have more confidence in the
reported earnings. On the other hand, if managers of a firm are typically motivated by a
desire to hide information from the investor, the future performance of the firm is less
likely to coincide closely with the reported income stream and the investors will exhibit
less confidence in the reported income. This gives us a way of distinguishing the

motivations of the manager. Other things being equal, firms in which the investors price
the discretionary accruals more positively are likely to have had more IEM and those in
which the investors price the discretionary accruals less positively are likely to have had
more OEM. In other words, these different motivations of EM are likely to have
different economic consequences that are typically measured by investor reaction in an
efficient capital market. Extensive literature typified by Healy (1985) and DeAngelo
(1988) suggests that managers use accruals opportunistically to hide performance and
this is likely to result in a negative market reaction. However, Dechow (1994) shows
that accrual-based earnings provide a superior measure of firm performance than cash
flows. Subramanyam (1996) shows that, on the average, the market values both the
discretionary and the non-discretionary parts of accruals. In summary, these results
suggest that both IEM and OEM co-exist. However, the literature is silent on whether
firms with different characteristics exhibit different levels of OEM and IEM. In this
paper, we examine how one such firm characteristic, namely the investment opportunity
set (IOS), is associated with the levels and mix of IEM and OEM.
First, we show a positive association between IOS and the absolute value of
discretionary accruals. Such an increase could be due to increases in either or both types
of EM. Next, we use market reaction to identify which types of EM are increased by
IOS. In our second step, we show that IOS increases the value relevance of earnings in
terms of the earnings-return relationship (ERR) and the pricing of discretionary accruals
by the market2. Even though these results are consistent with the view that discretionary
accruals have a higher IEM content in high-IOS firms, there are some alternative

explanations that need to be addressed. The first concern is whether the results are
driven by the particular method (modified Jones model) of measuring the discretionary
and the non-discretionary accruals. We address this concern by replicating our results
using the Healy model, the DeAngelo model as well as the cross-sectional versions of
both the Jones model and the modified Jones model (Dechow et al., 1995). The second
concern is one of mechanical relationship between the earnings response coefficient and
IOS (Collins and Kothari, 1989). The rationale behind this concern is the following. All
firms derive value from assets-in-place and from IOS. Assets-in-place are measured and
reported by the accounting system but IOS is not. Therefore, accounting earnings are
primarily from the assets-in-place but the market price incorporates both assets-in-place
and IOS. Therefore, in high-IOS firms, the price includes a much higher proportion of
the assets that are not part of the accounting system, resulting in a high price-to-earnings
(PE) ratio and earnings response coefficient (ERC). We address this concern by
examining separately the role of IOS in the pricing of discretionary accruals in firms
with different PE ratios. We find that the discretionary accruals of firms with higher IOS
are priced higher even in the lowest and second lowest PE quartiles.
The results of this paper should be interpreted with some caution. If EM is
achieved not by discretionary accruals but by the choice of accounting policies or offbalance sheet financing, our models do not pick up the effects. In particular, managers
could increase the informativeness of discretionary accruals but nullify the increase by
their choice of accounting policies and off-balance sheet transactions. Such a systematic
strategic managerial behavior would partly negate our results.

Section 2 presents background to the research. Section 3 presents the research

design including the definition of the measures, selection of the sample and descriptive
statistics. Section 4 specifies the analyses and discusses the results. Sensitivity analysis
of the results is presented in Section 5. Section 6 presents the summary and conclusions.

2. BACKGROUND
An examination of IEM and OEM requires us to be precise in our
characterization of these terms 3 . A number of earlier studies have categorized EM.
Healy and Wahlen (1999) confine their definition of EM to firms that manage earnings
opportunistically. Guay et al. (1996) define performance measure hypothesis as EM
under which managers strive to accurately reflect the impact of current economic events
in the current earnings report. In contrast, they define opportunistic accrual
management hypothesis as EM under which managers reduce the reporting accuracy of
earnings. Christie and Zimmerman (1994) define efficient managerial actions4 (which
include both reporting and action choices) as those that increase the aggregate wealth of
contracting parties comprising of shareholders, debt holders and managers. In contrast,
they define opportunistic managerial actions as those that increase the managers
wealth but do not increase the aggregate wealth of all contracting parties.
Our categorization of IEM and OEM is similar to the categorization by Guay et
al. (1996). Unlike Christie and Zimmerman (1994), our categorization is not directly
related to the wealth of the contracting parties but explicitly considers the private
foresight information of the manager 5 . If the private information is highly value-

relevant, the contract will be designed to induce predominantly IEM. Prior literature also
suggests that the discretion accorded by GAAP provides an important means for
managers to impart their knowledge to investors (Healy and Palepu, 1993). On the other
hand, if the private information is not highly value-relevant, the contract might allow for
a high OEM.
Both analytical and empirical researchers have examined the EM phenomenon.
Most analytical studies, using the rational equilibrium viewpoint, seem to suggest that
IEM is an important form of EM (see Verrechia, 1986; Evans and Sridhar, 1996;
Demski, 1998). Fudenberg and Tirole (1995) build a theory of EM based on managers
concern about keeping their position or avoiding interference. This suggests that
opportunism manifests itself in different forms. In a similar vein, empirical researchers
have also examined the existence and magnitude of discretionary accruals in different
situations under different motivations (see Healy, 1985; McNichols and Wilson, 1988;
Jones, 1991; Carlson and Bathala, 1997; Dechow et al., 1996; Gul et al., 2001). Another
stream of empirical research has focused on the effect of EM on ERR. Watts and
Zimmerman (1986, 1990) find that high-debt firms exhibit a lower earnings-stock
relationship. Skinner (1993) examines growth opportunities in relation to debt levels,
compensation contracts and accounting procedure choices. In a similar vein, Barclay,
Smith and Watts (1995) argue that firms with high growth opportunities find debt
financing very costly and therefore, posit a negative relationship between growth
opportunities and debt levels. Warfield et al. (1995) provide evidence that increased
managerial ownership reduces the level of discretionary accruals and increases the

explanatory power of earnings for returns. They argue that low managerial ownership
results in greater accounting-based constraints. These constraints induce OEM by
managers at low managerial ownership levels. To sum up, the prior empirical literature
has documented the existence of EM and has characterized many situations resulting in
OEM, such as high debt level and low management ownership level. Typically,
empirical studies have not presented direct evidence of IEM.
Given this tilt in empirical results towards OEM, is there any theoretical
argument for expecting IEM in high-growth firms? Fishman and Hagerty (1989) argue
that because the investors cannot observe and monitor the investment decisions of
manager, they invest far too little in the firm. Therefore, all firms have an incentive to
make more informative disclosures to compete for investor attention and reduce
underinvestment. If investors get more information, this will get reflected in the stock
price and the firm can better utilize its investment opportunities. We argue that in highIOS firms, investment decisions are more crucial and less observable than in low-IOS
firms and consequently, they have a greater need to avoid underinvestment and make
credible informative disclosures. Consistent IEM increases investor confidence and
thereby reduces underinvestment in high-IOS firms.

3. RESEARCH DESIGN
3.1 Measurement of Variables
Investment Opportunity Set: There is no consensus on the best single proxy for
growth (Skinner, 1993). In this study, we report the results based on a composite factor

of three widely used proxies: (i) Market to Book ratio of equity (MBE), (ii) Market to
Book ratio of assets (MBA) and (iii) Property, Plant and Equipment over total market
value of assets (PPE). This composite factor has been considered superior to a single
proxy variable because it captures the piecewise correlation and variation of several
proxy variables (Gaver and Gaver, 1993; Gul and Tsui, 1998; Gul, 1999). However,
based on the literature, we have used two other measures of IOS to test the hypotheses.
These are (i) Market to Book ratio of equity alone, and (ii) composite factor of MBE,
PPE and the ratio of Research and Development Expenses to Sales.
Discretionary Accruals: An issue in testing the existence and magnitude of the
effect of discretionary accruals is the ability of currently available models to decompose
the earnings into the discretionary and non-discretionary parts. Empirical studies such as
Dechow et al. (1995) and Hansen (1996) make assumptions about the behavior of
earnings or the ERR in the absence of EM and test the current models against those
benchmarks. Guay et al. (1996) examine the relative performance of various models and
conclude that the cross-sectional modified Jones model is most likely to identify
discretionary accruals. Bartov et al. (2001), DeFond and Jiambalvo (1994) and
Subramanyam (1996) further support the use of cross-sectional modified Jones model.
Even so, we conduct our tests using Healy, DeAngelo, cross-sectional Jones and crosssectional modified Jones models and find consistent results. In the interest of brevity, we
report only the cross-sectional modified Jones model (Dechow et al., 1995)6 results.

The cross-sectional modified Jones model estimates non-discretionary earnings

(NDE) as a function of the level of property, plant and equipment, changes in revenue
and changes in accounts receivable in the following model:
NDE

it

= a

+ a ( REV
AR ) + a PPE
1
it
it
2
it

(1)
after estimating the parameters ai, i=0,1,2, in the Jones model given by
TA

it

= a

+ a REV
+ a PPE
+
it
it
it
1
2

(1A)
Where
TA = total accruals, measured as the difference between net income (earnings before
extraordinary items and discontinued operations) and operating cash flows
(Subramanyam, 1996; Becker et al., 1998).
REV = change in net revenue
AR = change in accounts receivable
PPE = property, plant and equipment
All the variables are deflated by total assets at t-1
The model is estimated separately for each combination of two-digit SIC code and
calendar year to obtain industry-specific estimates of the coefficients in equation (1).
Discretionary accruals are defined as (TAit NDEit ) .

3.2 Sample and Descriptive Statistics

Financial data to compute discretionary accruals and earnings and stock return
data are drawn from the Compustat 1998 for the three-year period 1995-1997. To be

included in the sample, companies had to meet the following selection criteria: (1)
sufficient data to compute discretionary accruals are available from the Compustat
database, (2) data necessary to compute stock returns and data for companies earnings,
market capitalization and firm risk measured by Compustat beta are available from the
Compustat database, and (3) five-year quarterly earnings data to compute the persistence
of earnings are available from the same database. These criteria yield 4113 firms and
9638 firm-year observations. Finally, observations that are more than three standard
deviations from their respective means are deleted in order to mitigate outlier effects.
This leaves us with a sample of 3972 firms with 9072 firm-year observations. The
minimum number of firms in any year is 2478 while the maximum number is 3470.
The composite IOS variable is computed using principal component analysis on
three growth measures, namely, market-to-book value of equity, market-to-book value
of assets and property, plant and equipment. It explains 72.7% of the total variance of
the three components. The variables correlation coefficients with the three growth
measures are 0.56, 0.86 and -0.7 respectively.
Table 1 reports the descriptive statistics of variables. Discretionary accruals (DA)
computed by the modified Jones model have a mean close to zero (-0.12% of total
assets). The median value is slightly above zero at 0.27% of total assets. 51.4% of the
sample firm-years show income-increasing accruals (DA >0) whereas 48.6% show
income-decreasing accruals. These descriptive statistics suggest that income-decreasing
discretionary accruals are almost as prevalent as income-increasing ones.

We also

performed extensive tests on differences in values of variables between high-IOS and

10

low-IOS firms. We found that high-IOS firms are characterized by larger size, higher
beta and higher persistence of earnings. Interestingly, there were no significant
differences in non-discretionary earnings and discretionary accruals between high-IOS
and low-IOS firms.
Insert Table 1 here

The literature (see Barclay et al., 1995) has found that firms with more growth
options are likely to have less debt. This could be because of many reasons including
underinvestment and signaling. The correlations between variables in Table 2 show that
IOS and debt are negatively correlated (correlation coefficient of 0.243). The low
correlation coefficient suggests that it is unlikely to cause serious multi-collinearity
problems.
Insert Table 2 here

4. ANALYSIS AND MAIN RESULTS

4.1 IOS and the Magnitude of Discretionary Accruals

In this subsection, we document that IOS is positively associated with the

magnitude of EM. There is evidence in the literature (Skinner, 1993) that firms with
greater investment opportunities exhibit greater EM. A possible explanation suggested
by Healy and Palepu (1993) is that managers communicate value-relevant private
information by managing earnings of high-IOS firms since they are likely to have more

11

value-relevant private information 7 . Thus, we expect a positive association between

firms with high-IOS and the magnitude of discretionary accruals.
Apart from IOS, many other variables have an effect on the magnitude of
discretionary accruals. There is extensive previous literature (Sweeney, 1994; DeFond
and Jiambalvo, 1994; Watts and Zimmerman, 1986, 1990) on the role of debt and debt
covenants in EM. The findings have been consistent with the view that for firms with
high levels of debt, greater income-increasing accruals are undertaken in the years in
which the debt constraints are likely to be binding and income-decreasing accruals are
undertaken in other years. An appealing explanation is that the managers perceived cost
of technical default of debt covenants is higher than the perceived loss in value resulting
from managing the discretionary accruals. Therefore, they engage in income increasing
accruals when the debt covenants are likely to be binding and in income decreasing
accruals to bank some of the income for future periods of possible binding debt
constraints (Cookie-jar hypothesis). If this is true, in a pooled cross-sectional analysis,
irrespective of whether the debt constraints are binding or not, the magnitude of
discretionary accruals is likely to be significantly higher for firms with more debt than
for firms with less debt.
Other variables also have been shown to affect the magnitude of discretionary
accruals. Larger firms have greater exposure, and are more likely to be under greater
scrutiny by higher quality auditors. This perhaps leads to less OEM. We therefore expect
a negative association between firm size and the magnitude of discretionary accruals.
Firms with a higher beta have a greater incentive to reduce the volatility of earnings so

12

as to convey lower risk to the market. Based on this argument, we expect a positive
association between beta and the magnitude of discretionary accruals. Another variable
of interest is the persistence of earnings. The greater the magnitude of discretionary
accruals, the more is the likelihood they reverse and less is the persistence of earnings.
Therefore, we expect a negative association between earnings persistence and the
magnitude of discretionary accruals. Regulation serves as a monitor of managers
actions and can potentially constrain the extent of discretionary accruals. Thus, we
expect a negative relationship between regulation and the magnitude of discretionary
accruals.
In order to document the relationship of the magnitude of discretionary accruals
with IOS after controlling for the above variables, we test the following regression
model:
ABSDA = a1 + b1 IOS + b2 DEBT + b3 SIZE + b4 BETA + b5 PERS + b6 REG
(2)
where
ABSDA = the absolute value of discretionary accruals from the cross-sectional
modified Jones model, scaled by lagged total assets, to indicate the degree to
which management exercises discretion in managing earnings.
IOS =

investment opportunity set or growth opportunity measured by the principal

component of three IOS variables, namely market-to-book equity ratio,
market-to-book asset ratio and scaled property, plant and equipment. The
principal component is calculated from the values of the three IOS variables
at year t-1.8.

DEBT =

ratio of long-term debt to total assets.

SIZE =

logarithm of the firms market value of equity in millions of dollars.

13

BETA =

firm risk measured by Compustat beta.

PERS =

earnings persistence as measured by first-order autocorrelation in earnings

for five years (twenty quarters) up to the year of observation.

REG =

dummy variable equals one if the company operates in a regulated industry

(SIC codes 40-49 and 6063) and zero otherwise.9
As per the arguments presented above, we expect b1 to be positive and

significantly different from zero; b2 and b4 to be positive and b3, b5 and b6 to be negative.
Table 3 reports results for regression (2). IOS is positively associated with the
magnitude of discretionary accruals at the 0.001 level, controlling for firm size, risk,
earnings persistence and regulatory environment. The evidence is consistent with our
argument that managers of high-growth firms are more inclined to use discretionary
accruals to signal their information about the firms future growth opportunities.
As predicted, debt levels are also significantly associated with the magnitude of
discretionary accruals, suggesting that the managers of high-debt firms are more likely
to manage earnings than low-debt firms. The negative coefficient on the firm size
variable in Table 3 is consistent with large firms being subject to greater exposure and
scrutiny by analysts and auditors, leading to conservative reporting and less OEM. The
positive coefficient on the firm risk variable is consistent with high-beta firms having a
greater incentive to reduce volatility of earnings so as to convey lower risk to the
market. The results also indicate that firms with high earnings persistence and regulated
firms have a smaller magnitude of discretionary accruals.
Insert Table 3 here

14

4.2 IOS and the Value Relevance of Earnings

As suggested earlier, managers use EM in the presence of IOS to credibly

communicate their private information 10 to the investors. This makes the current
earnings report more informative about the future of the firm and should result in an
improvement in the value relevance of earnings (i.e. ERR).
In evaluating the impact of IOS on the ERR, we control for debt, size, systematic
risk, earnings persistence and regulation. The inclusion of these variables is based on
research on earnings explanatory power (Freeman, 1987; Easton and Zmijewski, 1989,
Warfield et al., 1995; Wild and Kwon, 1994) and from research on managerial
incentives in the selection and reporting of accounting numbers (Watts and Zimmerman,
1978; Zimmerman, 1983; Warfield et al., 1995). We expect debt to have a negative
effect on ERR because higher debt levels are more likely to provide incentives for OEM
to satisfy debt covenants. Size, on the other hand, should have a positive effect because
of greater earnings quality in larger firms. We expect beta to have a negative effect
because of increased risk. Similarly, the persistence of earnings should have a positive
effect. We also expect regulated firms to have a better ERR than non-regulated firms
because of the monitoring role of regulation. The specification of the regression model
to examine the association of IOS with the ERR, after controlling for the relevant
variables (see Warfield et al., 1995 for a similar model), is given by:
RET = a + b1EARN + b2EARN*IOS + b3EARN*DEBT + b4EARN*SIZE +
b5EARN*BETA + b6EARN*PERS + b7EARN*REG
where,

15

(3)

RET

= annual stock returns measured as compounded monthly stock returns for a

twelve-month period ending three months after the end of the fiscal year of the
firm11.

EARN = net income before extraordinary items.

All other variables are previously defined. All independent variables are scaled by the
lagged stock price.
We expect b2 to be positive. Consistent with the earlier works of Watts and
Zimmerman (1986, 1990), we expect b3 to be negative because higher debt levels cause
more OEM. Based on previous studies, we expect b4 and b7 to be positive (Warfield et
al., 1995; Chaney and Jeter, 1992). We expect b5 to be negative (Zmijewski and
Hagerman, 1981) but b6 to be positive (Easton and Zmijewski, 1989; Lipe, 1990).
The results of regression (3) of returns on earnings, earnings-IOS interaction and
earnings interactions with control variables for the sample are presented in the first panel
of Table 4. The evidence shows that earnings informativeness increases with IOS [b2
(0.304) is significantly positive at the 0.01 level] after controlling for the effects of debt,
firm size, firm risk, earnings persistence and the regulatory environment. The evidence
is consistent with greater earnings informativeness when the firms growth opportunity
is high and lower earnings informativeness when debt is high. The results for IOS are
consistent with the argument that IEM is more prevalent for high-IOS firms. Parameter
estimates on the other control variables are largely consistent with theoretical
expectations and prior literature. Specifically, the market reaction to earnings is
significantly negatively related to debt and positively to firm size. This is consistent with
evidence in Warfield et al. (1995) and Chaney and Jeter (1992) and their interpretation

16

that the market perceives large firms earnings as more relevant as these firms
accounting choices are under increased scrutiny by financial analysts and investors. The
interaction term between beta and earnings is negative and insignificant. The sign of
coefficient estimate for regulation is consistent with our prediction but insignificant.
However, the expected positive effect of earnings persistence is not observed in our
sample.
Table 4 also reports the results of estimating regression (3) separately for years
1995, 1996, and 1997 to assess the consistency of the earnings informativeness-IOS
relationships across sample years. The evidence demonstrates that IOS increases
earnings informativeness at the 0.10 level, or better in one-tailed tests in each of the
three years.
Insert Table 4 here

4.3 IOS and the Pricing of Discretionary Accruals

Though we test for the impact of IOS on ERR, it does not constitute a direct test
for the role of IOS in the pricing of discretionary accruals in the market. We decompose
earnings into the non-discretionary part, NDE, and the discretionary accruals, DA 12 .
Then, we regress returns on the discretionary and non-discretionary components of
earnings and their interactions with IOS. We expect IOS to increase the pricing of
discretionary accruals by the market. The specification of the regression model to
examine the differential pricing of discretionary accruals based on IOS, after controlling
for the relevant variables, is given by:

17

RET = a + b1NDE + b2DA + b3 NDE*IOS + b4 DA*IOS + b5 EARN*DEBT +

b6EARN*SIZE + b7EARN*BETA + b8EARN*PERS + b9EARN*REG
(4)
where,
NDE = Non-discretionary component of annual earnings computed by the modified
Jones cross-sectional model
DA =

Discretionary accrual component of annual earnings computed as the residual in

modified Jones cross-sectional model

All independent variables are scaled by the lagged stock price.

As a test of consistency with Subramanyam (1996), we expect b1 and b2 to be
positive and significant. We are primarily interested in the sign of b4.
The results of regression (4) are presented in Table 5. Regression results show
that the returns are positively associated with DA [b2 (0.567) is significantly positive at
the 0.01 level]. This result is consistent with Subramanayam (1996) in that the market
prices discretionary accruals. However, this market pricing of discretionary accruals is
enhanced by IOS [b4 (0.357) is significantly positive at the 0.01 level]. The positive
effect of IOS on market pricing of DA supports the view that when IOS is high, IEM is
relatively more prevalent than OEM.
Insert Table 5 here

Prior literature (Skinner, 1993) suggests that the IOS effects might be moderated
by debt. First we note that the correlation between debt and IOS for all measures of IOS
is not significant enough to cause multi-collinearity problems in our regressions. Further,
we split the sample at the median into high debt and low debt sub-samples and carry out

18

separate regressions similar to (4), but without the interactions with the debt variable in
the two sub-samples. The results of these sub-sample regressions are given in Table 6
Insert Table 6 here

The results show positive IOS effects in both sub-samples. There is no clear
evidence that the effect of IOS in enhancing the market pricing of discretionary accruals
is moderated by debt. These results lend support to the view that the direct effect of IOS
on the informativeness of discretionary accruals is perhaps much stronger than the
indirect effect of IOS through debt.

5. SENSITIVITY ANALYSIS

The evidence presented in the previous section shows that high-IOS firms
increase the market pricing of discretionary accruals. One concern is whether the limited
ability of the modified Jones model to separate discretionary and non-discretionary parts
(see the discussion of this issue in section 3) of accruals might bias our results. We have
reported results under the cross-sectional modified Jones model that has been suggested
as being the least problematic (Guay et al., 1996; Bartov et al., 2001; DeFond and
Jiambalvo, 1994). However, we have also conducted the analysis using the crosssectional Jones, Healy and De Angelo models. The results are similar to the ones
reported here.
There is also a concern that high-IOS firms have high price to earnings ratio and
this might directly lead to a higher pricing of earnings. Moreover, if the decomposition

19

of earnings into discretionary and non-discretionary parts is not very reliable, the
discretionary accrual metric might have non-discretionary earnings component in it. If
earnings are highly priced by the market and the discretionary accrual has measurement
error, it will also be mechanically highly priced. To address this concern, we divided the
sample into four quartiles based on the PE ratios. Within each PE ratio quartile, we
carried out regression (4). We find that b4 is positive and significant in the lowest two
quartiles as well as in the top quartile. This result suggests that the association between
IOS and the pricing of discretionary accruals is not driven mechanically by the PE ratio
of the firms.
The measurement of variables such as debt, size, and persistence is generally
accepted in the literature. However, there is some concern about the measurement of the
growth opportunity set. We have reported results using the principal component of a set
of three measures - market-to-book equity ratio, market-to-book asset ratio and scaled
property, plant and equipment. Market-to-book equity ratio is perhaps the most
commonly used single variable to measure growth opportunity. However, using a
composite measure such as the one we have used reduces the measurement error13. This
view is supported by earlier studies by Gaver and Gaver (1993), Gul and Tsui (1998)
and Gul (1999). Nevertheless, as a sensitivity check we consider two other proxies of
IOS, namely the market-to-book ratio of equity by itself and a principal component of
market-to-took value of equity, scaled PPE and R &D/Sales ratio. The results are
consistent with those obtained using the former measure of IOS. Table 7 summarizes the
results using these different IOS proxies.

20

Insert Table 7 here

The third aspect of sensitivity is whether the returns are directly influenced by
the IOS and debt in addition to their effects on the relationship between earnings and
returns. Regressions (3) and (4) do not control for IOS and debt separately. Therefore,
we introduced IOS and debt as control variables and estimated them. Introduction of
these main effects neither change the direction nor the significance of the estimates of
(3) and (4). From this, we infer that the main effects of IOS and debt do not drive the
effects that we have observed. Finally, the use of market adjusted returns and fiscal year
returns yield qualitatively the same results.
There has been some support in the literature for the idea that the incentives for
income-increasing and income-decreasing discretionary accruals are different from each
other. Therefore, we divided the sample into income-increasing and income-decreasing
sub-samples and ran regression (4) to determine if the incremental pricing effects of IOS
are similar in the two sub-samples. Results show that the positive incremental effect on
market pricing of discretionary accruals in high-IOS firms is significant in the income
decreasing sub-sample. This suggests that the market views income decreasing
discretionary accruals by high-IOS firms as highly informative. In our view of
discretionary accruals as a mix of IEM and OEM, it is intuitively appealing that income
decreasing discretionary accruals by high-IOS firms has a greater IEM content than
income increasing discretionary accruals.

21

6. SUMMARY AND CONCLUSIONS

In this paper, we draw on the IOS/accounting choice and EM streams of the

literature to explore the linkages between IOS and managers choice of OEM or IEM.
More specifically, we investigate whether managers of firms with high-IOS are more
likely to use discretionary accruals for IEM or OEM purposes. Our results based on an
analysis of 9072 firm-year observations of US listed companies show the following.
First, we find a positive association between the IOS and discretionary accruals, a result
consistent with some of Skinners (1993) findings. Second, we also find that there is a
positive association between IOS and the pricing of discretionary accruals. This
evidence suggests that the discretionary accruals are predominantly associated with IEM
in high-IOS firms. These results are also consistent with the notion that high-IOS firms
manage earnings more as a means of conveying value-relevant private information than
to opportunistically hide inferior performance.
A number of tests are conducted to reduce the likelihood that these results are
artifacts of measurement problems. Furthermore, many different sensitivity tests added
credence to the association of IOS with increased value relevance of earnings. The
increased value relevance of earnings and DA associated with high-IOS firms is
consistent with an increased ex-ante expectation of higher IEM in such firms.

22

Endnotes:
1

Earnings numbers are imperfect measures of the (unknown) increase in the economic value of a

firm that is reported by self-interested and privately informed managers who work within the
framework of a compensation contract. In general, considerable residual discretion is available
to the managers in reporting the earnings. The managers will use this discretion to maximize
their own interest. In a rational equilibrium setting, such residual managerial discretion must be
optimal for the investors as well. There are two reasons for allowing such discretion in reporting.
First, because the manager is better informed about the future of the firm, it is in the interest of
the investor to provide a credible mechanism to reveal this information. Ideally, the investor will
opt for a compensation contract that will encourage the manager to work optimally and report
most of his information honestly. This might require allowing residual discretion in reporting
earnings. In this case, the investor expects and rewards the use of such discretion. Alternatively,
if the cost of reducing managerial discretion is prohibitive, investors will optimally choose to
allow such residual discretion. In this case, the investors expect but penalize the use of such
discretion.

The equilibrium contract between the shareholders and managers is a trade-off between the

expected opportunism of the managers (reduces ERR) and the expected informativeness of the
report (increases ERR). Even though the market might not have the same foresight information
as the manager, the ERR is based on the expected communication of whatever foresight
information the manager has. Note that on the average, the manager will not have the incentive
to deviate from optimal opportunism and informativeness.

23

Theoretically, EM results from some blockage (or a high cost) of the communication in all

relevant dimensions of the managers private information that precludes the application of the
revelation principle (Dye, 1988). An interior optimum not only allows for the communication of
private information but also expects the manager to indulge in some residual opportunistic
reporting. In other words, it anticipates a mix of OEM and EEM.

Managers can choose projects, increase or decrease training, research and development and

other discretionary activities or negotiate with the customers to move sales from one period to
another. All these activities constitute real earnings management. Our paper focuses on the use
of reporting discretion and not real earnings management.

The differences in definition appear subtle but are in fact, substantive. Consider the income

increasing accruals undertaken by a firm to seek relief from debt covenants. Christie and
Zimmerman (1994) argue that it is an efficient accounting choice because it reduces the
recontracting costs with debt holders. However, this reduces the informativeness of earnings and
would be considered opportunistic in our categorization. We believe that eventually, delaying
bad information will also reduce the aggregate wealth of the contracting parties and the two
categorizations will converge.

A discussion of the measurement errors and implications is given in the section on sensitivity

analysis.

24

Signalling theory suggests that credible communication of private information is possible only

if it is personally costly to the managers. For example, the managers with positive private
information will find it less costly to undertake income-increasing accruals than those with
negative information. This creates a separating equilibrium between managers with positive
information and managers with negative information. In this situation, income increasing
accruals signal positive information and similarly, income decreasing accruals signal negative
information. There is greater need for this signalling in firms with high-IOS than in low-growth
firms.

Detailed discussion of why this measure has been used is given in the section on sensitivity

analysis.

This criterion identifies 1,254 regulated firms (13.8%) from the original 9,072 in the sample.

The remaining 7,818 firms (86.2%) are non-regulated firms.

10

This information is sufficiently valuable to the investor and it is in his interest to provide

suitable incentives to the manager for disclosure.

11

This return window approximately matches the period between earnings announcements.

Additional tests are performed for using fiscal-year returns in the regression model. The
sensitivity analyses show that results reported in the paper are robust to the alternative return
window.

25

12

In order to be consistent with the rest of the analysis, the DA computed using the modified

Jones model is multiplied by the previous years assets (the scaling variable in Jones model) and
divided by the closing stock price of the previous period before it is used in the regression.

13

When we measure IOS as a function of MV/BV, we might be committing the following

mistake: A firm that has very long lived aged assets has a low BV and this might result in a highIOS measure. However, this firm might be (actually, is likely to be) a low-growth company and
mistakenly gets into the sample of high-growth firms because of the measurement error. A new
firm that has recently acquired assets has a high BV and this could result in a low-IOS measure.
This firm might very well be a high-growth firm. The use of PPE as another measure of growth
alleviates this problem.

26

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32

TABLE 1

Mean
0.2109
-0.0030
-0.0012
0.0000
0.1640
5.0790
0.8195
0.7277

RET
EARN
DA
IOS
DEBT
SIZE
BETA
PERS
RET

EARN
DA

:
:

IOS

DEBT
SIZE
BETA
PERS

:
:
:
:

Descriptive Statistics of Continuous Variables

Median
Maximum
Minimum
0.1401
11.5
-0.97
0.0524
5.75
-7.11
0.0027
0.93
-0.88
-0.1119
6.24
-3.41
0.1130
1.18
0.00
4.9867
12.01
0.00
0.8040
10.72
-21.08
0.7819
1.70
-0.40

Std. Dev.
0.6269
0.2825
0.1599
0.7257
0.1789
2.2608
0.9018
0.2670

annual stock returns measured as compounded monthly stock returns for a twelve-month period ending three
months after the end of the fiscal year of the firm.
net income before extraordinary items scaled by lagged stock price.
discretionary accrual component of annual earnings computed as the residual in modified Jones cross-sectional
model.
investment opportunity set or growth opportunity measured by the principal component of three IOS variables,
namely market-to-book equity ratio, market-to-book asset ratio and scaled property, plant and equipment. The
principle component is calculated from the values of the three IOS variables at year t-1.
ratio of long-term debt to total assets.
logarithm of the firms market value of equity in millions of dollars.
firm risk measured by Compustat beta.
earnings persistence as measured by first-order autocorrelation in earnings for five years (twenty quarters) up
to the year of observation.

33

TABLE 2
Pearson Correlation Coefficients between Variables
RET
EARN
DA
EARN
0.162**
DA
0.043**
0.082**
NDE
0.051**
0.482**
-0.834**
IOS
-0.059**
-0.022*
-0.007
DEBT
-0.036**
-0.048**
-0.017
SIZE
0.175**
0.252**
0.023*
BETA
0.095**
-0.011
-0.009
PERS
0.016
0.049**
0.013
REG
0.025*
0.035**
0.031**
** Correlation is significant at the 0.01 level (two-tailed);
RET

EARN
DA
NDE
IOS

:
:
:
:

DEBT
SIZE
BETA
PERS

:
:
:
:

REG

NDE

IOS

DEBT

SIZE

-0.006
-0.012
-0.243**
0.119**
0.086**
0.088**
0.001
0.146**
-0.037**
0.149**
0.016
0.200**
-0.072**
0.275**
-0.008
-0.160**
0.168**
0.155*
* Correlation is significant at the 0.05 level (two-tailed).

BETA

PERS

0.045**
-0.047**

0.050**

annual stock returns measured as compounded monthly stock returns for a twelve-month period ending three months after the end of
the fiscal year of the firm.
net income before extraordinary items scaled by lagged stock price.
discretionary accrual component of annual earnings computed as the residual in modified Jones cross-sectional model.
non-discretionary component of annual earnings computed by the modified Jones cross-sectional model
investment opportunity set or growth opportunity measured by the principal component of three IOS variables, namely market-tobook equity ratio, market-to-book asset ratio and scaled property, plant and equipment. The principle component is calculated from
the values of the three IOS variables at year t-1.
ratio of total debt to total assets.
logarithm of the firms market value of equity in millions of dollars.
firm risk measured by Compustat beta.
earnings persistence as measured by first-order autocorrelation in earnings for five years (twenty quarters) up to the year of
observation.
dummy variable equals one if the company operates in a regulated industry (SIC codes 40-49 and 60-63) and zero otherwise.

34

TABLE 3
Regression of the Absolute Value of Discretionary Accruals on IOS, Debt and
Control Variables

ABSDA = a1 + b1 IOS + b2 DEBT + b3 SIZE + b4 BETA + b5 PERS + b6 REG

Variable
Predicted Sign
Estimate
t
+/0.1690
39.419***
a1
b1
+
0.0309
17.214***
b2
+
0.0188
2.644**
-0.0129
-22.396***
b3
+
0.0085
6.150***
b4
b5
-0.0111
-2.291*
-0.0105
-2.869**
b6
2
Sample size = 9072 Adjusted R = 9.0% F = 150.9
Sig. = 0.000
*** designate statistical significance at the 0.001 level, two-tailed test
** designate statistical significance at the 0.01 level, two-tailed test
* designate statistical significance at the 0.05 level, two-tailed test
ABSDA :
IOS

DEBT
SIZE
BETA
PERS

:
:
:
:

REG

the absolute value of discretionary accruals from the modified Jones crosssectional model.
investment opportunity set or growth opportunity measured by the principal
component of three IOS variables, namely market-to-book equity ratio,
market-to-book asset ratio and scaled property, plant and equipment. The
principle component is calculated from the values of the three IOS
variables at year t-1.
ratio of long-term debt to total assets.
logarithm of the firms market value of equity in millions of dollars.
firm risk measured by Compustat beta.
earnings persistence as measured by first-order autocorrelation in earnings
for five years (twenty quarters) up to the year of observation.
dummy variable equals one if the company operates in a regulated industry
(SIC codes 40-49 and 60-63) and zero otherwise.

35

TABLE 4
Regression of Returns on Earnings, Earnings-IOS Interaction, Earnings-Debt Interaction and Earnings Interactions with Other Control Variables for
the Full Sample and Individual Years
RET = a + b1EARN + b2EARN*IOS + b3EARN*DEBT + b4EARN*SIZE + b5EARN*BETA + b6EARN*PERS + b7EARN*REG
Parameter
estimates
Full sample (95-97)
Estimate
(t-statistic)
1995
Estimate
(t-statistic)
1996
Estimate
(t-statistic)
1997
Estimate
(t-statistic)

Adj. R2

b1

b2

b3

b4

0.200***
(21.971)

0.510***
(4.105)

0.304***
(2.724)

-0.354**
(-2.223)

0.091***
(2.656)

-0.028
(-1.006)

-0.239*
(-1.463)

0.108
(1.030)

9072

0.038

0.270***
(18.651)

1.177***
(3.095)

0.205*
(1.341)

0.049
(0.100)

-0.021
(-0.446)

-0.023
(-0.379)

-0.994**
(-2.475)

0.598***
(3.091)

2478

0.016

6.8
(0.000)

0.052***
(4.981)

0.187
(1.110)

0.192**
(2.168)

-0.392**
(-2.305)

0.212***
(6.735)

0.021
(1.119)

-0.132
(-0.610)

-0.038
(-0.232)

3124

0.099

50.1
(0.000)

0.284***
(18.382)

0.627***
(3.189)

0.387*
(1.550)

-0.356
(-1.174)

0.056
(1.190)

-0.130*
(-1.383)

-0.149
(-0.579)

0.135
(0.871)

3470

0.038

20.4
(0.000)

b5

b6

b7

Sample
size

F-value
(sig.level)
20.4
(0.000)

Figures in parentheses denote t-statistics based on the heteroskedasticity-consistent covariance matrix (White, 1980).
*, **, *** designate statistical significance at the 0.10, 0.05 and 0.01 level, one-tailed test, respectively.
RET : annual stock returns measured as compounded monthly stock returns for a twelve-month period ending three months after the end of the
fiscal year of the firm.
EARN : net income before extraordinary items.
IOS
: investment opportunity set or growth opportunity measured by the principal component of three IOS variables, namely market-to-book
equity ratio, market-to-book asset ratio and scaled property, plant and equipment. The principle component is calculated from the values of
the three IOS variables at year t-1.
DEBT : ratio of long-term debt to total assets.
SIZE : logarithm of the firms market value of equity in millions of dollars.
BETA : firm risk measured by Compustat beta.
PERS : earnings persistence as measured by first-order autocorrelation in earnings for five years (twenty quarters) up to the year of observation.
REG : dummy variable equals one if the company operates in a regulated industry (SIC codes 40-49 and 60-63) and zero otherwise.
All independent variables are scaled by lagged stock price in the regression.

36

TABLE 5
The Effect of IOS on the Pricing of Discretionary Accruals
RET = a + b1NDE + b2DA + b3NDE*IOS + b4DA*IOS + b5EARN*DEBT + b6EARN*SIZE + b7EARN*BETA + b8EARN*PERS + b9EARN*REG
Parameter
estimates
Full sample
(95-97)
Estimate
(t-statistic)
1995
Estimate
(t-statistic)
1996
Estimate
(t-statistic)
1997
Estimate
(t-statistic)

b1

b2

b3

b4

b5

b6

0.200***
(22.144)

0.523***
(4.260)

0.567***
(4.423)

0.303***
(2.754)

0.357***
(2.715)

-0.296**
(-2.209)

0.089***
(2.653)

0.270***
(18.604)

1.122***
(2.938)

1.214***
(3.269)

0.174
(1.104)

0.354**
(1.725)

0.043
(0.087)

0.183
(1.121)

0.194
(1.165)

0.205***
(2.535)

0.141
(1.022)

-0.354**
(-2.045)

0.212***
(6.723)

0.642***
(3.290)

0.709***
(3.497)

0.389*
(1.553)

0.435**
(1.758)

-0.397
(-1.375)

0.059*
(1.289)

0.052***
(5.040)
0.283***
(18.347)

-0.014
(-0.301)

b7

b8

b9

Adj.
R2

F-value
(sig.)

-0.030
(-1.065)

-0.268**
(-1.670)

0.087
(0.845)

9072

0.041

43.8
(0.000)

-0.023
(-0.377)

-0.976***
(-2.457)

0.578***
(3.063)

2478

0.016

5.38
(0.000)

0.023
(1.191)

-0.147
(-0.706)

-0.054
(-0.324)

3124

0.099

39.2
(0.000)

-0.140*
(-1.526)

-0.162
(-0.683)

0.120
(0.784)

3469

0.038

16.4
(0.000)

Figures in parentheses denote t-statistics based on the heteroskedasticity-consistent covariance matrix (White, 1980).
*, **, *** designate statistical significance at the 0.10, 0.05 and 0.01 level, one-tailed test, respectively.
RET : annual stock returns measured as compounded monthly stock returns for a twelve-month period ending three months after the end of the
fiscal year of the firm.
NDE : non-discretionary component of annual earnings computed by the modified Jones cross-sectional model.
DA
: discretionary accrual component of annual earnings computed as the residual in modified Jones cross-sectional model.
IOS
: investment opportunity set or growth opportunity measured by the principal component of three IOS variables, namely market-to-book
equity ratio, market-to-book asset ratio and scaled property, plant and equipment. The principle component is calculated from the values of
the three IOS variables at year t-1.
DEBT : ratio of long-term debt to total assets.
SIZE : logarithm of the firms market value of equity in millions of dollars.
BETA : firm risk measured by Compustat beta.
PERS : earnings persistence as measured by first-order autocorrelation in earnings for five years (twenty quarters) up to the year of observation.
REG : dummy variable equals one if the company operates in a regulated industry (SIC codes 40-49 and 60-63), zero otherwise.
All independent variables are scaled by lagged stock price in the regression.

37

TABLE 6
The Effect of IOS or Debt on the Pricing of Discretionary Accruals for High/Low Debt and IOS
Sub-samples
RET = a + b1NDE + b2DA + b3NDE*IOS +b4DA*IOS + b5EARN*SIZE +b6EARN*BETA +
b7EARN*PERS + b8EARN*REG
High Debt
Low Debt
0.184***
0.220***
a
(18.974)
(15.042)
0.295*
0.629***
b1
(1.590)
(3.744)
0.354**
0.666***
b2
(1.833)
(3.756)
0.117
0.408***
b3
(0.911)
(2.350)
0.187*
0.423***
b4
(1.272)
(2.332)
0.085***
0.081
b5
(3.311)
(1.230)
-0.007
-0.040
b6
(-0.166)
(-1.145)
-0.131
-0.395**
b7
(-0.521)
(-2.030)
-0.059
0.161
b8
(-0.516)
(0.903)
4.2%(4536)
4.0% (4536)
Adj. R2 (N)
Figures in parentheses denote t-statistics based on the heteroskedasticity-consistent covariance matrix (White, 1980).
*, **, *** designate statistical significance at the 0.10, 0.05 and 0.01 level, one-tailed test, respectively.
RET
:
annual stock returns measured as compounded monthly stock returns for a twelve-month period ending
three months after the end of the fiscal year of the firm.
NDE
:
non-discretionary component of annual earnings computed by the modified Jones cross-sectional
model.
DA
:
discretionary accrual component of annual earnings computed as the residual in modified Jones crosssectional model.
IOS
:
investment opportunity set or growth opportunity measured by the principal component of three IOS
variables, namely market-to-book equity ratio, market-to-book asset ratio and property, scaled plant
and equipment. The principle component is calculated from the values of the three IOS variables at
year t-1.
SIZE :
logarithm of the firms market value of equity in millions of dollars.
BETA :
firm risk measured by Compustat beta.
PERS :
earnings persistence as measured by first-order autocorrelation in earnings for five years (twenty
quarters) up to the year of observation.
REG
:
dummy variable equals one if the company operates in a regulated industry (SIC codes 40-49 and 6063), zero otherwise.
All independent variables are scaled by lagged stock price in the regression.

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TABLE 7
Result Summaries of Regressions 3, 4 and 5 Using Other IOS Proxies
IOS Proxy
Regression 3
Regression 4
EARN*IOS
DA*IOS
Market to book
0.016**
0.016**
(2.091)
(1.660)
0.336**
0.419**
MB_PPE_RD
(2.136)
(2.326)
Figures in parentheses denote t-statistics based on the heteroskedasticity-consistent covariance
matrix (White, 1980).
*, **, *** designate statistical significance at the 0.10, 0.05 and 0.01 level, one-tailed test,
respectively.
Market to book : ratio of prior year market to book value of equity.
MB_PPE_RD : principal component of market to book value, scaled properties, plant and
equipment and research and development expenses over sales ratio. The
principle component is calculated from the values of the three IOS variables at
year t-1.

39