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Does Accrual Management Impair the Performance of Earnings-Based Valuation Models?

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  • Lucie Courteau

    ()
    (Free University of Bozen-Bolzano, School of Economics and Management, Italy.)

  • Jennifer L. Kao

    ()
    (Department of AMIS, University of Alberta, Edmonton, Alberta, Canada.)

  • Yao Tian

    ()
    (Department of Accounting and Finance, San Jose State University, San Jose, CA, USA.)

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    Abstract

    This study examines empirically how the presence of accrual management may affect firm valuation. We compare the performance of earnings-based and non-earnings-based valuation models, represented by Residual Income Model (RIM) and Discounted Cash Flow (DCF), respectively, based on the absolute percentage pricing and valuation errors for two subsets of US firms: “Suspect” firms that are likely to have engaged in accrual management and “Normal” firms matched on industry, year and size. Results indicate that RIM enjoys an accuracy advantage over DCF when accrual management is not a serious concern. However, the presence of accrual management significantly narrows RIM’s accuracy advantage over DCF from the level observed for the matched Normal firms. These results are robust to the choice of model benchmark (i.e., current stock price vs. ex post intrinsic value), alternative definitions of Suspect (i.e., loss or earnings-decline avoidance vs. earnings-decline avoidance only vs. loss avoidance only) and of Normal firms (i.e., excluding vs. including real activity manipulators), and different assumptions about post-horizon growth (i.e., 2% vs. 4%). The overall conclusion that accrual management impairs RIM’s performance extends to settings where the regression model is expanded to include accrual components and when we focus on large, rather than small, earnings manipulators. Taken together, these results highlight the importance of considering earnings quality when assessing the performance of earnings-based valuation models.

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    Bibliographic Info

    Paper provided by School of Economics and Management at the Free University of Bozen in its series BEMPS - Bozen Economics & Management Paper Series with number BEMPS12.

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    Length: 43 pages
    Date of creation: Jul 2013
    Date of revision:
    Handle: RePEc:bzn:wpaper:bemps12

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    Keywords: Accrual Management; Firm Valuation; Earnings- and Non Earnings-based Valuation Models; Valuation Errors.;

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    References

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