The impact of accounting information quality on the mispricing of accruals: The case of FRS3 in the UK
Introduction
We compare the empirical evidence of accrual anomaly before and after a major change of accounting regulation to examine how it is affected by accounting information quality. Since Sloan (1996) existing literature documents a negative relationship between accruals and subsequent stock returns but has yet to reach a consensus on the underlying cause of this anomaly. We examine this issue by exploiting a unique setting of accounting regulation change in the UK, i.e. the introduction of Financial Reporting Standard No. 3: Reporting Financial Performance (FRS3) in October 1992. In doing so, we intersect and contribute to two strands of literature: (a) the effects of information quality on accrual anomaly (e.g., Drake et al., 2007) and (b) the impact of FRS3 in the UK on accounting information quality (e.g., Acker et al., 2002, Athanasakou et al., 2007). There is currently little evidence on the impact of accounting regulatory intervention on stock return anomalies in the capital markets and we fill this gap.
Our study’s innovation is to examine whether the accrual anomaly is reduced following regulatory interventions designed to improve market-wide accounting information environment. FRS3 seeks to reduce earnings manipulation and increase the disclosure of earnings performance. It demands UK companies to classify exceptional items more appropriately, eliminate the use of extraordinary items, and disclose additional income components. Existing literature documents improved earnings forecast (Acker et al., 2002, Lin, 2002), reduced earnings management (Athanasakou et al., 2007), and greater value relevance of reported earnings (Lin, 2006) following FRS3. Given the direct relevance of FRS3 on reported earnings information, we believe it may exert an impact to the mispricing of accruals in the UK.
Sloan (1996) attributes the accrual anomaly to the functional fixation hypothesis (e.g., Abdel-Khalik and Keller, 1979, Hand, 1990) and suggests that investors overprice accruals because they are unable to distinguish the difference in persistence between the accruals and cash flow components of earnings. Merton (1987) suggests that incomplete information can cause asset pricing anomalies to arise in the capital markets even if it is dominated by rational agents. Brav and Heaton (2002) argue that rational investors would underweight lower precision signals, which leads to temporary mispricing, and correct their original valuation upon arrival of new information, which leads to subsequent abnormal returns. If the accrual anomaly is indeed a manifestation of mispricing and if investors’ misjudgements are conditional on the information set available, the anomalous returns should be more pronounced among companies that supply poorer quality information. Existing studies confirm this prediction by documenting cross-sectional variations in accrual anomaly that is conditional on information quality (e.g., Drake et al., 2007).
We compare changes in the magnitude of the accrual anomaly in the UK from pre- (1986–1992) to post- (1995–2002) FRS3 periods. Following existing literature on accrual anomaly, we implement the Mishkin (1983) non-linear test, hedge portfolio return tests, and the Fama and MacBeth (1973) cross-sectional regression approaches. To account for the possibility of such changes arising purely by chance or due to other market-wide confounding reasons such as business cycles and Internet bubble, we identify cross-sectional variations in the degree to which companies are expected to be more sensitive to the FRS3.1 Since the reduction of earnings management is one of the major objectives of FRS3, its impact should be more pronounced among companies where accounting disclosure quality is lower due to greater managerial discretionary effect. We identify such companies based on the quality of their accruals, following the approach of Francis et al., 2005, Francis et al., 2007, McNichols, 2002. To strengthen the robustness of our findings, we control for other factors that existing literature purports to be associated with accrual anomaly. These include value-growth effect (Beaver, 2002, Desai et al., 2004, Cheng and Thomas, 2006), limits to arbitrage (Mashruwala et al., 2006), and ownership dispersion (LaFond, 2005, Pincus et al., 2007).
We find a significant reduction of accrual anomaly in the UK from the pre- to post-FRS3 periods. For instance, across the whole sample the hedge portfolio tests indicate a significant drop of over 4% in annual abnormal returns between the pre- and post-FRS3 periods. The reduction is driven by the low accounting information quality companies, which experience a significant decline of around 6% in annual abnormal returns. The changes associated with high accounting information quality companies from pre- to post-FRS3 periods are statistically insignificant. These findings are robust to alternative methodologies and consistent with our prediction that companies with poorer accounting quality are more sensitive to the mandatory accounting regulation change. Our overall inference is that the improvement of accounting information quality due to FRS3, particularly in terms of reported earnings, contributes to the decrease in the mispricing of accruals.
Our approach in studying the accrual anomaly contributes to the literature in a number of ways. First, if accruals are mispriced due to both investors’ own fixation bias and companies’ accounting information quality, examining the changes in accrual anomaly after an accounting regulatory intervention enables us to separate these two effects. Assuming investors’ cognitive bias is not affected by accounting regulation, the significant reduction of accrual anomaly after FRS3 indicates that the mispricing is indeed partially driven by the quality of accounting information from its supply side, i.e. the companies. Second, the information environment of companies is influenced by two sources, i.e. the inherent uncertainty due to operating environment and the uncertainty attributed to managerial discretion. Since FRS3 is a market-wide mandatory accounting regulation change, it is expected to affect mainly the managerial discretionary component of companies’ information environment. By observing the impact of FRS3 on accrual anomalies, we are essentially identifying the influence of managerial discretion in reported earnings on the mispricing of accruals. Finally, we address a topical issue of whether regulatory intervention could be socially beneficial to the capital market. This is especially interesting against the backdrop of the on-going mandatory change in accounting standards in many countries to converge toward International Financial Reporting Standards (IFRS). A fundamental debate on this issue is whether or not corporate disclosure improvements are driven by incentives or standards (e.g., Ball et al., 2003, Christensen et al., 2008). Evidence that the well-documented accrual anomaly is reduced following FRS3 adds evidence in support of regulatory intervention.
Our paper is organised as follows. Section 2 reviews the literature and develops the hypotheses. Section 3 describes our sample and methodology. Section 4 presents the empirical findings. Section 5 concludes.
Section snippets
Institutional background of FRS3
FRS3 was introduced by the UK Accounting Standard Board (ASB) on 29th October, 1992. It significantly affected how UK companies report financial performance in two ways. First, it reduces earnings management by treating previously classified extraordinary items as exceptionals and eliminating the use of extraordinary items to smoothen earnings. It also discourages misclassification of exceptional items since opportunistic behaviour as such could be more easily detected under the rigorous
Sample and descriptive statistics
Table 1 describes our sample selection. We collect all accounting and market-based data from Datastream and obtain analysts’ earnings forecast data from I/B/E/S. Our sample period starts from 1986 when I/B/E/S coverage of UK companies begins. To compare the mispricing of accruals in our UK sample before and after the introduction of FRS3, we define the pre-FRS3 period as 1986–1992 and the post-FRS3 period as 1995–2002. We skip the 1993–1994 initial transition period to address the argument put
Mishkin tests
As a direct test of market efficiency we implement the Mishkin (1983) tests and present our findings in Table 3. To avoid using both pre- and post-FRS3 earnings in the same regression, we also exclude year 1992 from the test. Panel A shows the coefficients estimated simultaneously for the forecast and pricing equations using the generalised non-linear least square estimation. Panel B reports the results from the market efficiency tests. Within the whole sample is
Conclusion
We examine if changes in accounting information quality following a mandatory regulatory intervention affect the well-documented accruals anomaly. We expect the accrual anomaly to be more pronounced in poorer information environment. While existing literature provides evidence in support of this prediction through cross-sectional analyses, we exploit the introduction of FRS3 in October 1992 in the UK as our research setting. FRS3, which seeks to reduce earnings management and enrich the
Acknowledgements
We would like to thank two anonymous referees, Agnes Cheng, Jennifer Francis, Per Olsson, Wayne Thomas, and Martin Walker for their valuable comments. We would also thank the contribution of I/B/E/S for providing analysts’ forecast data as part of a broad academic program to encourage research.
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