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The role of accruals as a signal in earnings and dividend announcements : New Zealand
evidence
Hardjo Koerniadi Alireza Tourani-Rad
Article information:
To cite this document:
Hardjo Koerniadi Alireza Tourani-Rad, (2011),"The role of accruals as a signal in earnings and dividend
announcements ", Journal of Applied Accounting Research, Vol. 12 Iss 2 pp. 108 - 122
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JAAR
12,2
The role of accruals as a signal
in earnings and dividend
announcements
108 New Zealand evidence
Hardjo Koerniadi and Alireza Tourani-Rad
Department of Finance, Faculty of Business and Law,
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1. Introduction
Numerous studies on earnings management hypothesize that managers manipulate
accruals for their own benefit. Few studies, however, argue that managers can also use
accruals to improve the value relevance of reported earnings to help investors better
assess firms operating performance (Holthausen and Leftwich, 1983; Healy and
Palepu, 1993). Further, while substantial evidence on managers opportunistic behavior
on accruals has been documented in the literature (see Healy and Wahlen, 1999;
Kothari, 2001, for a review), empirical evidence on the informativeness of accruals is
scarce and inconclusive. The purpose of this study is to investigate whether managers
use accruals to communicate private information regarding firm future performance.
Journal of Applied Accounting
Research
Vol. 12 No. 2, 2011 The authors would like to thank an anonymous referee and the participants at the 2008 Pacific
pp. 108-122 Basin Finance Economics Accounting Management Conference and at the 2008 Australasian
r Emerald Group Publishing Limited
0967-5426 Finance and Banking Conference, for their helpful comments and suggestions. The authors are
DOI 10.1108/09675421111160682 responsible for any remaining errors.
Preliminary evidence on the accrual signaling hypothesis is reported by Wilson Accruals as a
(1986) who finds that total accruals have incremental information content beyond signal in
that of cash flows and earnings. Two more recent studies by Guay et al. (1996) and
Subramanyam (1996) decompose total accruals into discretionary and announcements
nondiscretionary components and find that discretionary component of accruals is
positively correlated with stock returns, suggesting that discretionary accruals have
information that is priced by the market. Subramanyam also finds that discretionary 109
accruals are significantly and positively correlated with future earnings and future
cash flows. Based on these results, Subramanyam argues that discretionary accruals
are informative for predicting firm future profitability.
The positive correlation between discretionary accruals and stock returns
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suggests that managers may deliberately use accruals to convey private information
to the market. Consistent with this view, Sankar and Subramanyam (2001) develop a
model that shows when managerial discretion is allowed by generally accepted
accounting principles (GAAP), managers use this discretion to communicate their
private information through reported earnings. Empirical evidence in line with Sankar
and Subramanyam is reported by Brooks (1996) and more recently by Kang (2005).
Brooks examines the effects of earnings and dividend announcements on the level of
information asymmetry and finds that information asymmetry falls at earnings
announcements but not at dividend announcements suggesting that private
information is released at earnings announcements. Kang reports that the frequency
of accruals-related disclosure is positively (negatively) correlated with analysts
forecast accuracy (dispersion) on future earnings, suggesting that managers use
accruals to release their private information.
The positive association between discretionary accruals and stock returns or
future profitability, however, is consistent not only with the accrual signaling
hypothesis but also with the opportunistic income smoothing hypothesis as
suggested by Guay et al. (1996) and DeFond and Park (1997). DeFond and Park
argue that in an effort to maintain their job security, when current (future)
period earnings are poor (good), managers borrow earnings from the future by
increasing accruals, whereas when current (future) earnings are good (poor), managers
decrease accruals to save current earnings for possible use in the future. This
hypothesis is similar to the cookie jar accounting reserves phenomenon whereby
managers stash accruals during good times and use accruals during bad times
(Levitt, 1998).
The fact that the results of Subramanyam (1996) and Guay et al. (1996) can be
explained by two conflicting hypotheses can be attributed to the authors use of
broad sample data (Louis and Robinson, 2005). To mitigate this problem, Louis and
Robinson (2005) use stock split data as their research setting in examining the accrual
signaling hypothesis. Assuming that managers use discretionary accruals to signal
and use stock splits to reinforce the signal, Louis and Robinson find a positive
association between pre-split discretionary accruals and the positive abnormal returns
surrounding the split announcement dates. Based on this finding, Louis and Robinson
conclude that managers use both discretionary accruals and stock splits to
communicate private information to the market.
To our knowledge, except for Louis and Robinson (2005), no other study examines
the signaling hypothesis of accruals. It is an open question, therefore, whether
managers use accruals to communicate their private information only in conjunction
with stock splits or whether they also do so in conjunction with other corporate events.
JAAR This study attempts to address this question as to whether accruals explain future
12,2 profitability by using a different research setting from that of Louis and Robinson
(2005) and by investigating a different market, namely, New Zealand.
Firms in New Zealand usually announce earnings and dividends
contemporaneously. Such announcements are an important source of information for
investors and shareholders especially in a country where the level of information
110 asymmetry is high (Cheng and Leung, 2006). New Zealand firms are mostly owned by
large shareholders (La Porta et al., 1998; Koerniadi and Tourani-Rad, 2009) whose
presence would generally lead to low level of voluntary corporate disclosures
(Hossain et al., 1994; Mitchell et al., 1995; Lakhal, 2005). This is because large
shareholders are assumed to have access to firm private information, thus reducing
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the need for public disclosures of prospective information (Chau and Gray, 2002).
Furthermore, the New Zealand corporate disclosure regime during the sample period
was observed to be weak. Firms were allowed to treat price-sensitive information
as an asset, instead of releasing the information immediately (Poskitt and Yang, 2006).
There was also little evidence of active enforcement of the New Zealand disclosure
regime (Dunstan et al., 2008). The results of our study are expected to shed more light
on signaling aspects of accruals and to some degree alleviate the negative perception of
managerial discretions over accruals vastly documented in the earnings management
literature and hopefully add more supporting evidence to the signaling hypothesis of
accruals which could be a new strand in this literature.
Our results provide support to the accrual signaling hypothesis. Consistent with
prior studies, we find that the markets reaction to contemporaneous earnings and
dividend increase announcements is significantly positive. More importantly, we
observe that discretionary accruals of dividend-increasing firms are positive and
significantly correlated with the positive market reaction to the announcements and
firm future profitability. This positive association between discretionary accruals
and firms future profitability is robust to performance, growth, and post-earnings
announcement drift effects.
The rest of the paper proceeds as follows. In Section 2 we develop the hypotheses,
describe the methodology, and discuss the sample selection process. In Section 3 we
report the empirical results. Finally, in Section 4, we present concluding remarks.
2. Research design
2.1 Hypothesis development
Lintner (1956) provides the first evidence on the information content of dividend
reporting. In particular, Lintner shows that firms tend to have target payout ratios and
will increase dividends only when they believe that future earnings are sufficient to
support the higher payout. Lintner further reports that firms are reluctant to cut
dividends, and thus will not increase dividends if they perceive the increase in
profitability to be transitory. Subsequent empirical results on the information content
of dividend changes, however, are inconclusive. While several studies report that
dividend changes signal information about future profitability (Healy and Palepu,
1993; Bajaj and Vijh, 1990; Nissim and Ziv, 2001), others find results inconsistent with
the information content of dividends (De Angelo et al., 1996; Benartzi et al., 1997). The
mixed results on the information content of dividends suggest that companies may
change their dividend policy for reasons other than signaling, such as free cash flows
or tax clienteles (Fama and Babiak, 1968; Benartzi et al., 1997; Bartholdy and Brown,
1999; Allen et al., 2000).
The literature also reports that stock markets react positively to the direction of Accruals as a
unexpected earnings in earnings announcements (Ball and Brown, 1968; Bernard and signal in
Thomas, 1989). Managers opportunistic manipulation of accruals, however, could
influence market reactions by distorting firm earnings toward their desired level. announcements
As a result, either dividend changes or earnings announcements alone may be a noisy
signal of future profitability.
Healy and Palepu (1993) argue that when financial reporting is inadequate for 111
communicating information on firm performance, financial policy changes (such as
dividend changes) are needed to communicate the future prospects of the firm. Thus,
they suggest that managers may communicate information through both earnings and
financial policy instruments such as dividends by means of contemporaneous earnings
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Louis and Robinson (2005) suggest that optimistic managers are likely to use accruals
to reinforce information in corporate events such as dividends. When managers use
accruals to communicate information regarding improved future profitability, they
JAAR increase accruals to signal this information to the market. Accordingly, accruals
12,2 should be positive and should be positively correlated with announcement returns and
firm future profitability. As we assume that contemporaneous earnings and dividend
increase announcement is a signaling event, the positive association between
discretionary accruals and future profitability is more likely to be consistent with the
signaling hypothesis of accruals than with the opportunistic income smoothing
112 hypothesis. Thus, our second and third hypotheses are, respectively:
2.2 Methodology
2.2.1 The accruals models. We measure total accruals as the difference between
earnings and operating cash flows. Computing accruals directly from statements of
cash flows provides a more precise measure of accruals and avoids the measurement
error that arises when estimating accruals using the balance sheet approach (Collins
and Hribar, 2002). Earnings are defined as operating income after depreciation but
before interest expense, taxes, and special items. All variables are deflated by total
assets at the beginning of the period.
Kothari et al. (2005) report that the commonly used discretionary accruals models
do not control for performance effects on accruals. High-performance firms may report
high discretionary accruals that are not attributed to managers discretion over
accruals but to firm performance effects. This is particularly true for increasing-
dividend firms since these firms are likely to do well. Kothari et al. (2005) also report
that the Jones discretionary accruals model with current return on assets (ROAt)
included as an additional regressor enhances the reliability of inferences from earnings
management research. The ROA-adjusted Jones model is:
1 DREVt PPEt
ACC a1 a2 a3 a4 ROAt ft 1
At1 At1 At1
where ACC is total accruals defined as the difference between earnings and cash
flows from operations, DREV is the change in revenues, PPE is property, plant, and
equipment and A is total assets. ROA is measured as operating income after
depreciation but before interest expense, taxes, and special items, divided by total
assets. All variables are scaled by lagged total assets. Nondiscretionary accruals are
the fitted values and discretionary accruals are the residuals of the model.
2.2.2 Information content of contemporaneous dividend and earnings
announcements. This study uses final dividend announcement dates of dividend-
increasing firms as the announcement event. Dividend changes are measured as the
difference between the total (interim plus final) ordinary cash dividend in the current
year and the total dividend in the previous year.
We estimate abnormal returns using the market model (Brown and Warner, 1980).
Sample firms abnormal announcement returns are calculated as the difference
between the sample firms returns and the firms expected returns:
Regression (3a) estimates the association between total accruals and announcement
returns, while regression (3b) estimates the association between the components of
accruals and announcement returns. CAR1, 1 is the cumulative abnormal return
surrounding the announcements, CF is operating cash flows, DDIV is the change in
dividends, DA is discretionary accruals, NDA is nondiscretionary accruals. Following
Rangan (1998), we include the log normal of the market value of the firms equities
(SIZE) and book-to-market ratio (B/M), as control variables.
2.2.4 Accruals and future profitability. The signaling theory of accruals posits that
managers use accruals to communicate private information regarding firm future
profitability. In this section we investigate whether discretionary accruals of dividend-
increasing firms explain future profitability.
Several studies report that current earnings are a significant predictor of one-year-
ahead earnings (Finger, 1994; Kim and Kross, 2005). Accordingly, in this study we
JAAR define future profitability as one-year-ahead operating income after depreciation but
12,2 before interest expense, taxes, and special items. To examine the hypothesis that
managers use their discretion on accruals to signal future profitability, we follow
Subramanyam (1996) by estimating the following regression:
Bit
Et1 a0 b1 CFit b2 NDAit b3 DAit b4 et1 4
114 Mit
where E is earnings, defined as operating income after depreciation but before interest
expense, taxes, and special items, scaled by lagged total assets (at t); CF is operating
cash flows, scaled by lagged total assets (at t1); NDA and DA are nondiscretionary
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and discretionary accruals, respectively, and B/M is book value of equity divided by
market value of equity (at t1). The book-to-market ratio is included to control for the
effect of growth on one-year-ahead operating earnings (Smith and Watts, 1992; Gaver
and Gaver, 1993).
2.3 Data
This study is conducted using all nonfinancial firms listed on the NZX from 1992 to
2003 with financial report data available on the 2003 Datex database. From this
database we identified which firms and when they changed their dividends. Given we
argue that firms use both dividend increases and accruals to communicate information
to the market as our research setting, we first need to ensure that this research setting
is where firms are likely to signal by examining market reactions to contemporaneous
earnings and dividend increase announcements. To do so, we collect announcement
dates and price data of the dividend-increasing firms from the NZX Weekly Diary and
Datastream, respectively. From the NZX Weekly Diary database we obtain data on
92 firms with 244 dividend increase announcement dates during the sample period.
3. Empirical results
3.1 Abnormal returns around dividend announcements
Table I presents daily average abnormal announcement returns for dividend-
increasing firms and their corresponding t-statistics during the event window.
Consistent with prior studies and our first hypothesis, the New Zealand stock market
reacts positively and significantly to these announcements. On average, the average
abnormal stock return on the announcement day estimated using the market model is
1 0.23 46 1.23
0 1.66 64 5.66***
1 0.21 49 1.32
CAR(1, 1) 2.09 64 1.93**
Table I. Notes: There are 244 announcements from 1992 to 2003. The average abnormal returns are estimated
Abnormal returns with the market and the market-adjusted models. In the market model, the estimation period is
surrounding from 220 to 21 days prior to the announcements, b is adjusted according to Scholes and Williams
contemporaneous (1977) and t-statistics are presented using the heteroskedasticity-adjusted approach (Boehmer et al.,
earnings and dividend 1991).
announcements ***Significant at 1%; **significant at 5%
1.66 percent and significant at the 1 percent level. The positive and significant average Accruals as a
announcement abnormal return suggests that private information is released to signal in
and priced by the market on announcements of contemporaneous earnings and
dividend increases. announcements
3.2 The accrual model
Table II summarizes the statistics of the variables used in the ROA-adjusted Jones 115
model. The coefficients on DREV, PPE, and ROA are all statistically significant and
collectively explain 98 percent of total accruals. The accrual model is significant as
reported by the statistically significant F-statistic and high adjusted R2.
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significant; however, the coefficients of both DDIV and DA are positive and
significant indicating that both change in dividends and discretionary accruals have
incremental information content. This result is consistent with our third hypothesis
that managers use both change in dividends and accruals to disclose their private
information to the market.
CAR CAR
nondiscretionary accruals; NDI, nondiscretionary earnings defined as the sum of cash flows and
nondiscretionary accruals; LE, lagged operating income after depreciation but before interest expense, Table V.
taxes, and special items, scaled by lagged total assets; B/M is the book-to-market ratio. The sample The association between
period is from 1992 to 2003. t-statistics are in parentheses. future profitability and the
***Significant at 1%; **significant at 5% components of earnings
which reverse in the following period. The coefficient on DA, however, is positive
and statistically significant. This result indicates that discretionary accruals
significantly explain future profitability and is consistent with our hypothesis that
managers use accruals to convey information regarding future profitability.
Bernard and Thomas (1990) observe that changes in earnings are serially
correlated, recognized in the literature as the post-earnings announcement drift effect.
They report that an unexpected change in earnings in one quarter will be followed by
progressively smaller changes of the same sign in the following three quarters.
Therefore, it is possible that instead of capturing the hypothesized signaling effect,
discretionary accruals capture a post-earnings announcement drift effect. To control
for this effect, we proxy for the unexpected component of earnings by lagged earnings
(LE) and nondiscretionary income (NDI)[2]. Nondiscretionary income is defined as
operating cash flows plus nondiscretionary accruals (Subramanyam, 1996). If the
positive coefficient on DA observed in panel A of Table V can be attributed to the post-
earnings announcement drift effect, NDI and LE should capture the drift effect and the
coefficient on DA should be zero. Thus, we estimate the following regression for
dividend-increasing firms:
Bit
Et1 a0 b1 DAit b2 LEit b3 NDIit b4 et1 5
Mit
Panel B of Table V reports the results on the association between the earnings
components and future profitability after controlling for the unexpected component
of earnings. As expected, the coefficients on NDI and LE are both positively and
significantly correlated with future profitability. If dividend-increasing firms
do not use accruals to signal future profitability, after controlling for the earnings
drift and the growth effects, discretionary accruals should not be correlated
with future profitability. However, the results show that the coefficient on DA is still
significantly positive and the magnitude of the coefficient is greater than that
on NDI[3].
JAAR 3.6 Robustness tests
12,2 The analysis above is carried out using the ROA-adjusted Jones model. Several studies
propose different accruals models. For example, Pae (2005) and Chan et al. (2004) argue
that since cash flows are negatively correlated with accruals, adding scaled cash flows
into the modified Jones model increases the performance of the model in estimating
discretionary accruals from total accruals. The cash flows Jones model (CFM) is:
118
1 DREVt DRECt PPEt CF
TA a1 a2 a3 a4 ft 6
At1 At1 At1 At1
Coulton et al. (2005) suggest adding lagged total accruals and the ratio of future
sales growth into the modified Jones model to capture the reversal effect of accruals.
The lagged (LTACC)- and the forward-looking (GROWTH)-modified Jones models are,
respectively:
1 DREVt DRECt PPEt
TA a1 a2 a3 a4 TAt1 ft 7
At1 At1 At1
and
1 DREVt DRECt PPEt
TA a1 a2 a3 a4 TAt1
At1 At1 At1
a5 GROWTH ft 8
where TAt1 is the lagged scaled total accruals and GROWTH is the ratio of Sales
Salest .
t1
Table VI reports the results for the association between abnormal returns and the
components of current earnings controlling for changes in dividends. The results
show that, similar to the results reported in Table IV, both changes in dividends and
discretionary accruals are all positive and significantly correlated with the
announcement abnormal returns across the three accrual models. Table VII reports
CFM 0.037 0.001 0.029 0.098 0.011 0.009 0.006 4.89% 244
(2.33)** (2.56)** (0.78) (2.21)** (0.83) (1.56) (2.34)**
LTACC 0.039 0.001 0.070 0.107 0.027 0.010 0.006 5.46% 230
(2.44)** (2.57)** (2.25)** (2.40)** (2.35)** (1.69)* (2.37)**
GROWTH 0.036 0.001 0.062 0.091 0.024 0.009 0.006 4.65% 202
(2.15)** (2.49)** (1.92)* (1.95)* (2.00)** (1.60) (2.08)**
Notes: The independent variable is the cumulative abnormal returns (CAR1, 1). DDIV, change in
dividends; CF, operating cash flows, scaled by lagged total assets; DA, discretionary accruals; NDA,
nondiscretionary accruals; B/M, book-to-market ratio; SIZE is the log normal of market value equity;
Table VI. CFM, the cash flow Jones model; LTACC, the lagged accrual modified Jones model; GROWTH, the
The associations between forward-looking modified Jones model. The sample period is from 1992 to 2003. t-statistics are in
discretionary accruals and parentheses.
abnormal returns **Significant at 5%; *significant at 10%
Intercept NDA DA CF B/M Adjusted R2 N
Accruals as a
signal in
CFM 0.173 0.095 0.196 0.027 0.047 17.74% 244 announcements
(17.86)*** (1.74)* (3.05)*** (1.38) (5.63)***
LTACC 0.175 0.040 0.153 0.024 0.047 16.48% 230
(17.52)*** (0.84) (2.30)** (1.37) (5.49)***
GROWTH 0.175 0.013 0.055 0.003 0.048 14.13% 202 119
(15.56)*** (0.26) (0.74) (0.16) (5.21)***
Notes: CF, operating cash flows, scaled by lagged total assets; DA, discretionary accruals; NDA,
nondiscretionary accruals; B/M, the book-to-market ratio; CFM, the cash flow Jones model; LTACC, the
lagged accrual modified Jones model; GROWTH, the forward-looking modified Jones model.
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The independent variable is future profitability which is defined as operating profit after depreciation Table VII.
at time t 1, scaled by lagged total assets. The sample period is from 1992 to 2003. t-statistics are in The associations between
parentheses. discretionary accruals and
***Significant at 1%; **significant at 5%; *significant at 10% future profitability
results for the association between future profitability and the components of accruals.
The results are qualitatively similar to those reported in Table V.
4. Summary
This study examines whether managers use both accruals and changes in dividends to
communicate information regarding firm future profitability. We find that, on average,
the markets reaction to dividend increase announcements is significantly positive,
which is consistent with our hypothesis that these announcements are a signaling
event. We also find that in addition to changes in dividend, accruals, and discretionary
accruals of dividend-increasing firms explain the positive market reaction. Further
analysis shows that discretionary accruals of dividend-increasing firms are positively
and significantly associated with their future profitability. The significantly positive
association between discretionary accruals of dividend-increasing firms and future
profitability is robust to performance, growth, and post-earnings announcement
drift effects.
The documented results are consistent with managers using both accruals and
changes in dividends to communicate information regarding firm future profitability.
This finding extends the literature on accruals as it highlights that discretionary
accruals need not only be associated with opportunistic earnings management.
Rather, firms may use discretionary accruals in conjunction with another signaling
device to corroborate the signal. So far, managers are observed to use accruals as a
signal in conjunction with stock splits and contemporaneous earnings and dividend
increase announcements. It remains to be seen, however, whether other corporate
events also provide incentives to managers to use accruals to communicate their
private information to the market.
Notes
1. We also estimated the abnormal returns using a market-adjusted return model (Brown and
Warner, 1980). The results are very similar and not reported.
2. Unavailable lagged earnings data reduce the sample size from 244 to 230 firm-year
observations.
JAAR 3. The positive relations among accruals, earnings, and dividend increases may also be
attributed to dividend reinvestment plans (DRP). Reinvesting dividends will increase
12,2 the amount of dividends (but not the dividend rate) and next years earnings. However,
there are only 33 (14 percent) observations with DRPs during the sample period. We thank an
anonymous referee who raised this issue.
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Corresponding author
Hardjo Koerniadi can be contacted at: hkoernia@aut.ac.nz