The Role of Working Capital Accruals on Earnings Quality and Stock Return

Abstract

A failure to beat earnings expectations often results in an immediate fall in a firm’s stock price, while exceeding market expectations is normally rewarded by investors in the form of an increased stock price. As a result, managers may have a vested interest in ‘managing’ the reported earnings growth when remuneration packages are linked to corporate profitability. Investors may be misled by this earnings management process if they are fail to consider the quality of earnings when assessing stock returns. Investors can determine earnings quality through the information disclosures provided by management, although such information may not be routinely provided by corporate management teams. In situations where the market focuses primarily on firms’ reported income and fails to consider the quality of accounting earnings, there may be temporary divergence of stock prices from their correct values. Where the market focuses on the reported income figure in a firm’s income statement it fails to consider information about earnings quality, such as the disclosures about working capital accruals. The Financial Accounting Standards Board (FASB) states that the usefulness of accounting information is the principal objective of financial statements (FASB, 1978). This paper investigates whether the usefulness of accounting information in the decision making process is enhanced by recognizing the impact that information about earnings quality may have on stock returns. More specifically, the paper focuses on the impact of accounting accruals as the main measurement and indicator of earnings quality.