An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

S. P. Kothari
Massachusetts Institute of Technology

Elena Loutskina
Boston College

Valeri Nikolaev
Tilburg University

Abstract: We show that the agency theory of overvalued equity rather than investors’ fixation on accruals explains the accrual anomaly documented by Sloan (1996). Under this theory, managers of overvalued firms are likely to manage their firms’ accruals upwards to prolong the overvaluation. Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms. In contrast, undervalued firms do not face incentives to report low accruals. Therefore, we predict and find an asymmetric relation between accruals and both prior and subsequent returns. In addition, consistent with the predictions of the agency theory of overvalued equity, we find high, but not low, accrual firms’ investment-financing decisions and insider trading activity are distorted. Overall, return behavior, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity and inconsistent with investor fixation on accruals.

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