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Earnings Management and Mispricing of Allowance for Funds Used During Construction in the Electric Utility Industry
Pervaiz Alam,
Kent State University
Liang Fu, University of Florida
ABSTRACT. The deregulation experienced by the electric utility industry in recent years has dramatically increased the competition from new suppliers and has increased the uncertainty of the recovery of prior costs. This changing environment puts managers in the electric utility industry under increasing pressure to improve financial performance. This study hypothesizes and finds that there is an indication of earnings management in a discretionary income account, Allowance for Funds Used During Construction (AFUDC). The level of AFUDC increases with the magnitude of discretionary accruals. In addition, the stock market overestimates the impact of AFUDC in predicting one-year-ahead earnings. A subsequent hedge-portfolio test based on the mispricing insight earns significant abnormal returns, and these abnormal returns cannot be fully explained by either the three Fama-French (1992) risk factors, or the earnings-price anomaly (Basu, 1977).
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