Empire-Building Incentives and the Effectiveness of Accrual Investment

I. INTRODUCTION In his influential paper, Sloan (1996) shows that high (low) accruals predict lower (higher) future profits and stock returns.(2) While this well-known accrual anomaly has continued to intrigue financial economists after a decade, a recent work by Fairfield et al. (2003a) puts more pieces into the accrual puzzle by revealing that growth in the book value of long-term operating assets, or "long-term asset accruals" in a more comprehensive accrual definition, has an equally strong negative association with future profits and stock returns. In explaining their findings, Fairfield et al. (2003a) argue that working capital accruals and long-term asset accruals are both proxies for firm growth. They conjecture that the negative implications of these accruals for future profitability may be related to conservative accounting or diminishing marginal returns on investments. Richardson et al. (2005) posit that the measurement of long-term asset accruals and working capital accruals entails more subjectivity and less reliability than the measurement of other items, such as cash flows or liability changes. They, thus, suggest that measurement error, be it from innate accounting attributes or earnings manipulation, accounts for the negative association between accruals/long-term asset accruals and future profitability. In this paper, I provide another potential explanation. In the accounting literature, accruals are traditionally viewed as an attribute of earnings management or earnings discretion (Xie, 2001; Chan et al., 2004). However, they are also a measure of firm investment in current working capital. (1) In the corporate finance literature, long-term asset accruals have been shown as a valid measure of capital investment (Hsiao and Li, 2013). I link firm investment in accruals/long-term asset accruals to agency theory (Jensen, 1986; Jensen 2005) and document evidence that the empire-building agency cost (over-investment) may partially explain the negative association between accruals/long-term asset accruals and future profitability. (3) Specifically, I find that the negative association is stronger when firms have greater investment discretion, i.e., for those firms with higher free cash flow and lower leverage. The association is also stronger following equity overvaluation that may prompt management to over-invest in property, plant, equipment, and perhaps other working capital. Applying a parsimonious model to decompose investment into a nondiscretionary component and a discretionary component, I find that the negative association is primarily driven by the positive discretionary investment sample, where over-investment is more likely to occur. In the negative discretionary investment sample, there does not appear to be a negative association. Lastly, the negative association seems stronger for accruals and long-term asset accruals generated in the fourth fiscal quarter, when management are often in a position to either spend the money or "waste" the budget. (4) Collectively, evidence shows that agency costs could potentially affect the accrual-earnings relationship. In this study, I do not attempt to distinguish behaviors between accruals and long-term asset accruals. Long-term asset accruals may be viewed as long-term investment, and accruals may be viewed as short-term investment. I put them side-by-side to highlight the common attributes between them. My work is also related to Titman et al. (2004), who find that the negative association between capital investment and stock returns is affected by free cash flow and leverage. However, they do not study accruals or long-term accruals. Nor do they examine the association between accruals and firm profitability. The negative relationship between accruals and future stock returns does not necessarily imply market inefficiency or agency problems. Even in an efficient market, accruals/investment could negatively co-vary with future stock returns if, in anticipation of lower future discount rates, firms endogenously increase investment (Lamont, 1997; Zhang et al. …