Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly

S.P. Kothari, E. Loutskina, V. Nikolaev

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Abstract

We show that the agency theory of overvalued equity (see Jensen, 2005) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996).Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation.Thus, high-accrual portfolios are likely to be over-represented with over-valued firms.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, so undervalued firms are not concentrated in low accrual decile portfolios.Therefore, across the accrual decile portfolios, 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, and analyst forecast optimism is concentrated among the high-accrual decile portfolios.Overall, return behavior, analyst optimism, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity, but do not support investor fixation on accruals.
Original languageEnglish
Place of PublicationTilburg
PublisherAccounting
Number of pages65
Volume2006-103
Publication statusPublished - 2006

Publication series

NameCentER Discussion Paper
Volume2006-103

Keywords

  • accrual anomaly
  • earnings management
  • agency theory of overvalued equity

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    Kothari, S. P., Loutskina, E., & Nikolaev, V. (2006). Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly. (CentER Discussion Paper; Vol. 2006-103). Accounting.