The Investigate the Role of Accruals in the Capital Market

International Journal of Management and Humanity Sciences. Vol., S (3), 3891-3894, 2014
Available online at http://www.ijmhsjournal.com
ISSN 2322-424X©2014
The Investigate the Role of Accruals in the Capital Market
Leila Lak*, Mehdi Talebghasabi, Zahra Mousavi, and Hamid Moridipour
Department of Accounting, Andimeshk Branch, Islamic Azad University, Andimeshk, Iran
*Corresponding author E-mail: lak1365@yahoo.com
Abstract
This study attempts to investigate the role of accruals in the capital market. It first
attempts to define accruals and compare discretionary accruals with involuntary
accruals. It also tries to investigate the influential factors on accruals and their
advantages and disadvantages. Finally, the conclusions are given.
Keywords: Accruals, Discretionary Accruals, Earnings Quality, Involuntary Accruals
Introduction
Accruals send signals to users of financial statements that are neglected in the cash systems. On one
hand, these signs are true images of the current circumstances of the enterprise and on the other; they
enable users to have a more accurate prediction of future circumstances and particularly of future cash
flows. The financial standards association believes that accruals are of benefits in assessing dividends.
On the other side, some financial analysts question the reliability and relevance of earnings for their
accruals. They raise the issue that managers tend to manipulate accruals using a variety of legal approaches
in order to balance profit. This is while in the process of financial decision making, the role and importance of
cash flows have become apparent in a way that decisions made without considering them are inefficient
ones or will fail in operation (Haghighat and Bakhtiari, 2009).
Theoretical foundations
Definition of accruals: accruals are created in using accounting commitment and it can be defined as the
difference between accounting profit and the cash flows related to it. These affect the earnings due to the
principles of compliance and fulfillment, timing of transactions and selection of accounting methods and in
this sense the quality of profit can be considered the degree of closeness between company profits and cash
flows (Dastgir and Khodadadi, 2007).
Comparison of discretionary accruals with involuntary accruals
Accruals are divided into discretionary accruals and involuntary accruals: the discretionary accruals are
items that the management can exhibit a level of control over whereas involuntary accruals are items with no
possible control from the management.
Discretionary accruals are a result of goal-oriented accounting in order to control profits (McNicoles,
2000). Discretionary accruals have richer information-generating content (Arab, M. 2006). The management
of discretionary accruals is not done using basic economic activities of an enterprise; it is rather done
through choosing accounting methods and estimates. Meanwhile, manipulation of real operations is
accomplished via changing fundamental operations of a company. The main economic events of a company
limit the management’s ability to report earnings according to accounting figures. As a result, if discretionary
accrual figures are used at the end of year, the earnings-related objectives may not be attained. This will limit
the management of discretionary accruals. Earnings’ management activities based on accruals will generate
no cash flow whatsoever (Cohen and Zaroween, 2008). In case of most discretionary accruals, the
company’s accountants cannot discover the company’s operations (from management’s view). Heili (1985)
considers discretionary accruals the adjustments of cash flow selected by the management for affecting
reported earnings. Francis (2005) believe that the more freedom of action the management has to create
them, the more likely it is for these items to be used for influencing earnings.
Involuntary accruals are necessitated by accounting standards and are influenced by economic conditions
and limited by organizational rules and other external elements. As a result, these items are relatively safe
from being manipulated by the management. Hence, involuntary accruals are subject to managements ideas
Intl. J. Manag. Human. Sci. Vol., S (3), 3891-3894, 2014
(Mostafazadeh, 87). Ronen and Yari (2008) consider involuntary accruals to be the consequence of
transactions in the current period, performance level and business strategies, contracts and economic
events of the company and are certain to exist. They consider involuntary accruals to be the result of
objective-oriented selection of approaches and accounting manners for earnings management. Involuntary
accruals account for a proportion of accruals in which the management is not included. Studies Zay( 2001)
reported that the durability of involuntary accruals is higher than that of the discretionary.
Effectiveness of accruals in earnings quality
From Hicks viewpoint, earnings quality is nothing but an honest report of the earnings. Earnings quality
can be divided into three categories of earnings’ stability, levels of accrual figures and earnings reflecting
related economic transactions. Earnings stability is the recurrence (frequency) of current earnings. The
higher the earnings stability, the more powerful a company is for keeping the current earnings and the higher
the earning quality. The accrual figures are negatively correlated with earnings quality since the higher they
are the lower the earnings quality of the company. Moreover, consistent with the extent that the accounting
earnings represent real economic transactions, the earnings quality rises (McNichals, 2002). Scholer (2004)
defines earnings quality as the correlation between accruals and cash flows. The earnings quality depends
on the amount of cash generated through the operations and the level of accruals reflected in earnings
(Barth, et.al. 2002) and higher levels of accruals will lower the earnings quality (Nourvash, 2005). The quality
of accruals and earnings quality decline in face of risks. Accruals are considered significant elements for
determining the earnings quality and have usages in stocks analysis. Less reliable accruals will lead to less
stable earnings (Scot, et.al. 2005). High levels of accruals would lead to a decline in earnings quality. More
accruals mean lower quality and less earnings stability. Accruals are temporary adjustments that attempt to
address problems related to timing of cash flows and realizing earnings. It can be generally said that the
closer the accruals are to cash flows, the higher the earnings quality.
Effectiveness of accruals on other aspects of the market
For the investors, the closer the accruals are to cash flows, the higher the earnings quality. Thus, the low
accruals quality will reduce this distance and cause higher investment risk while making decisions about a
certain company. Agnoa attempts to investigate the relationship between accruals and dividends and
reported a negative correlation between accruals quality with expected dividends.
The higher power of accruals and current cash flows in predicting future accruals, cash flows is correlated
with predicting expected dividends, earnings stability and earnings relationships (Modares, et.al.2008).
Studies by Dastgir and Rastegar showed that earnings quality (earnings stability) is correlated with accruals
quality. Francis and Mitchel showed that companies with more accruals hire more proficient accountants to
make sure that no earnings management is involved.
Accruals negatively affect liquidity of companies’ stocks. Normalization of discretional accruals will lead to
lower liquidity (Moradzadeh, et.al, 2010). The accruals quality is correlated with cash and cash equivalents
(Fakhari and Taghavi, 2009). Accruals are negatively correlated current cash flows and positively correlated
with past and future cash flows. The lower the quality of accruals, the higher the debt and capital costs of the
company will be. This shows the effect of accruals in decisions (Francis, 2005).
Dessai, et.al found that irregular accruals will only decrease by operational cash flows. According to
Decho and Dicho (2002), accruals quality decrease as the accruals estimation error decrease. Low reliability
of accruals will lead to low earnings stability (Richardson, et.al. 2005). Companies with lowers accruals have
lower expected dividends than companies with higher accruals (Youlisana, 2009).
Higher levels of accruals, particularly irregular accruals are indicative of low earnings quality (Mirz, et.al.
2003). Extra profits of the portfolios according to relative accruals are higher than the same profits using
traditional accruals (Hafizollah, et.al, 2011).
Flaws of accruals
The most important drawback of accruals is the uncertainty of figures specifically the earnings in
comparison with cash basis. In fact, due to elements like judgment, allocation and estimation, uncertainty is
considered an inseparable part of accruals basis. Appreciating the features of accrual items is a very
important objective in financial accounting research. Accrual items are more conceptual than cash flows and
are influenced by optional objectives of managers. Earning returns due to the accrual element of earnings is
less stable in comparison with the cash flow element of the earnings. In other words, the cash flow
component of current earnings is more stable than the accrual component (Oslovan, 1996). Accruals have
less predictive power than cash flow.
Irregularity of accrual items challenges the goods market and similarly the irregular earnings can be
earned by selecting an approach according to the available information (Dichau, et.al, 2001). Managers tend
to manipulate the accruals to balance the reported earnings.
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By using accrual items, the cash flow generated through a financial event is measured with an estimate
and in case it is wrong, the accrual items and earnings are modified in future. This estimation error and
subsequent modifications reduce accrual items’ earnings (Decho and Dicho, 2002).
Uncertainty
Being subject to
Less
predictive
power
manipulate
Reduce
earning
influenced by optional
objectives of managers
Figure 1. The decreasing trend of accruals
Temporal accruals lead to a decrease in predictive ability and cause the estimates based on them to be
wrong with the consequent stoppage of cash flow (in or out).
The advantages of accrual
Accruals send signals to users of financial statements that are neglected in the cash systems. On one
hand, these signs are true images of the current circumstances of the enterprise and on the other, they
enable users to have a more accurate prediction of future circumstances and particularly of future cash flows
(Mirzaei and Mehrazin 2012). The financial standards association believes that accruals are of benefits in
assessing dividends. Accrual items present a better indication of the company’s performance in comparison
with cash flows. The accrual accounting system considers temporary adjustments and mobilizes cash flows
accordingly, for instance, credit sales using an accrual account in the name of accounts with their cash flows
still to come. Thus, identifying cash flow of this credit sale is moved from the time of receiving cash to the
time of transaction. This is one of the most important benefits of accruals that is due to using the accrual
system leading to better assessments of the company’s performance (Decho and Dicho, 2002).
Sloven (1996) showed that buying the stocks of a company with less accrual items and selling the shares
of companies with more accrual items will provide the investor with high coverage. Studying accruals and
their many strategies can contribute a great deal to forming a shares portfolio.
Accruals that are a result of correct estimations would lead to higher cash income so the accounting
earnings of accruals can be considered a measuring device by many users of financial statements for the
performance of the company.
The ability to
indicate the
company's value
Increment of
profit at the
time of stock
sales
better
company’s
performance
Signal
feature
Figure 2. The criteria for accruals prominence are
The role of accruals
One of the approaches of manipulating a company’s earnings is using accruals; because accrual
accounting will provide managers with considerable choice in determining earnings in different time periods.
Earnings stability is affected by the amount and signs of accruals (Dicho and Ross, 2005). Accruals show the
predictions for economic gains in future and also cash income and output.
Accruals are one of the pivotal components of earnings and financial statements and the accrual items are
relevant in evaluating the profits of shareholders. Sloven’s studies indicate that accruals have higher return
mean in comparison with cash flows (that is less stability) in earnings.
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Conclusion
Identifying accruals and studying them would result in the market being aware of their advantages and
risks. Studies showed that higher levels of accruals will reduce their quality. In other words, increase in
accruals will create more problems in timing and adjusting the cash flows. Identifying factors influencing
accruals will result in controlling them. Quality control of accruals affects earnings.
Accruals are important management tools for managing earnings. When the management has more
accruals, there is higher incentive for earnings management since they are not readily visible and stay
hidden. In order to boost earnings quality and preventing earnings management, the capital market must be
fully aware of these items.
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