The Bright Side of Discretionary Accruals: Evidence from Finance and Innovation

• Author: Keming Li,(Grace) Qing Hao
• DOI: http://doi.org/10.1111/eufm.12068
• Published date: 01 September 2016
• Date: 01 September 2016

The Bright Side of Discretionary

Accruals: Evidence from Finance and

Innovation

(Grace) Qing Hao

College of Business, University of Texas at Arlington, USA

E-mail: Qhao@uta.edu

Keming Li

Department of Accounting, Computing and Finance, Texas A&M University-San Antonio, USA

E-mail: keming_li@hotmail.com

ABSTRACT

We find cross-sectional evidence that a financially constrained firm with

patentable innovation opportunities can use discretionary accruals to reveal

information about the firm’s prospects and facilitate its financing activities.

Specifically, using firms with patents in the National Bureau of Economic Research

(NBER) patent database, we find that among financially constrained firms, higher

discretionary accruals are associated with more capital being raised, greater

research and development (R&D) expenditures, more patents, more patent

citations, and better operating performance in the future. These positive

relationships are driven by firms that raise equity capital, especially those that

raise equity capital from employees.

Keywords: discretionary accruals, innovation, research and development (R& D),

patent, financial constraint, equity financing

JEL classification: G30, G32, M41

The authors are grateful to three anonymous referees, John Doukas (the Editor), Jay Ritter

and Dave Diltz for helpful comments and suggestions. The authors also thank Wendy

Jennings for editorial assistance. Grace Hao would like to acknowledge financial support

from the College of Business Administration at the University of Texas at Arlington.

European Financial Management, Vol. 22, No. 4, 2016, 540–575

doi: 10.1111/eufm.12068

© 2015 John Wiley & Sons, Ltd.

1. Introduction

The earnings management literature finds that managers use discretionary accruals

opportunistically in various contexts.

1

In contrast, empirical evidence is relatively scant

regarding managers’use of discretionary accruals to reveal information about a firm’s

prospects and the reduction of information asymmetry between managers and investors.

2

A notable exception is the study by Linck, Netter and Shu (2013, LNS hereafter), who

find that among financially constrained firms with investment opportunities,

discretionary accruals prior to their investments in tangible assets are informative

instead of manipulative.

However, no study has demonstrated that the findings in LNS can be generalised to

investments in intangible assets, such as research and development (R&D). This is an

important issue as innovation can bring rapid change and growth to economies, and it has

long been recognised as an important driver of economic growth. Given the increasingly

important role of R&D (e.g., Chan et al., 2001), it is important to determine whether

managers of innovative, financially constrained firms are able to use positive

discretionary accruals to signal good prospects. Prior research indicates that interpreting

firm performance from reported earnings is more difficult for R&D-intensive firms (Joos

and Plesko, 2005; Franzen et al., 2007), as R&D has higher levels of information

asymmetry due to the intangible and long-term nature of the projects. Therefore, we

expect that managers of innovative, financially constrained firms have a greater incentive

to send out signals of growth prospects. One possible mechanism of signaling is

discretionary accruals.

Using a panel of firms that have patents in the National Bureau of Economic Research

(NBER) patent database, we examine the information content of past performance

matched discretionary accruals (Kothari et al., 2005) among financially constrained

firms with patentable innovation opportunities. We have several findings. First,

financially constrained firms with innovation opportunities have significantly higher

discretionary accruals than unconstrained firms. In addition, among financially

constrained firms with innovation opportunities, the level of discretionary accruals is

positively related to future external financing, R&D investments, the number of patents,

the number of patent citations, and operating performance. In contrast, we do not find

1

When managers use their discretion to mislead investors, discretionary accruals are

regarded as opportunistic. Studies have found evidence of opportunistic earnings

management around the following corporate events: initial public offerings (Aharoney

et al., 1993; Teoh et al., 1998; Teoh et al., 1998a), seasoned equity offerings (Teoh et al.,

1998b; Rangan, 1998), share repurchases (Gong et al., 2008), stock-for-stock mergers

(Erickson and Wang, 1999; Louis, 2004), management buyouts (Perry and Williams, 1994),

reverse leveraged buyouts (Chou et al., 2006), and when earnings would fall short of

expected dividend thresholds (Daniel et al., 2008).

2

We are only aware of a few empirical studies finding that discretionary accruals reflect

economic value instead of being opportunistic and value irrelevant, for example,

Subramanyam (1996), Louis and Robinson (2005), and Linck et al. (2013). However, a

number of theoretical studies, such as Chaney and Lewis (1995), Guay et al. (1996), Demski

(1998), and Arya et al. (2003), suggest that firms can use discretionary accruals to make their

earnings more informative than cash flows.

© 2015 John Wiley & Sons, Ltd.

The Bright Side of Discretionary Accruals 541

such positive relationships among unconstrained firms. More importantly, we further

determine that the positive relationships between discretionary accruals and future

innovation activities are driven by constrained firms that raise equity capital, especially

from employees. The results are robust to controlling for firm characteristics such as size,

asset growth, profitability, cash flow volatility and institutional ownership, as well as

endogeneity. The findings suggest that discretionary accruals not only are informative

about firms’fundamentals, but also play an important role in facilitating firms’capital

raising activities and growth.

At first glance, our finding of a positive association between discretionary accruals and

future innovation activities may seem to be at odds with the existing findings in the

literature that the use of discretionary accruals prior to seasoned equity offerings (SEOs)

tend to be manipulative and opportunistic (Teoh et al., 1998b; Rangan, 1998). However,

two important differences between our study and the studies on SEOs help to reconcile

the seemingly conflicting findings. First, a significant portion of the equity issuance

proceeds in our sample are not raised through the type of equity issuance examined in the

SEO literature. Since 1996 is the starting year for mandatory electronic filings with the

Securities and Exchange Commission (SEC), we examine a subsample of financially

constrained firms that went public since 1996. Among these firms, we hand check the

SEC filings by those that issue equity. We find that in 97.36% of the cases, the firm issues

equity to their employees in employee benefit plans (SEC S-8 form). While SEOs seek to

raise equity capital from outside investors, equity issuance to employees is supposed to

retain and incentivise employees in addition to raising capital. We argue that firms have

no incentive to manage their earnings upward opportunistically before this type of equity

issuance and will discuss this in more detail later. Consequently, discretionary accruals

prior to this type of equity issuance are more likely to be truthful and informative

regarding the firms’growth prospects.

The second difference between our study and the studies on SEOs focuses on

financially constrained firms with patentable innovation opportunities. Studies on

earnings management prior to SEOs typically examine all firms, regardless of whether

they are financially constrained firms, R&D-intensive firms, or whether the firm has

patentable innovation opportunities. It is possible that the firms in our sample use

discretionary accruals differently than other firms, which contributes to the different

findings. For example, financially constrained technology companies may be more likely

to use their own stocks to compensate and incentivise their employees, which, as

discussed previously, can have important implications for the information content of

their discretionary accruals.

3

Our study makes three contributions. First, our study contributes to the literature on

finance and innovation (e.g., Brown et al., 2009; Hall and Lerner, 2010; Hsu et al., 2014),

and more broadly the literature on finance and economic growth (e.g., Levine, 2005).

Given the critical value of innovation and the negative effect of financial constraints on

3

Another potential explanation is mentioned by He and Tian (2013). A major tool for real

earnings management is to cut R&D expenditures. However, real earnings management and

accrual-based earnings management are shown to be substitutes (e.g., Cohen et al., 2008). If

financially constrained, R&D-intensive firms can use discretionary accruals to substitute the

need to cut R&D expenditures, then these firms may benefit from higher discretionary

accruals.

© 2015 John Wiley & Sons, Ltd.

542 (Grace) Qing Hao and Keming Li