Why ‘Democracy’ and ‘Drifter’ Firms can have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers

Abstract

Do managers exercise accounting discretion in an opportunistic or efficient manner? Good governance structures, which mitigate agency costs, are necessary to ensure that the accounting information supplied by management is not opportunistically manipulated. The output of quality accounting information, in turn, serves as an input to better governance structures. Thus, governance and earnings quality (EQ) are inexorably linked through a complementarity relationship. This suggests two previously unexamined relationships. Firstly, the governance effects on performance in the influential paper by Gompers, Ishii and Metrick (2003) is overrated without good EQ, measured by the magnitude of abnormal accruals (AA), as an input. I find evidence that removing firms with Low AA attenuates the good governance (Democracy) portfolio returns to no different from zero over the period of 1991-2008. Good governance per se no longer pays off. Isolating the long portfolio of Democracy firms with Low AA generates a positive abnormal return of 10.5 percent per year from 1991 to 2008. Secondly, the uncertainty associated with the abnormal accruals signal is interactively resolved with information about the firm’s governance structure, and the unique pairing of the signals contains unique information about the future prospects of the firm. Thus, firms with high or extreme income-increasing AA, when accompanied by weak (Dictatorship) and mixed (Drifter) governance structures, have negative abnormal future returns as predicted in the seminal paper by Sloan (1996), but Democracy firms have positive abnormal returns. The results suggest either that abnormal accruals are a coarse measure of EQ or earnings manipulation for good governance firms, or that their shareholders benefit from “earnings management” because the high abnormal accruals signals future performance. Overall, the results highlight the joint importance of governance and abnormal accruals in contributing to the total information environment to separate winners from losers.

Keywords: Corporate governance, abnormal accruals, earnings quality, contextual information, returns predictability, special items

JEL Classification: G10, G11, G12, G30, G34, M4