This paper examines if the stock market prices discretionary accruals. Evidence reveals that, on average, the market attaches value to discretionary accruals. This evidence is consistent with two alternative scenarios: (1) managerial discretion improves the ability of earnings to reflect economic value, and (2) discretionary accruals are opportunistic and wdue-irrelevant but priced by an inefficient market. Further evidence is consistent with the former explanation. There is evidence of pervasive income smoothing, which improves the persistence and predictability of reported earnings. There is also evidence that discretionary accruals predict future profitability and dividend changes. Despite several sensitivity checks, measurement error in the discretionary accruals proxy is an alternative explanation for the results. Key words: Capital markets; Valuation; Earnings management; Discretionary accruals: Income smoothing; Dividends; Signaling J E L class!fication: M41 1. Introduction The role of accruals in arriving at a summarized measure of firm performance is an important question in accounting research. Accrual earnings is regarded as a superior measure of firm performance than cash flows because it mitigates I thank S.P. Kothari (editor), Vic Bernard (discussant), Bill Beaver, Bob Bowen, Mark DeFond, Ellen Engel, Frank Heflin, Bill Kross, Susan Moyer, Terry Shevlin,D. Shores, Brett Trueman, Terry Warfield, John
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