This paper examines the market pricing of Jones (1991) modelestimated abnormal accruals (often termed “discretionary accruals” in the prior literature) to test whether stock prices rationally reflect the one-year-ahead earnings implications of these accruals. Using the Mishkin (1983) and hedge-portfolio test methods Sloan (1996) employs, I find that the market overestimates the persistence, or one-year-ahead earnings implications, of abnormal accruals, and consequently overprices these accruals. These results extend Subramanyam (1996) by demonstrating that the market not only prices, but also overprices abnormal accruals. They also suggest that the overpricing of total accruals that Sloan (1996) documents is due largely to abnormal accruals. The results are robust to five alternative measures of abnormal accruals, and still hold when I estimate abnormal accruals after controlling for major unusual but largely nondiscretionary accruals. The latter finding is consistent with the notion that the market overprices the portion of abnormal accruals stemming from managerial discretion.

This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur 1996), (2) a proxy for expected future normal earnings (Ohlson 1995; Penman 1992), or (3) a proxy for loss firms' abandonment option (Berger et al. 1996; Barth et al. 1996; Burgstahler and Dichev 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.

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