Discretionary Accruals and the Emergence of Profitability

Abstract

This study examines discretionary accruals associated with firms' reaching profitability after a series of quarterly losses. As firms approach profitability, we posit they will be characterized with less income increasing discretion given the reversing nature of accruals. We find results consistent with this expectation. The discretionary accrual behavior for firms that remain profitable contrasts to that of a control sample that does not remain profitable. In the quarters preceding a reported profit, firms that sustain profitability use significantly lower income increasing discretionary accruals. For these firms, we also find that past discretion relates inversely to future profitability. We interpret our results as evidence that discretionary accruals for persistent loss firms can serve as a leading indicator of the ability to sustain future profits.