Does corporate diversification enhance accrual quality?

This study aims to examine the association between corporate diversification and accrual quality and test whether the diversification effect hypothesis, which predicts that measurement errors in accruals ultimately decline as firms become more diversified, or the measurement error hypothesis, which predicts that these errors increase, prevails.

This study modifies an existing empirical framework that uses the downward bias inherent in earnings persistence to measure accrual reliability and applies it to a sample of firms listed on the New York Stock Exchange, American Stock Exchange and NASDAQ from 1998 to 2016.

The results indicate a significantly positive association between firms’ diversification level and accrual reliability, which suggests that the diversification effect dominates the measurement errors effect, leading to an increase in firms’ accrual quality. The authors also found additional evidence suggesting that this positive association is more pronounced when a firm’s underlying operating activities among segments are less correlated, which is consistent with the fact that the diversification effect becomes more evident if a firm participates in diverse lines of business.

This study proposes that applying fewer sets of estimation methods or assumptions to a cluster of segments could yield more measurement errors in accruals. It fills a research gap by showing that the portfolio diversification effect mitigates the detrimental effect of measurement errors in consolidated financial reporting.