What is the Accrual Anomaly ?

Over the last 15 years , starting with Sloan (1996), hundreds of academic papers have been written documenting that stocks of companies with low accruals outperform stocks of companies with high accruals if the stocks are held for a one year period.

Accruals are estimates and allocations made by accountants to align revenues and costs in a specific period. If all buyers and suppliers paid when the services were provided there would be no need for accrual accounting, but much of modern commerce is based on contractual relationships where the timing of cash payments does not match when the services are delivered and the amount of a payment or cost is not fully known when the contract is signed. Accruals are accounting estimates of the unknown amounts that attempt to show what the impact of the delayed revenue or cost would be on current profits.

Sloan (1996) shows that accruals are less persistent than cash flows and that investors fixate on earnings failing to correctly distinguish between the different properties. In particular, they overestimate (underestimate) the lower (higher) persistence of accruals (cash flows) when forming future earnings expectations. Consequently, this leads to an “accrual anomaly” where firms with relatively high (low) levels of accruals experience negative (positive) future abnormal stock returns that are concentrated around future earnings announcements. Sloan (1996) concludes that investors do not fully comprehend the greater subjectivity involved in the estimation of accruals, causing them to make flawed decisions.

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