Accruals Bibliography

Ali, A., X. Chen, T. Yao, and T. Yu. 2008, Do mutual funds profit from the accruals anomaly? Journal of Accounting Research Vol.46, No.1, pp. 1-26.

Using data on both fund stockholdings and fund returns, we examine whether actively managed equity mutual funds trade on and profit from the accruals anomaly. We find that few, if any, mutual funds trade on the anomaly. The top 10% of mutual funds that have the highest portfolio weights in low accruals stocks have a greater, but still relatively small, exposure to low-accruals stocks. Nonetheless, these funds make significant profit net of actual transaction costs, exhibiting an average Fama-French three-factor alpha of 2.83% per year. We also find that these funds are smaller, less diversified, and exhibit higher fund return volatility and higher fund flow volatility.

Ali, D. A.; Hwang, L. and Trombley, M., 2000. Accruals and future stock returns: tests of the naïve investor hypothesis. Journal of Accounting, Auditing & Finance 15, pp. 161-181.

We explore whether the association between accruals and future returns documented by Sloan (1996) is due to fixation by naive investors on the total amount of reported earnings without regard for the relative magnitude of the accrual and cash flow components. Contrary to the predictions of the naive investor hypothesis, we find that the predictive ability of accruals for subsequent annual returns and for quarterly earnings-announcement stock returns is not lower for large firms or for firms followed more by analysts or held more by institutions. Further, we find that the ability of accruals to predict future returns does not seem to depend on stock price or transaction volume, measures of transaction costs, also contrary to predictions of the naive investor hypothesis. These results are robust to regression and hedge portfolio tests. We conclude that the predictive ability of accruals for subsequent returns does not seem to be due to the inability of market participants to understand value-relevant information.

Allen, E., J. Larson, R. Chad, and R.G. Sloan. 2010 Accrual Reversals, Earnings and Stock Returns. Working paper.

Accounting accruals anticipate future economic benefits and must ultimately reverse. If the anticipated economic benefits are not realized, then the accrual reversal impacts future earnings. We show that extreme accruals are followed by predictable accrual reversals that impact future earnings. We demonstrate that the predictable accrual reversals following extreme accruals explain both the lower persistence of the accrual component of earnings and the predictable stock returns following extreme accruals (Sloan, 1996). Finally, we corroborate our findings using a hand-collected sample of inventory write-downs by demonstrating that write-downs are systematically related to the reversal of previous extreme positive inventory accruals.

Aboody, David, John Hughes, and Jing Liu. (December, 2005). Earnings Quality, Insider Trading, and Cost of Capital. Journal of Accounting Research

Previous research argues that earnings quality, measured as the unsigned abnormal accruals, proxies for information asymmetries that affect cost of capital. We examine this argument directly in two stages. In the first stage, we estimate firms’ exposure to an earnings quality factor in the context of a Fama-French three-factor model augmented by the return on a factor-mimicking portfolio that is long in low earnings quality firms and short in high earnings quality firms. In the second stage, we examine whether the earnings quality factor is priced and whether insider trading is more profitable for firms with higher exposure to that factor. Generally speaking, we find evidence consistent with pricing of the earnings quality factor and insiders trading more profitably in firms with higher exposure to that factor.

Baker, Malcolm P. and Wurgler, Jeffrey A., Investor Sentiment and the Cross-Section of Stock Returns. Journal of Finance, Vol. 61, No. 4, pp. 1645-1680, August 2006.

We study how investor sentiment affects the cross-section of stock returns. We predict that a wave of investor sentiment has larger effects on securities whose valuations are highly subjective and difficult to arbitrage. Consistent with this prediction, we find that when beginning-of-period proxies for sentiment are low, subsequent returns are relatively high for small stocks, young stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme growth stocks, and distressed stocks. When sentiment is high, on the other hand, these categories of stock earn relatively low subsequent returns.

Balsam, Steven; Bartov, Eli and Marquardt, Carol, 2002, Accruals Management, Investor Sophistication, and Equity Valuation Evidence from 10-Q Filings, Journal of Accounting Research, Vol. 40, No. 4, pp. 987-1012

The release of the full set of financial statements in Form 10-Q provides investors with the data necessary to estimate the discretionary portion of earnings, thereby allowing them to better assess the integrity of reported quarterly earnings. We thus expect a negative association between unexpected discretionary accruals estimated using 10-Q disclosures and stock returns around 10-Q filing dates. Consistent with our expectations, we document a negative association between unexpected discretionary accruals and cumulative abnormal returns over a short window around the 10-Q filing date. Furthermore, this association varies systematically with investor sophistication. Finally, results from portfolio tests indicate that this association is economically as well as statistically significant. One interpretation of our findings is that accruals management has substantial valuation consequences, which are quickly impounded into stock prices

Barth, M. E., and A. P. Hutton, 2004, Analyst earnings forecast revisions and the pricing of accruals. Review of Accounting Studies Vol.9, No.1, pp. 59-96.

We investigate the relation between two market anomalies to provide insights into analyst’s role as information intermediaries. Prior research finds that accruals and analyst earnings forecast revisions predict future returns. We find that the accrual and forecast revision strategies generate hedge returns of 15.5% and 5.5% when implemented independently. Strikingly, a combined strategy that uses forecast revisions to refine the accrual strategy generates a hedge return of 28.5%. Firms with consistent accrual and forecast revision signals have less persistent accruals and earnings. We also find that accruals can be used to refine the forecast revision strategy—high accruals are associated with over optimism in analyst forecasts. Our findings indicate that although forecast revisions reflect information about accrual and earnings persistence beyond that reflected in the level of current year accruals, investors do not fully incorporate this information into their valuation assessments.

Barth, Mary E.; Cram, Donald P. and Nelson, Karen K., 2001, Accruals and the Prediction of Future Cash Flows, The Accounting Review, Vol. 76, No. 1, pp. 27-58.

We compare the predictive abilities of earnings and cash flows for future cash flows. We base our predictions on a model of the relation between future cash flows and past earnings and its components, including cash flows. As predicted, we find that current and past earnings explain significantly more variation in future cash flows than current and past cash flows, but only after permitting the cash and accrual components of earnings to have different multiples. As predicted, disaggregating the accrual component of earnings significantly further enhances the predictive ability of earnings for future cash flows. Contrary to claims in the popular press, the depreciation and amortization components of earnings have significant predictive ability for future cash flows. Our inferences are robust to controlling for operating cycle and industry membership.

Beneish, M.D. and Nichols, D. Craig, the Long and Short of the Accrual Anomaly (June 2006).

The paper provides evidence that the relation between accruals and future returns is not symmetric. We find that firms with low accruals generate insignificant abnormal returns in asset pricing regressions that control for either earnings quality or operating volatility. In contrast, we find that accrual hedge returns are driven by firms with large positive accruals and firms with high probabilities of earnings overstatement. This asymmetry is consistent with our view that upwards rather than downwards earnings management is an important contributor to accrual mispricing. We also find that firms with high accruals are smaller and have higher arbitrage risk (residual return volatility), suggesting that short sellers are unlikely to arbitrage away these negative abnormal returns. We conclude that an omitted risk factor explains results for low accruals and that transaction costs/limits to arbitrage explain the persistence of mispricing for high accruals.

Beneish, M.D. and Vargus, M.E., 2002, Insider trading, earnings quality, and accrual mispricing, Accounting Review Vol.77, No.4, pp. 755-791.

This paper investigates whether insider trading is informative about earnings quality and the valuation implications of accruals. We show that (1) the one-year-ahead persistence of income-increasing accruals is significantly lower when accompanied by abnormal insider selling and greater when accompanied by abnormal insider buying; (2) the accrual mispricing phenomenon observed in previous work (e.g., Sloan 1996) is due to the mispricing of income-increasing accruals; (3) one-year-ahead hedge returns to trading strategies based on the direction of accruals and insider trading significantly exceed those based on accruals alone; and (4) the lower persistence of income-increasing accruals accompanied by abnormal insider selling appears to be at least partly attributable to opportunistic earnings management. Our evidence suggests that market participants and researchers can use managers’ contemporaneous trading in ex ante assessing the likelihood that the firms’ accruals are of high or low quality, and in assessing the likelihood of earnings management. Our evidence suggesting that insiders trade on their knowledge of factors associated with accrual persistence is also relevant to policymakers charged with regulating insider trading.

Beneish, M.D.; Lee C.M.C. and Tarpley R.L., 2001, Contextual financial statement analysis through the Prediction of Extreme Returns Review of Accounting Studies Vol.6, Numbers 2-3,  pp. 165-189.

This study examines the usefulness of contextual fundamental analysis for the prediction of extreme stock returns. Specifically, we use a two-stage approach to predict firms that are about to experience an extreme (up or down) price movement in the next quarter. In the first stage, we define the context for analysis by identifying extreme performers; in the second stage we develop a context-specific forecasting model to separate winners from losers. We show that extreme performers share many common market-related attributes, and that the incremental forecasting power of accounting variables with respect to future returns increases after controlling for these attributes. Collectively, these results illustrate the usefulness of conducting fundamental analysis in context.

Bhojraj, S., and B. Swaminathan. How Does the Corporate Bond Market Value Capital Investments and Accruals?  Review of Accounting Studies, 14.1 (2009): 31-62.

This paper examines whether the mispricing of accruals documented in equity markets extends to bond markets. The paper finds that corporate bonds of firms with high operating accruals underperform corporate bonds of firms with low operating accruals. In the first year after portfolio formation, the underperformance is 115 basis points using an accrual measure that includes capital investments and 93 basis points using an accrual measure that is based only on working capital investments. The Sharpe ratios of the zero-investment bond accrual portfolios are comparable to those of the corresponding zero-investment stock accrual portfolios. The results are also robust to risk adjustments based on both a factor model consisting of the Fama and French (J. Financial Econ 33 (1993) 3) stock and bond market factors and a characteristics model based on bond ratings and duration. Cross-sectional Fama–MacBeth regressions that use individual bond data and control for stock and bond issuances in addition to ratings and duration also confirm the time-series portfolio findings. Overall, our results reveal an accrual anomaly among bonds similar to that observed among stocks.

Bradshaw, M.T., S.A.  Richardson, and R.G.  Sloan.  2001.  Do analysts and auditors use information in accruals? Journal of Accounting Research, Vol. 39, No. 1, pp. 45-74.

Existing research indicates that firms with high accruals are more likely to experience future earnings problems, but that investors’ expectations, as reflected in stock prices, do not appear to anticipate these problems. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they provide investors with information concerning the future earnings problems experienced by firms with high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts’ earnings forecasts do not incorporate the predictable future earnings declines associated with high accruals. Second, we examine the behavior of independent auditors. We find no evidence that auditors signal the future earnings problems associated with high accruals through either their audit opinions or through auditor changes. Overall, our evidence indicates that analysts and auditors do not alert investors to the future earnings problems associated with high accruals, thus corroborating previous findings that investors do not appear to anticipate these problems.

Chan, K., L.K.C. Chan, N. Jegadeesh, and J. Lakonishok. 2006. Earnings quality and stock returns, Journal of Business Vol.79, No.3, pp.1041-1082.

An exclusive focus on bottomline income misses important information contained in accruals (the difference between accounting earnings and cash flow) about the quality of earnings. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses—earnings manipulation, extrapolative biases about future growth, and under reaction to changes in business conditions—to explain accruals’ predictive power. Checks for robustness using within-industry comparisons and data on U.K. stocks are also provided.

Chan, Konan; Jegadeesh, Narasimhan and Sougiannis, Theodore, 2004, The Accrual Effect on Future Earnings, Review of Quantitative Finance and Accounting, Volume 22, Number 2, pp. 97-121.

Earnings manipulation has become a widespread practice for US corporations. However, most studies in the literature focus on whether certain incentives would facilitate managers to manipulate earnings and there has been little evidence documenting the consequences of earnings manipulation. This paper fills this gap by examining how current accruals affect future earnings (the accrual effect) and measuring the size of this effect. We find that the aggregate future earnings will decrease by $0.046 and $0.096, respectively, in the next one and three years for a $1 increase of current accruals. Over the very long-term (25 years), 20% of current accruals will reverse. This negative accrual effect is more significant for firms with high price-earnings ratios, high market-to-book ratios and high accruals where earnings management is more likely to occur. We show that incorporating the accrual effect is useful in improving the accuracy of earnings forecasts for these firms. Accordingly, the empirical results are consistent with the notion that earnings management causes the negative relationship between current accruals and future earnings. In addition, this paper shows that one recently developed accrual model has better performance than the popularly cited model in identifying manipulated earnings.

Chen K, Cash Flow and Accruals (2008)

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Cheng, C. and Thomas, W., 2006, Evidence of the abnormal accrual anomaly incremental to operating cash flows, The Accounting Review Vol.81, Issue 5, pp. 1151-1168.

Recent research provides evidence that the operating cash flows-to-price ratio subsumes accruals in explaining future annual returns. This suggests that the accrual anomaly is part of the overall value-glamour anomaly and does not represent the mispricing of earnings. We extend the literature by using multiple measures of abnormal accruals and separate analyses of future annual returns and future earnings announcement returns. The results reveal that the operating cash flows-to-price ratio does not subsume abnormal accruals in explaining future annual returns or future announcement returns. We also find that the operating cash flows-to-price ratio does not subsume total accruals in explaining future announcement returns. These results are not consistent with accruals being a manifestation of the value-glamour anomaly. Our study contributes to the current debate on the existence and the extent of the (abnormal) accrual anomaly. Moreover, the methodology employed can help researchers in exploring mispricing phenomena.

Chu, J. 2011. Does growth subsume the implications of accruals for future performance? Working paper.

There is ample confusion in the literature on the role of accruals and growth in explaining earnings persistence and future returns. The problem stems from accrual and growth proxies being positively correlated, and neither convincingly subsuming the other in empirical tests. This study identifies a subset of firms for which accruals do not capture growth, thus providing a discriminating test. Specifically, I focus on firms with negative operating cycles and non-cash net working capital balances. These firms typically have declining net working capital as they grow because their business models result in current liabilities increasing at a faster rate than current assets. In this setting, high growth firms tend to have negative accruals. Contrary to the growth hypothesis, high growth firms with low accruals experience high future profitability and returns. These findings indicate that accounting distortions embedded in accruals have distinct implications for future performance.

Collins, D. W., and P. Hribar. 2002. Errors in Estimating Accruals: Implications for Empirical Research. Journal of Accounting Research, 40: 105-134.

This paper examines the impact of measuring accruals as the change in successive balance sheet accounts, as opposed to measuring accruals directly from the statement of cash flows. Our primary finding is that studies using a balance sheet approach to test for earnings management are potentially contaminated by measurement error in accruals estimates. In particular, if the partitioning variable used to indicate the presence of earnings management is correlated with the occurrence of mergers and acquisitions or discontinued operations, tests are biased and researchers are likely to erroneously conclude that earnings management exists when there is none. Additional results show that the errors in balance sheet accruals estimation can confound returns regressions where discretionary and non-discretionary accruals are used as explanatory variables. Moreover, we demonstrate that tests of market mispricing of accruals will be understated due to erroneous classification of “extreme” accruals firms.

Collins, D. and Hribar, P., 2000, Earnings-based and accrual-based market anomalies: one effect or two? Journal of Accounting & Economics Vol.29, No.1, pp. 101-123.

This hentai porn paper investigates whether the accrual pricing anomaly documented by Sloan (1996) for annual data holds for quarterly data and whether this form of market mispricing is distinct from the post-earnings announcement drift anomaly. We find that the market appears to overestimate (underestimate) the persistence of the accrual (cash flow) component of quarterly earnings and, therefore, tends to overprice (underprice) accruals (cash flows). Moreover, the accrual (cash flow) mispricing appears to be distinct from post-earnings announcement drift. A hedge portfolio trading strategy that exploits both forms of market mispricing generates abnormal returns in excess of those based on unexpected earnings, accruals, or cash flow information alone.

Collins, celeb sex videos D., G. Gong, and P. Hribar. 2003. Investor sophistication and the mispricing of accruals. Review of Accounting Studies, Volume 8, Numbers 2-3, pp. 251-276.

This paper examines the role of institutional investors in the pricing of accruals. Using Bushee’s (1998) classification of institutional investors, we show that firms with a high level of institutional ownership and a minimum threshold level of active institutional traders have stock prices that more accurately reflect the persistence of accruals. This result holds after controlling for differences in the persistence of accruals between firms with high and low institutional ownership, and after controlling for other characteristics that are correlated with institutional ownership and future returns. Additionally, firms with low institutional ownership are smaller, less profitable, and have lower share turnover, suggesting that limits to arbitrage impede institutional investors from exploiting the seemingly large abnormal returns for these firms.

Colmes, Carmier Accruals, Investment 2010

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Cooper, M.J., H. Gulen, and, M.J. Schill. 2008. Asset growth and the cross-section of stock returns. The Journal of Finance, Volume 63, Number 4, pp. 1609-1651.

We test for firm-level asset investment effects in returns by examining the cross-sectional relation between firm asset growth and subsequent stock returns. Asset growth rates are strong predictors of future abnormal returns. Asset growth retains its forecasting ability even on large capitalization stocks. When we compare asset growth rates with the previously documented determinants of the cross-section of returns (i.e., book-to-market ratios, firm capitalization, lagged returns, accruals, and other growth measures), we find that a firm’s annual asset growth rate emerges as an economically and statistically significant predictor of the cross-section of U.S. stock returns.

Core, J.E.; Guay, W.R. and Verdi R., 2008. Is accruals quality a priced risk factor? Journal of Accounting and Economics Vol.46, Issue 1, pp. 2-22.

In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (FLOS) [2005. The market pricing of accruals quality. Journal of Accounting and Economics 39, 295–327] conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS’ regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor.

Dechow P., Kothari S.P., and Watts R, The Relation Between Earnings and Cash Flows, Journal of Accounting and Economics, Vol.25, 1998.

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firm’s series. The implications and predictions are tested on a 1337 firm sample over 1963–1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

Dechow, P, W. Ge, and C. Schrand, 2009. Earnings quality and earnings management. Journal of Accounting and Economics

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Dechow, P., and Ge, W., 2006, The persistence of earnings and cash flows and the role of special items: implications for the accrual anomaly. Review of Accounting Studies Volume 11, Numbers 2-3, pp. 253-296.

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

Dechow, P.M. and Dichev, I.D., 2002, The quality of accruals and earnings: The role of accrual estimation errors, The Accounting Review, Vol. 77, Supplement: Quality of Earnings Conference (2002), pp. 35-59.

This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. We argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. We derive an empirical measure of accrual quality as the residuals from firm-specific regressions of changes in working capital on past, present, and future operating cash flows. We document that observable firm characteristics can be used as instruments for accrual quality (e.g., volatility of accruals and volatility of earnings). Finally, we show that our measure of accrual quality is positively related to earnings persistence.

Dechow, P.M., W. Ge, C.R. Larson, and R.G. Sloan. 2011. Predicting Material Accounting Misstatements. Contemporary Accounting Research, Forthcoming.

We examine 2,190 Securities and Exchange Commission Accounting and Auditing Enforcement Releases (AAERs) issued between 1982 and 2005. We obtain a comprehensive sample of firms that are alleged to have misstated their financial statements. We examine the characteristics of misstating firms along five dimensions: accrual quality, financial performance, nonfinancial measures, off–balance sheet activities, and market-based measures. We compare misstating firms to themselves during nonmisstatement years and misstating firms to the broader population of all publicly listed firms. We find that managers appear to be hiding diminishing performance during misstatement years. We find that accruals are high and that misstating firms have a greater proportion of assets with valuations that are more subject to managerial discretion. In addition, the extent of leasing is increasing and there are abnormal reductions in the number of employees. Misstating firms are raising more financing, have higher price-to-fundamental ratios, and have strong prior stock price performance. We develop a model to predict accounting misstatements. The output of this model is a scaled logistic probability that we term the F-score, where values greater than one suggest a greater likelihood of a misstatement.

Dechow, P.M.; Richardson, S.A. and  Sloan, R.G., 2008, The persistence and pricing of the cash component of earnings, Journal of Accounting Research, Volume 46 Issue 3, pp. 537 – 566.

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments.

DeFond, Mark L. and Park, Chul W., 2001, The Reversal of Abnormal Accruals and the Market Valuation of Earnings Surprises, The Accounting Review, Vol. 76, No.3, pp. 375-404.

If the market anticipates the reversing nature of abnormal working capital accruals, then the reported magnitude of earnings surprises that contain abnormal accruals will differ from the underlying magnitude that is priced by the market. We expect the market’s perception of this difference to affect the ERCs associated with earnings surprises that contain abnormal accruals. We test our predictions using an abnormal accruals measure that captures the difference between reported working capital and a proxy for the market’s expectations of the level of working capital required to support current sales levels. Consistent with our hypotheses, we find higher ERCs when abnormal accruals suppress the magnitude of earnings surprises, and lower ERCs when abnormal accruals exaggerate the magnitude of earnings surprises. We also find results consistent with analysts predictably considering the reversing implications of abnormal accruals in revising future earnings forecasts. These findings are consistent with market participants anticipating the reversing implications of abnormal accruals. However, analysis of subsequent stock returns provides evidence that market participants do not fully impound the pricing implications of abnormal accruals at the earnings announcement date.

Desai, H. M.; Rajgopal, S. and Venkatachalam, M., 2004, Value-glamour and accruals mispricing: one anomaly or two? The Accounting Review, Vol.79, No. 2, pp. 355-385.

We investigate whether the accruals anomaly is a manifestation of the glamour stock phenomenon documented in the finance literature. Value (glamour) stocks, characterized by low (high) past sales growth, high (low) book-to-market (B/M), high (low) earnings-to-price (E/P), and high (low) cash flow-to-price (C/P), are known to earn positive (negative) future abnormal returns. Note that “C” or cash flow is operationalized in the finance literature as earnings adjusted for depreciation. Sloan (1996) shows that firms with low (high) total accruals earn positive (negative) future abnormal returns. We find that a new variable, operating cash flows measured as earnings adjusted for depreciation and working capital accruals, scaled by price (CFO/P) captures mispricing attributed to the four traditional value-glamour proxies and accruals. Interpretation of this finding depends on the reader’s priors. If the reader believes that value-glamour phenomenon can be operationalized only as C/P, and not CFO/P, then one would conclude that CFO/P is a parsimonious variable that captures the mispricing attributes of two distinct anomalies, value glamour and accruals. However, if a reader views the value-glamour anomaly broadly as a fundamentals-to-price anomaly, then (1) the CFO/P variable can be considered an expanded value-glamour proxy and; (2) our results are consistent with Beaver’s (2002) conjecture that the accruals anomaly is the glamour stock phenomenon in disguise.

Fairfield, P. M., Whisenant, J. S. and Yohn, T. L., 2003, Accrued earnings and growth: implications for future profitability and market mispricing, Accounting Review, Vol.78, No.1, pp. 353-371.

Prior research reveals that the accrual component of profitability is less persistent than the cash flow component, and that investors fail to fully appreciate their differing implications for future profitability (Sloan 1996). However, accruals are a component of growth in net operating assets as well as a component of profitability. Just as we can disaggregate profitability into accruals and cash flows from operations, we can disaggregate growth in net operating assets into accruals and growth in long-term net operating assets. We find that, after controlling for current profitability, both components of growth in net operating assets-accruals and growth in long-term net operating assets-have equivalent negative associations with one-year-ahead return on assets. This result is consistent with conservative accounting and diminishing marginal returns on investments. We also find that, after controlling for current profitability, the market appears to equivalently overvalue accruals and growth in long-term net operating assets relative to their association with one-year-ahead ROA. Our evidence suggests that the accrual anomaly documented in Sloan (1996) is a special case of what could be viewed as a more general growth anomaly.

Francis, J.; LaFond, R.; Olsson, P. and Schipper, K., 2005, The market pricing of accruals quality, Journal of Accounting and Economics Vol.39, Issue 2, pp. 295-327.

We investigate whether investors price accruals quality, our proxy for the information risk associated with earnings. Measuring accruals quality (AQ) as the standard deviation of residuals from regressions relating current accruals to cash flows, we find that poorer AQ is associated with larger costs of debt and equity. This result is consistent across several alternative specifications of the AQ metric. We also distinguish between accruals quality driven by economic fundamentals (innate AQ) versus management choices (discretionary AQ). Both components have significant cost of capital effects, but innate AQ effects are significantly larger than discretionary AQ effects.

Gerard X, Guido R, Koutsoyannis C, Tale of Two Strategies: Cash Flow, Accruals and the Role of Investor Sentiment State Street Global Advisors, London UK, E14 5NU

This study documents a subtle and counter-intuitive interaction between operating cash flow (CFO) and accruals, and their association with future stock returns. While the two strategies should by construction capture similar anomalies, we find evidence in two large stock markets that they appear distinct, and that returns to these strategies are strongly negatively correlated. We show that the presence and behavior of financially distressed firms influences asymmetrically the performance of accruals and CFO strategies. Given their highly speculative nature, we find investor sentiment to be an important determinant of the performance of financially distressed firms. Because accruals and CFO based strategies load asymmetrically on financially distressed securities, strategies based on accruals (cash flow) perform particularly well (poorly) during high sentiment periods and particularly poorly (well) during low sentiment periods.

Graham and Dodd. 1934. Security Analysis: Principles and Technique. 1E. New York and London: McGraw-Hill Book Company, Inc.

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Green, J., R.M. Hand J, and M. Soliman. 2010. Going, Going, Gone? The Demise of the Accruals Anomaly, Management Science.

Consistent with public statements made by sophisticated practitioners, we show that the hedge returns to Sloan’s (1996) accruals anomaly have decayed in U.S. markets to the point that they are no longer positive. While we cannot unambiguously identify the causal factor or factors involved, our empirical analyses suggest that the anomaly’s demise stems at least in part from a decline in the size of the mispricing signal (as measured by accruals in the extreme accruals deciles and the relative persistence of cash flows and accruals) and an increase in the capital invested by hedge funds into exploiting the signal (as measured by hedge fund assets under management and trading volume in extreme accrual decile firms). In light of the roles played by academic accountants in discovering and exploiting the accruals anomaly, we conclude that accounting scholarship can causally affect, not just associatively study, capital market prices and efficiency.

Hafzalla, N., R. Lundholm, and E. Van Winkle. 2011. Percent Accruals. Accounting Review, 86(1), 209-236.

We document how the effectiveness of an accruals-based trading strategy changes with the benchmark used to identify an extreme accrual. We measure “percent accruals” as accruals scaled by earnings, rather than total assets, and show that this seemingly small change produces a radically different sort of the data. We find that a trading strategy based on percent accruals yields significantly larger annual hedge returns than the traditional accruals measure, and does so mostly by improving the long position in low-accrual stocks. The hedge returns are also significant in all but the lowest quintile of arbitrage risk. We show that percent accruals more effectively select firms where the difference between sophisticated and naïve forecasts are the most extreme. As such, our results are consistent with the earnings fixation hypothesis and are inconsistent with some alternative explanations for the accrual anomaly. 

Hirshleifer, D., and Teoh, S.H., 2006, Limited investor attention and stock market misreactions to accounting information, Working Paper, Ohio State University.

We provide a model in which a single psychological constraint, limited investor attention, explains both under- and over-reaction to different earnings components. Investor neglect of information in current-period earnings about future earnings induces post earnings announcement drift, the strength of which is increasing with the persistence of earnings. Neglect of earnings components causes accruals and cash flows to predict abnormal returns. We derive new untested empirical implications relating the strength of the drift, accruals, and cash flow anomalies to the quality of earnings, to the number of distracting events, and to the volatilities of and correlation between accruals and cash flows.

Hirshleifer, D.A., K. Hou, and S.H. Teoh. 2011. The Accrual Anomaly: Risk or Mispricing? Management Science (forthcoming).

We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.16, higher than that of the market factor or the SMB and HML factors of Fama and French (1993). According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the loadings on this accrual factor-mimicking portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings suggest that investors misvalue the accrual characteristic, and cast doubt on the rational risk explanation.

Hirshleifer, D.A., K. Hou, S. Teoh, and Y. Zhang. 2004. Do investors overvalue firms with bloated balance sheets? Journal of Accounting and Economics 38, pp. 297-331.

When cumulative net operating income (accounting value-added) outstrips cumulative free cash flow (cash value-added), subsequent earnings growth is weak. If investors with limited attention focus on accounting profitability, and neglect information about cash profitability, then net operating assets, the cumulative difference between operating income and free cash flow, measures the extent to which reporting outcomes provoke over-optimism. During the 1964–2002 sample period, net operating assets scaled by total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

Hirshleifer, David A.; Hou, Kewei and Teoh, Siew Hong, Accruals and Aggregate Stock Market Returns, 2007, Journal of Financial Economics, Forthcoming.

Past research has shown that the level of operating accruals is a negative cross-sectional predictor of stock returns. This paper examines whether the accrual anomaly extends to the aggregate stock market. In contrast with cross-sectional findings, there is no indication that aggregate operating accruals is a negative time series predictor of stock market returns; the relation is strongly positive for the market portfolio and also for several sector and industry portfolios. In addition, innovations in accruals are negatively contemporaneously associated with market returns, suggesting that changes in accruals contain information about changes in discount rates, or that firms manage earnings in response to market-wide undervaluation.

Hirshleifer, David; Teoh, Siew Hong and Yu, Jeff Jiewei, 2007, Do short-sellers arbitrage accrual-based return anomalies? MPRA Paper No. 5510, posted 07. November 2007.

We find a positive association between short-selling and accruals, and between short selling and NOA, during 1988-2003. The accrual and NOA return anomalies are asymmetric. The absolute value of mean abnormal returns is larger for high-accrual firms than low-accrual firms on NASDAQ, but not on NYSE, and the abnormal return asymmetry is stronger among firms with low institutional holdings. For NOA, there is only limited evidence that the abnormal return asymmetry is stronger on NASDAQ than on NYSE. These findings indicate that there is short arbitrage of the accrual and NOA anomalies, but that short sale constraints limit the effectiveness of short arbitrage (especially among NASDAQ firms).

Houge, T. and Loughran, T. (2000) Cash Flow Is King? Cognitive Errors by Investors. Journal of Behavioral Finance, Vol. 1, No. 3 & 4, pgs 161 – 175.

When investors fixate on current earnings, they commit a cognitive error and fail to fully value the information contained in accruals and cash flows. Extending the accrual anomaly documented by Sloan [1996], we identify significant excess returns from a cash flow-based trading strategy. The market consistently underestimates the transitory nature of accruals and the long-term persistence of cash flows. We find that the accrual anomaly derives from the poor performance of high accrual firms, which are more likely to manage earnings. Combining the accrual and cash flow information also reveals that investors misvalue the quality of earnings. Contrary to Fama [1998], these anomalies are robust to the three-factor model with equally or value-weighted portfolio returns.

Hribar, Paul and Collins, Daniel W., 2002, Errors in Estimating Accruals: Implications for Empirical Research, Journal of Accounting Research, Vol. 40, No. 1, pp. 105-134.

This paper examines the impact of measuring accruals as the change in successive balance sheet accounts, as opposed to measuring accruals directly from the statement of cash flows. Our primary finding is that studies using a balance sheet approach to test for earnings management are potentially contaminated by measurement error in accruals estimates. In particular, if the partitioning variable used to indicate the presence of earnings management is correlated with the occurrence of mergers and acquisitions or discontinued operations, tests are biased and researchers are likely to erroneously conclude that earnings management exists when there is none. Additional results show that the errors in balance sheet accruals estimation can confound returns regressions where discretionary and non-discretionary accruals are used as explanatory variables. Moreover, we demonstrate that tests of market mispricing of accruals will be understated due to erroneous classification of “extreme” accruals firms.

Jeuttner-Nauroth, B. and K. Skogsvik (2005). ‘A Note on the Impact of Conservative Accounting Principles in Abnormal Earnings Growth Modeling and Residual Income Valuation Modeling’. Working Paper. Deutsche Bundesbank and Stockholm School of Economics.

2009 Version:

The impact of conservative accounting in residual income valuation (RIV) and abnormal earnings growth (AEG) valuation modeling is investigated in this paper. Unconstrained and two types of constrained model specifications are evaluated regarding their ability to withstand biases in book values and earnings due to accounting conservatism. Given that the “clean surplus relation” holds and that the precision of forecasted accounting numbers is unaffected by the type of accounting principles, the unconstrained valuation models are – not surprisingly – found to be immune to conservatism. This does not hold for the constrained models, even though conservatism can be accommodated in these if the time-series specification of the conservative bias fulfils certain conditions. In a comparison between terminal value constrained models, the AEG model is found to be superior to the RIV model if the growth of the conservative bias in the terminal period is not too extreme. Comparing the information dynamics constrained models being proposed in Ohlson (1995) and Ohlson & Juettner-Nauroth (2005), the AEG model is potentially more accurate than the RIV model. However, in a company steady state setting with constant growth, there is no comparative advantage for the AEG model. Also, using the same set of forecasted accounting numbers in the information dynamics constrained RIV model as in the corresponding AEG model, the two models cannot be ranked.


Kang, Qiang; Liu, Qiao and Qi, Rong, 2006, Predicting Stock Market Returns with Aggregate Discretionary Accruals, EFA 2006 Zurich Meetings Paper.

2010 Version:

We find that the positive relation between aggregate accruals and one-year-ahead market returns documented in Hirshleifer, Hou, and Teoh [2009] is driven by discretionary accruals but not normal accruals. The return forecasting power of aggregate discretionary accruals is robust to choices of sample periods, return measurements, estimation methods, business condition and risk premium proxies, and accrual models used to isolate discretionary accruals. Our extensive analysis shows that aggregate discretionary accruals, in sharp contrast to aggregate normal accruals, contain little information about overall business conditions or aggregate cash flows and display little co-movement with ICAPM-motivated risk premium proxies. Our findings imply that aggregate discretionary accruals likely reflect aggregate fluctuations in earnings management, thereby favoring the behavioral explanation that managers time aggregate equity markets to report earnings.

2006 Working Paper:

We document that the value-weighted aggregate discretionary accruals have significant power in predicting the one-year-ahead stock market returns between 1965 and 2004. The predictive relation is stable and robust to different ways to measure market returns and discretionary accruals as well as to the inclusion of other known return predictors. The value-weighted aggregate discretionary accruals are positively related to future stock market returns and negatively correlated with contemporaneous market returns. Our extensive analysis favors the managerial equity market timing story and suggests that managers of large firms have stronger market timing ability than managers of small firms.

Kaserer C , Klinger, C ,  The Accrual Anomaly Under Different Accounting Standards   Lessons Learned from the German Experiment , Journal of Business Finance & Accounting , Vol. 35 , No 7-7 , pp 837-859 , 2008

Several studies document that investors systematically overreact to accrual-based accounting information. We address the question to what extent this accrual anomaly is related to different accounting standards. We provide empirical evidence that the accrual anomaly is also present in Germany. However, this anomaly seems mainly to be driven by firms presenting their financial statements under IFRS or US-GAAP, while the anomaly is unlikely to exist for those firms complying with German GAAP. It is argued that introducing true and fair view accounting, like IFRS, that relies on difficult-to-verify information, may not be suitable to improve accounting information quality in the context of a weak corporate governance system.

Khan, M. 2008. Are accruals mispriced: evidence from tests of an intertemporal capital asset pricing model? Journal of Accounting and Economics Volume 45, Issue 1, pp. 55-77.

This paper proposes a risk-based explanation for the accrual anomaly. Risk is measured using a four-factor model motivated by the Intertemporal Capital Asset Pricing Model. Tests of the model suggest that a considerable portion of the cross-sectional variation in average returns to high and low accrual firms is explained by risk. The four-factor model also performs better than some other widely used models in pricing a number of different hedge portfolios.

Kothari S., Sabino J., Zach T., 2005, Implications of Survival and Data Trimming for Tests of Market Efficiency, Journal of Accounting & Economics 39, 129-161.

Predictability of future returns using ex ante information (e.g., analyst forecasts) violates market efficiency. We show that predictability can be due to non-random data deletion, especially in skewed distributions of long-horizon security returns. Passive deletion arises because some firms do not survive the post-event long horizon. Active deletion arises when extreme observations are truncated by the researcher. Simulations demonstrate that data deletion induces a negative relation between future returns and ex ante information variables. Analysis of actual data suggests a 30–50% bias in the estimated relations. We recommend specific robustness checks when testing return predictability using ex ante information.

Kothari, S., E. Loutskina and V. Nikolaev, 2006, Agency theory of overvalued equity as an explanation for the accrual anomaly, CentER Discussion Paper, No. 2006-103, pp.1-65., Tilburg University Center for Economic Research.

We show that the agency theory of overvalued equity (see Jensen, 2005) rather than investors’ fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996).Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms’ accruals upwards to prolong the overvaluation. Thus, high-accrual portfolios are likely to be over-represented with over-valued firms. Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms. In contrast, undervalued firms do not face incentives to report low accruals, so undervalued firms are not concentrated in low accrual decile portfolios. Therefore, across the accrual decile portfolios, we predict and find an asymmetric relation between accruals and both prior and subsequent returns. In addition, consistent with the predictions of the agency theory of overvalued equity, we find high, but not low, accrual firms’ investment-financing decisions and insider trading activity are distorted, and analyst forecast optimism is concentrated among the high-accrual decile portfolios. Overall, return behavior, analyst optimism, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity, but do not support investor fixation on accruals.

Kraft, A., A. Leone, and C. Wasley. 2006. An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components. Journal of Accounting Research 44, no. 2: 297-339

Numerous accounting studies claim that investors fail to rationally price accrual-related information and that investors are functionally fixated. This study documents the importance of performing robustness tests when testing economic or behavioral explanations for apparent accounting-related security mispricing. We find that performing robustness tests that exclude a small number of firm-year observations (approximately 200 firm-year observations or about 1% of the entire sample) reveals an inverted U-shaped relation between buy-and-hold abnormal returns and total accruals. An inverted U-shaped relation is inconsistent with the functional fixation (earnings fixation) hypothesis. We conduct similar robustness tests for the abnormal accrual anomaly and the net operating assets anomaly proposed by other investigators, and also find an inverted U-shaped relation between buy-and-hold abnormal returns and abnormal accruals and net operating assets. These findings are inconsistent with the explanations put forth by those investigators. Such evidence leads us to conclude that the accrual-related anomalies are unlikely to be due to investors’ inability to process accounting information, as suggested by the functional fixation hypotheses tested.

Kraft, A., A. Leone, and C. Wasley. 2007. Regression-based tests of the market pricing of accounting numbers: The Mishkin test and ordinary least squares. Journal of Accounting Research Vol.45, No.5, pp. 1081-1114.

The test developed in Mishkin [1983] (hereafter, MT) is widely used to test the rational pricing of accounting numbers. However, contrary to the perception in the accounting literature, the exclusion of variables from the MT’s forecasting and pricing equations leads to an omitted variables problem that affects inferences about the rational pricing of accounting variables. Only if the omitted variables are rationally priced is their exclusion irrelevant. Failure to recognize this issue leads accounting researchers to employ the MT without appreciating how omitted variables affect the inferences they draw. We demonstrate that when additional explanatory variables are included in the MT, the rational pricing of accruals is not rejected. That is, the accrual anomaly documented in Sloan [1996] vanishes when additional explanatory variables are incorporated into the MT. We also show that in accounting research settings, where samples are large, ordinary least squares (OLS) is equivalent to the MT. As a result, accounting researchers should consider using OLS or be more explicit about the exact advantages of the MT over OLS in their research setting.

LaFond, R., 2005, Is the accrual anomaly a global anomaly? MIT Sloan School of Management Working Paper, 4555-05.

This paper investigates the subsequent return implications of accruals within a sample of large, developed, international equity markets and assesses whether similar institutional features account for the accrual anomaly across countries. I investigate the returns implications of accruals in 17 countries over the 1989 to 2003 time period. In general, the results of country-specific analysis indicate that the accrual anomaly is a global phenomenon. After decomposing total accruals, I find, in general, that accrual mispricing is largest for working capital accruals, specifically current asset accruals. However, the results of further analysis suggest that there is no dominant factor that explains the accrual anomaly internationally. Overall, the results indicate that the accrual anomaly is present in international markets yet the factor(s) driving the accrual anomaly appear to vary across markets.

Leippold, M., and H. Lohre. 2010. Data Snooping and the Global Accrual Anomaly. Working paper. 2010, EFA 2007 Ljubljana Meetings Paper.

Naively testing for accruals mispricing in 26 equity markets – one market at a time – we find statistical evidence of anomalous returns in some countries. However, some of these findings might well be spurious because of data snooping biases that arise when simultaneously testing several hypotheses. While the accrual anomaly is not deemed to be robust in some countries when properly accounting for multiple testing we find the international momentum effect to by and large pass the battery of multiple testing procedures. Moreover, we find the few robust accrual anomalies vanishing in recent times indicating that investors have been exploiting the mispricing.

Lev, B., and D. Nissim. 2006. The Persistence of the Accruals Anomaly. Contemporary Accounting Research 23, no. 1 (2006): 193-226.

The accruals anomaly — the negative relationship between accounting accruals and subsequent stock returns — has been well documented in the academic and practitioner literatures for almost a decade. To the extent that this anomaly represents market inefficiency, one would expect sophisticated investors to learn about it and arbitrage the anomaly away. We show that the accruals anomaly still persists and, even more strikingly, its magnitude has not declined over time. How can this be explained? We show that the accruals anomaly is recognized and, indeed, exploited by certain active institutional investors, but the magnitude of this accruals-related trading is rather small. By and large, institutions shy away from extreme-accruals firms because their attributes, such as small size, low profitability, and high risk stand in stark contrast to those preferred by most institutions. Individual investors are also, by and large, unable to profit from trading on accruals information due to the high information and transaction costs associated with implementing a consistently profitable accruals strategy. Consequently, the accruals anomaly persists and will probably endure.

Levi, S., 2008, Voluntary disclosure of accruals in earnings press releases and the pricing of accruals. Review of Accounting Studies Vol.13, No.1, pp. 1-21.

This study investigates firms’ decisions to disclose accruals information in earnings press releases versus to provide it only in 10-Q filings and the impact of this disclosure on the pricing of accruals. I find that firms disclose accruals in their press releases when earnings alone are a weak indication of cash flow performance and that following these disclosures the accruals information is fully impounded into stock prices. The evidence suggests that when investor demand for accruals is likely to exist and firms disclose the information in earnings press releases, the mispricing typically associated with accruals is mitigated.

Li, Dongmei and Zhang, Lu, Does q-theory with investment frictions explain anomalies in the cross-section of returns? Journal of Financial Economics, forthcoming.

Q-theory predicts that investment frictions steepen the relation between expected returns and firm investment. Using financing constraints to proxy for investment frictions, we document only weak evidence that the investment-to-assets and asset growth effects in the cross-section of returns are stronger in financially more constrained firms than in financially less constrained firms. There is no evidence that q-theory with investment frictions explains the investment growth, net stock issues, abnormal corporate investment, or net operating assets anomalies. Limits-to arbitrage proxies dominate q-theory with investment frictions in explaining the magnitude of the investment-to-assets and asset growth anomalies in direct comparisons.

Li, F., 2008, Annual report readability, current earnings and earnings persistence, Journal of Accounting and Economics Volume 45, Issues 2-3, pp. 221-247.

This paper examines the relation between annual report readability and firm performance and earnings persistence. I measure the readability of public company annual reports using the Fog index from the computational linguistics literature and the length of the document. I find that: (1) the annual reports of firms with lower earnings are harder to read (i.e., they have a higher Fog index and are longer); and (2) firms with annual reports that are easier to read have more persistent positive earnings.

Liu and Winstock (2006) 

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Livnat, J. and M. Santicchia. 2006. Cash Flows, Accruals and Future Returns. Financial Analysts Journal 62, no. 4 (2006): 48-61.

The study of the “accrual anomaly” reported here is unique because it analyzed originally reported–unrestated–quarterly data for 1991 through the first quarter of 2004 to calculate accruals and used U.S. SEC filing dates to identify the day on which investors first obtained information about accruals. The study found that the accrual anomaly exists for quarterly accruals as has been found for annual accruals. Future quarterly earnings were found to be more highly associated with current net operating cash flows than with accruals because accruals have less persistence. Companies with extremely high (low) current quarterly accruals have significant and negative (positive) abnormal returns through the subsequent four quarters.

Livnat, Joshua and López Espinosa, Germán, 2008, Quarterly Accruals or Cash Flows in Portfolio Construction? Financial Analysts Journal, Vol. 64, No. 3, pp. 67-79.

This study explores the incremental roles of accruals and net operating cash flows in generating abnormal returns using quarterly and rolling four-quarter data for the entire population of firms, as well as specific industries. Our results show that quarterly net operating cash flow (OCF) is a stronger signal about subsequent quarter’s returns than accruals, and that this result is also true for rolling four-quarter OCF and accruals data. However, when rolling four-quarter OCF and accruals are used to construct portfolios that are held for a whole year, OCF dominates accruals in the first three fiscal quarters, but not in the fourth quarter. Our industry-specific results are consistent with the entire population results; OCF is a stronger signal of future returns than accruals. Investment managers and financial analysts should focus more attention on the OCF than accruals, except possibly for industries where accruals are important in predicting future returns.

Livnat, Joshua and Petrovits, Christine, Investor Sentiment, Post-Earnings Announcement Drift, and Accruals, 2009, AAA 2009 Financial Accounting and Reporting Section (FARS) Paper.

There is growing evidence in the finance literature that investor sentiment affects stock prices. We examine whether stock price reactions to earnings surprises and accruals vary systematically with the level of investor sentiment. Using quarterly drift tests and monthly trading strategy (calendar time) tests, we find evidence that holding extreme good news firms following pessimistic sentiment periods earns significantly higher abnormal returns than holding extreme good news firms following optimistic sentiment periods. Similarly, our results suggest that holding low accrual firms following pessimistic sentiment periods earns significantly higher abnormal returns than holding low accrual firms following optimistic sentiment periods. We also document that abnormal returns in the short-window around preliminary earnings announcements for extreme good news firms are significantly higher during periods of low sentiment than during periods of high sentiment. Overall, our results indicate that investor sentiment influences the source of excess returns from earnings-based trading strategies.

Mashruwala, C., S. Rajgopal, and T. Shevlin, 2006. Why is the accrual anomaly not arbitraged away? The role of idiosyncratic risk and transaction costs. Journal of Accounting and Economics. Vol.42, Issues 1-2, pp. 3-33.

We show that the accrual anomaly documented by Sloan (1996) [Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71: 289–315] is concentrated in firms with high idiosyncratic stock return volatility making it risky for risk-averse arbitrageurs to take positions in stocks with extreme accruals. Moreover, the accrual anomaly is found in low-price and low-volume stocks, suggesting that transaction costs impose further barriers to exploiting accrual mispricing.

Mishkin, F. 1983. A Rational Expectations Approach to Macroeconomics: Testing Policy Ineffectiveness and Efficient-Markets Models, National Bureau of Economic Research, Inc. Pincus, M., Rajgopal, S. and Venkatachalam, M. 2007. The accrual anomaly: international evidence. Accounting Review 82, No.1, pp. 169-203.

Google Books:

Ng, J., 2005, Distress risk information in accruals, Working Paper, The Wharton School, University of Pennsylvania.

Past accruals anomaly studies have documented results that suggest that distress risk increases systematically across decreasing accruals portfolios. I investigate and find a negative relation between accruals and distress risk, evidence that suggests that the accruals trading strategy of buying firms with low accruals and selling firms with high accruals results in exposure to higher distress risk. I show that distress risk is compensated by higher future returns. I then show that the future abnormal returns from the accruals trading strategy decline after controlling for distress risk. This evidence suggests that that at least part of the high abnormal returns to the accruals trading strategy should be reclassified as normal returns for engaging in a trading strategy that involves higher distress risk. In addition, I find that the abnormal returns to the accruals trading strategy are largely driven by trading in firms within high distress risk portfolios.

Nikbakht – Tehran Stock Exchange – Accruals (2010)


Nikbakht and Aflatooni. (2010). The Value Relevance of Earnings Components in Two Different GAAPs.

The purpose of this study is to explore attribute differences between U.S. GAAP and Iranian GAAP (IRA-GAAP) earnings components. We compare the relative and incremental value relevance of IRA-GAAP and U.S. GAAP based operating cash flows and accruals. The issue is investigated by regressing listed Iranian firms’ stock returns on the levels of operating cash flows and accruals in IRA-GAAP and same items adjusted to U.S. GAAP.

The kamagra online results indicate that there are no significant differences between IRA-GAAP and U.S. GAAP based earnings components in explaining stock returns. Thus, operating cash flows and accruals components based on IRA-GAAP are not more value relevant than operating cash flows and accruals components adjusted to U.S. GAAP.

The results of this study have important implications for accounting standards setters in Iran and other countries about how cash flow statement classifications affect the value relevance of their items.

Penman, S., and X. Zhang, 2002. Accounting conservatism, the quality of earnings, and stock returns. The Accounting Review Vol.77, No.2, pp. 237-264.

When a firm practices conservative accounting, changes in the amount of its investments can affect the quality of its earnings. Growth in investment reduces reported earnings and creates reserves. Reducing investment releases those reserves, increasing earnings. If the change in investment is temporary, then current earnings is temporarily depressed or inflated, and thus is not a good indicator of future earnings. This study develops diagnostic measures of this joint effect of investment and conservative accounting. We find that these measures forecast differences in future return on net operating assets relative to current return on net operating assets. Moreover, these measures also forecast stock returns-indicating that investors do not appreciate how conservatism and changes in investment combine to raise questions about the quality of reported earnings.

Penman, S.H., 2001, On comparing cash flow and accrual accounting models for use in equity valuation: A response to Lundholm and O’Keefe (CAR, Summer 2001), Contemporary Accounting Research Vo.18, No.4, pp. 681-692.

A claim is commonly made that cash flow and accrual accounting methods for valuing equities must always yield equivalent valuations. A recent paper by Lundholm and O’Keefe 2001, for example, claims that, because of this equivalence, there is nothing to be learned from empirical comparison of valuation models. So they dismiss recent research that has shown that accrual accounting residual income models and earnings capitalization models perform, over a range of conditions, better than cash flow or dividend discount models. This paper demonstrates, with examples, that the claim is misguided. Practice inevitably involves forecasting over finite, truncated horizons, and the accounting specified in a model — cash versus accrual accounting in particular — is pertinent to valuation with finite-horizon forecasting. Indeed, the issue of choosing a valuation model is an issue of specifying pro forma accounting, and so, for finite-horizon forecasts, one cannot be indifferent to the accounting.

Pincus, M.; Rajgopal, S. and Venkatachalam, M., 2007, The accrual anomaly: international evidence. Accounting Review 82, No.1, pp. 169-203.

We consider stock markets in 20 countries to investigate whether the accrual anomaly (Sloan 1996), characterized by U.S. stock prices overweighting the role of accrual persistence, is a local manifestation of a global phenomenon. We explore whether the occurrence of the anomaly is related to country differences in accounting and institutional structures, and examine alternative explanations for its occurrence. We find stock prices overweight accruals in general, with accruals overweighting occurring in countries with a common law relative to a code law tradition. Using firm level data on a country-by-country basis, we document the occurrence of the anomaly in four countries, Australia, Canada, the U.K., and the U.S., and also in a sample of American Depository Receipts (ADRs) of firms domiciled in countries where we do not detect the anomaly. Using country-level data, we confirm the anomaly is more likely to occur in countries having a common law tradition, and also in countries allowing extensive use of accrual accounting and having a lower concentration of share ownership. Additional analyses reveal that earnings management and barriers to arbitrage best explain the anomaly.

Richardson, S.A., R.G. Sloan, M.T. Soliman, and I. Tuna. 2005. Accrual reliability, earnings persistence and stock prices. Journal of Accounting & Economics. Volume 39, Issue 3, pp.437-485.–files/alpha/SSRN-id521062.pdf

This paper extends the work of Sloan (1996. The Accounting Review 71, 289) by linking accrual reliability to earnings persistence. We construct a model showing that less reliable accruals lead to lower earnings persistence. We then develop a comprehensive balance sheet categorization of accruals and rate each category according to the reliability of the underlying accruals. Empirical tests generally confirm that less reliable accruals lead to lower earnings persistence and that investors do not fully anticipate the lower earnings persistence, leading to significant security mispricing. These results suggest that there are significant costs associated with incorporating less reliable accrual information in financial statements.

Richardson, S.A., R.G. Sloan, M.T. Soliman, and I. Tuna. 2006. The Implications of Accounting Distortions and Growth for Accruals and Profitability. Accounting Review. Vol.81, No.3, pp. 713-743.

Following Sloan (1996), numerous studies document that the accrual component of earnings is less persistent than the cash flow component of earnings. Disagreement exists, however, as to the explanation for this result. One stream of literature follows Sloan’s lead in arguing that this result is attributable to accounting distortions (Xie 2001; Dechow and Dichev 2002; Richardson et al. 2005). A second stream of literature argues that this result is attributable to a more general growth effect and that growth-related factors such as diminishing returns to new investment explain the lower persistence of accruals (e.g., Fairfield et al. 2003a; Cooper et al. 2005). We provide new evidence indicating that temporary accounting distortions are a significant contributing factor to the lower persistence of the accrual component of earnings. Our evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to sales growth and that extreme accruals are systematically associated with alleged cases of earnings manipulation.

Shi, L., and H. Zhang. 2011. Can the Earnings Fixation Hypothesis Explain the Accrual Anomaly? The Review of Accounting Studies (forthcoming).

This old milf paper provides empirical evidence to distinguish the earnings fixation hypothesis and the growth hypothesis, two competing explanations for the accrual anomaly originally documented in Sloan (1996). The earnings fixation hypothesis suggests that the accrual anomaly is due to investors’ fixation on reported earnings while the growth hypothesis suggests that the accrual anomaly is a manifestation of a more general growth risk/anomaly. We argue that, if investors fixate on reported earnings, future returns are related to not only accruals but also the responsiveness of the stock price to earnings, which leads to the empirical prediction that the returns to the accrual strategy are positively correlated with the stock price’s responsiveness to earnings. Our empirical evidence confirms this prediction and thus lends support to the earnings fixation hypothesis, but not to the growth hypothesis.

Singer, hot gay porn Sougiannis, Fedk (2010) – Does Accrual Anomaly End when Abnormal Accruals Reverse

The accrual anomaly is the negative relationship between extreme accruals and future stock returns. The fixation hypothesis states that this anomaly is due to mispricing caused by investor fixation on reported earnings without considering the reversing nature of accruals. The hypothesis implies that the market correction of the mispricing takes place when accruals reverse in the future, and that there should be no mispricing beyond the reversal point. We perform the most direct test of the fixation hypothesis by detecting not only the initiation but also the reversal of extreme abnormal accruals. For both extreme positive and extreme negative abnormal accruals firms, we find a significant association between the reversal quarter’s returns and the initiated accruals, but no association between initiated accruals and returns after the accruals reversal. Thus, the mispricing ends when the accruals reversal is complete, a result that supports the fixation hypothesis as an explanation for the accrual anomaly. In contrast to Fairfield et al. (2003), we find that the accrual anomaly is distinct from the growth in assets anomaly, and in contrast to Khan (2008), our controls for four well-known risk factors do not eliminate the accrual anomaly. We also find that analysts do not fully anticipate the reversal of accruals.

Skinner, D.J. 1994. Why Firms Voluntarily Disclose Bad News? Journal of Accounting Research, Vol. 32, No. 1 (Spring), pp. 38-60.

No abstract.

Sloan, R. G., P.M. Dechow, A.P. Hutton, and J.H. Kim. 2010. Detecting Earnings Management: A New Approach. Working paper.

This paper provides new approach for the detection of earnings management. Our approach exploits the inherent property of accrual accounting that any accrual-based earnings management in one period must reverse in another period. If the researcher has priors concerning the timing of the reversal, then incorporating these priors can significantly improve the power and specification of tests for earnings management. Our results suggest that the power of typical accrual-based models can be almost doubled and misspecification in samples with extreme earnings performance is substantially mitigated.

Sloan, R.G. 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, Vol. 71, No.3, pp. 289-315.

This paper investigates whether stock prices reflect information about future earnings contained in the accrual and cash flow components of current earnings. The extent to which current earnings performance persists into the future is shown to depend on the relative magnitudes of the cash and accrual components of current earnings. However, stock prices are found to act as if investors “fixate” on earnings, failing to reflect fully information contained in the accrual and cash flow components of current earnings until that information impacts future earnings. 

Soares  N , Stark  A  The Accruals Anomaly – Can Implementable Portfolio Strategies be Developed that are Profitable Net of Transaction Costs in the UK ?  September 2008

In black porn this paper, we provide evidence related to the existence, or otherwise, of the accruals anomaly in the UK stock market. Specifically, we find that average annual abnormal returns generally decline as prior period accruals move from low to high. This outcome can be interpreted as broadly consistent with the accruals anomaly via which investors overweight the persistence of accruals and underweight the persistence of cash flows in predicting next period’s earnings. Our results suggest that to make money out of any mispricing based upon ranking firms by accruals generally requires a portfolio strategy with long and, in particular, short positions in portfolios featuring relatively small capitalization firms. When taking into account conservative estimates of trading costs, the investment strategy is seen to generate losses if an initially equally-weighted investment approach is used or positive, but not statistically significant, abnormal returns if a value-weighted approach is followed. Overall, we conclude that, whilst there is evidence of mispricing consistent with the accruals anomaly, the profitable exploitation of the anomaly is not necessarily possible when transactions costs are taken into account. Thus, the accruals anomaly is not so egregious in the UK as to challenge the semi-strong version efficient markets hypothesis.

Teoh, S.H. and Y. Zhang.2009. Data Truncation Bias, Loss Firms, and Accounting Anomalies. AAA 2006 Financial Accounting and Reporting Section (FARS) Meeting Paper.

After performing a Least Trimmed Square procedure at 1%, Kraft, Leone, and Wasley (2006) find an inverted-U relation between Accruals or net operating assets (NOA) and subsequent one-year abnormal returns. They argue that this opposes behavioral explanations for the Accrual and NOA anomalies. We show that the inverted-U relation is a spurious consequence of the truncation bias noted in Kothari, Sabino, and Zach (2005). LTS trimming for these anomalies effectively trims observations by the value of the dependent variable (returns). We show that because returns skewness varies systematically with the accounting predictor, the LTS trimming induces a truncation bias that varies systematically across the accounting predictors. The variation in returns skewness is related to the variation in the incidence of loss firms across the accounting predictors. Among profit firms, which have less skewed returns and so are less subject to the truncation bias, the negative monotonic relation between accounting predictors and subsequent abnormal returns is robust to trimming. Thus, ex post non-random trimming of returns can spuriously induce evidence against either the efficient market hypothesis or behavioral theories. Additionally, this paper shows that the anomalies survive trimming, despite the truncation bias, when a larger set of asset pricing controls and test methods that control for cross-sectional dependence are used.

Thomas, J.K., and H. Zhang. 2002. Inventory Changes and Future Returns. Review of Accounting Studies, Vol. 7, 1 pp. 63-187, 2002.

We find that the negative relation between accruals and future abnormal returns documented by Sloan (1996) is due mainly to inventory changes. We propose three explanations for this result, derived from the prior literature, but find evidence inconsistent with all three explanations. To assist future investigations in formulating additional explanations, we document several empirical regularities for extreme inventory change deciles. We speculate that demand shifts explain our results, and examine the feasibility of alternative reasons for the stock market’s apparent inability to recognize the impending profitability reversals. Our evidence is consistent with earnings management masking the implications of demand shifts.

Wu, porn mobile Jin (Ginger); Zhang, Lu and Zhang, Frank, 2009, The Q-Theory Approach to Understanding the Accrual Anomaly, Journal of Accounting Research, Forthcoming.

Interpreting accruals as working capital investment, we hypothesize based on q-theory that firms optimally adjust their accruals in response to discount rate changes. A higher discount rate means less profitable investments and lower accruals, and a lower discount rate means more profitable investments and higher accruals. Our evidence supports this optimal investment hypothesis: (1) adding an investment factor into standard factor regressions substantially reduces the magnitude of the accrual anomaly, often to insignificant levels; (2) accruals covary negatively with discount rate estimates from the dividend discounting model, and for the most part, with estimates from the residual income model; (3) accruals with low accounting reliability covary more with capital investment than accruals with high accounting reliability; and (iv) expected returns to accruals-based trading strategies are time-varying, suggesting that the deterioration of the accrual effect in recent years might be temporary and likely to mean-revert in the near future.

Xie, H. 2001. The Mispricing of Abnormal Accruals. The Accounting Review, Vol. 76. 2001, pp. 357-373.

This paper examines the market pricing of Jones (1991) model-estimated 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.

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Zach, T. (2007) Evaluating the ‘Accrual-Fixation’ Hypotheses as an Explanation for the Accrual Anomaly, Working paper, Ohio State University

Sloan (1996)’s result of return predictability based on accrual information has generated a large stream of literature. Sloan’s (1996) explanation for the phenomenon is that investors fixate on earnings without taking into account accruals’ tendency to reverse. Thus, the returns to an accrual strategy are related to accrual reversals. In this study, I directly examine this explanation. I use two properties of the accrual-fixation hypothesis – reversals and overreaction – to generate testable empirical predictions. First, I find that extreme accrual firms tend to remain in extreme deciles in two consecutive years. Further, I find that these sticky firms are associated with future abnormal returns, suggesting that the returns are not a result of accrual reversals, as implied by the accrual-fixation hypothesis. Second, I do not find any evidence of overreaction to accrual information based on the relation between the returns around earnings announcements in successive quarters. Overall, I conclude that my results are not consistent with the accrual-fixation hypothesis. A more conservative interpretation of my results is that the accrual-fixation hypothesis is not the major explanation for the accrual anomaly.

Zach, T., 2005, Evaluating the accrual-fixation hypothesis as an explanation for the accrual anomaly, Washington University Working Paper.

Sloan (1996) and a number of subsequent studies present evidence that a trading strategy based on publicly available accounting accruals earns abnormal returns of approximately 10% in the year following its initiation. This empirical regularity has been named the ‘accrual anomaly’. In this paper I investigate the accrual anomaly along two dimensions. First, I evaluate whether the accrual anomaly is related to other anomalies documented in the finance literature. Second, I investigate whether different methods for calculating long-term abnormal returns have an effect on the returns to the accrual strategy.

My results indicate that both mergers and divestitures have an effect on the returns generated by the accrual strategy. After excluding observations associated with either mergers or divestitures, there is a decrease of about 25% in the strategy’s returns. Second, different calculation methods for benchmark portfolio returns do not have a material effect on the returns of the accrual strategy. Third, when book-to-market is added to size as a second control for normal returns, returns to the accrual strategy decrease by approximately 20%. Fourth, the accrual strategy’s returns are much larger in a sample of Nasdaq firms. Overall, I conclude that the accrual anomaly is sensitive to the series of tests conducted in this study, although a substantial portion of it remains unexplained.

Zhang, F., 2007, Accruals, investment, and the accruals anomaly, The Accounting Review, Volume 82, Issue 5, pp.1333-1364.

This paper investigates two competing hypotheses for the accrual anomaly: investment/growth and persistence. Both investment/growth and persistence information in accruals are likely to vary cross-sectionally, depending on a firm’s business model, a fact that generates different cross-sectional implications for the accrual anomaly. I find that the magnitude of the accrual anomaly monotonically increases with the investment information contained in accruals, as measured by the co-variation between accruals and employee growth. In industries/firms in which accruals co-vary with employee growth, accruals show strong predictive power for future stock returns. In industries/firms in which accruals show little correlations with employee growth, the accrual anomaly is much weaker. In contrast, the evidence from the cross-sectional analysis is inconsistent with the persistence argument. From the earnings perspective, the evidence on one-year-ahead earnings growth is inconclusive, but the results on longer-term earnings growth support the investment argument but not the persistence argument. Collectively, I conclude that these results support the view that the accrual anomaly is attributable to the fundamental investment information contained in accruals.

Zhang, L., 2005, The value premium, Journal of Finance Vol. 60, No. 1, pp. 67-103.

The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linking risk and expected returns to economic primitives, such as tastes and technology, my model generates many empirical regularities in the cross-section of returns; it also yields an array of new refutable hypotheses providing fresh directions for future empirical research.

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