No abstract

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.

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.

A fundamental property of accrual accounting is to smooth temporary timing fluctuations in operating cash flows, indicating an inherent negative correlation between accruals and cash flows. We show that the overall correlation between accruals and cash flows has dramatically declined in magnitude over the past half century and has largely disappeared in more recent years. The adjusted R 2 from regressing (changes in) accruals on (changes in) cash flows drops from about 70% (90%) in the 1960s to near zero (under 20%) in more recent years. In exploring potential reasons for the observed attenuation, we find that increases in non‐timing‐related accrual recognition, as proxied by one‐time and nonoperating items and the frequency of loss firm‐years, explain the majority of the overall decline. On the other hand, temporal changes in the matching between revenues and expenses, and the growth of intangible‐intensive industries play only a limited role in explaining the observed attenuation. Finally, the relative decline of the timing role of accruals does not appear to be associated with an increase in the asymmetrically timely loss recognition role.

Prior research documents a negative link between risk and executive holding of stock, but a corresponding positive link for options. We find a similar negative relation for non-executive holding of stock. Our finding is consistent with the view that non-executives not only face significant incentives to reduce risk when they hold stock, but they are also able to affect corporate risk. While endogeneity cannot be ruled out fully, the results of a battery of tests suggest that it plays a limited role. A second robust result is that the documented relation becomes more negative as option-based executive compensation increases. Overall, corporate risk is related to the incentives created by stock and options held by both executives and non-executives, as well as interactions among those incentives. JEL Classifications: G30.