Accruals, Investment, and the Accrual Anomaly

Abstract

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.

Accruals and future performance: Can it be attributed to risk?

“…Sloan then suggests that this differential persistence in earnings components explains the negative relation between accruals and future firm performance. Subsequent research has offered a variety of alternative competing explanations for this negative relation: (i) diminishing marginal returns to new investment (e.g., Fairfield, Whisenant and Yohn, 2003;Richardson, Sloan, Soliman and Tuna, 2006;and Zhang, 2007), (ii) accounting distortions and earnings management (e.g., Xie, 2001, Richardson, Sloan, Soliman andTuna, 2005), (iii) risk (e.g., Kahn, 2008;Wu, Zhang and Zhang, 2010;Cooper and Priestley, 2011), and (iv) transaction costs (e.g., Mashruwala, Rajgopal and Shevlin, 2006). …”

Managerial Caution, Operating Performance, and Accounting Conservatism

“…It is, however, at least as probable that causation runs in the opposite direction -i.e., that the style of managerial decision making affects the properties of the accounting system. Several recent papers they investigate the effect that a firm's operating decisions have on the properties of its accounting information and report evidence consistent with this argument: e.g., Zhang (2007) demonstrates that the quality of accruals is closely related to growth; Wu et al (2010) show that the factors that influence growth, such as prevailing discount rates, also influence accrual quality. There is also an emerging literature studying the effect of accounting quality on managerial decisions: see, e.g., Biddle and Hilary (2006), McNichols and Stubben (2008), and Biddle et al (2009).…”

The Relationship between Accruals Quality, Earnings Persistence and Accruals Anomaly in the Canadian Context

“…Sloan (1996) also shows that investors fixate on earnings and fail to fully reflect the difference between properties of accruals and cash flows in forecasting future earnings. By equally weighting both earnings' components, investors tend to incorrectly overvalue persistence of the accruals component of current earnings when forming future earnings expectations, which leads stock prices to deviate from their intrinsic values and adjust their forecasts when realized earnings are less than expected for high-accrual firms (Mashruwala, Rajgopal, & Shevlin, 2006;Zhang, 2007). The negative relationship between current accruals and future stock returns is known as accruals anomaly.…”

“…Most studies dealing with accruals anomaly adopt Healy's definition of accruals which only takes into focus current accruals (Sloan, 1996;Xie, 2001;Chan, Chan, Jegadeesh, & Lakonishok, 2006;Zhang, 2007). In addition, most studies on accruals quality examine the U.S. financial market.…”