#38 – Accrual Anomaly

Authors: Patatoukas

Title: Asymmetrically Timely Loss Recognition and the Accrual Anomaly

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2653979

Abstract:

Conditionally conservative accounting practices mandate the more timely recognition of losses relative to gains through transitory negative accrual items. A direct implication of asymmetrically timely loss recognition is asymmetry in the persistence of accruals depending on whether the firm experiences a gain or a loss in the current year: accruals should be less persistent for loss years relative to profit years. If investors naively fixate on total earnings, however, conditional conservatism would imply that investors will tend to overestimate the persistence of accruals especially in loss years. Consistent with naïve earnings fixation, I find that Sloan’s (1996) accrual anomaly, i.e., the negative association between accruals and future abnormal stock returns, is more pronounced for loss firms relative to profit firms. The evidence is relevant for understanding the origins of the accrual anomaly and highlights that inferences with respect to the pricing of accruals can be affected by pooling loss firms with profit firms.

Notable quotations from the academic research paper:

"Separating firms based on the sign of reported earnings, I find that although the accrual anomaly extends across profit and loss firms, it appears to be stronger for loss firms. The average hedge return from buying/selling low/high accrual loss firms is 16.99 percent, while the hedge return from buying/selling low/high accrual profit firms is 5.82 percent. Evidence of accrual mispricing further increases when I separate loss firms experiencing negative contemporaneous abnormal returns (roughly 72 percent of all loss firms), with the hedge return from buying/selling low/high accrual loss firms rising to 21.77 percent.

Overall, the evidence suggests that the subsample of loss firms is more susceptible to accruals mispricing, which is consistent with the prediction that investors naively fixate on total earnings and, therefore, tend to overestimate the persistence of accruals especially in loss years. The evidence presented here also highlights that inferences regarding variation in the accrual anomaly across profit and loss firms are sensitive to the measurement of the accrual component of earnings."

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