Accrual Anomaly

The accrual anomaly is related to the negative association between accounting accruals (the non-cash component of earnings) and future stock returns. The logic of this anomaly is based on the reasoning that it is important to measure if company's earnings (as reported by company management) are based on real cash inflow or based on revenue recognition from questionable accounting practices. Companies which have low levels of accruals have more certain real earnings and therefore should earn higher market returns. This anomaly could be exploited by acquiring a long position in low accruals companies and a short position in high accruals companies.

Fundamental reason

An explanation that has been offered for the accrual anomaly, the earnings fixation hypothesis, holds that investors fixate upon earnings and fail to attend separately to the cash flow and accrual components of earnings. Since the cash flow component of earnings is a more positive forecaster of future earnings than the accrual component of earnings, investors who neglect this distinction become overly optimistic about the future prospects of firms with high accruals and overly pessimistic about the future prospect of firms with low accruals. As a result, high accrual firms become overvalued, and subsequently earn low abnormal returns. Similarly, low accrual firms become undervalued and are followed by high abnormal returns.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Yearly
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Financial instruments
stocks
Backtest period from source paper
1966-2003
Indicative performance
7.50%
Notes to Indicative performance
per annum, data from table 1
Estimated volatility
10.26%
Notes to Estimated volatility
estimated from t-statistic in table 1
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.34

Keywords:

equity long short, stock picking, financial statements effect, accruals effect

Simple trading strategy

The investment universe consists of all stocks on NYSE, AMEX and NASDAQ. Balance sheet based accruals (the non-cash component of earnings) are calculated as:
BS_ACC = ( ∆CA - ∆Cash) - ( ∆CL - ∆STD - ∆ITP) - Dep
Where:
∆CA = annual change in current assets
∆Cash = change in cash and cash equivalents
∆CL = change in current liabilities
∆STD = change in debt included in current liabilities
∆ITP = change in income taxes payable
Dep = annual depreciation and amortization expense
Stocks are then sorted into deciles and investor goes long stocks with the lowest accruals and short stocks with the highest accruals. Portfolio is rebalanced yearly during May (after all companies publish their earnings).

Source Paper

Lev, Nissim: The Persistence of the Accruals Anomaly
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=546108
Abstract:
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. Yet, we show that the accruals anomaly still persists and its magnitude has not declined over time. While we find that institutional investors react promptly to accruals information, it is clear that their reaction is rather weak and is primarily characteristic of active investors who constitute a minority of institutions. The main reason: Extreme accruals firms have characteristics which are unattractive to most institutional investors. Individual investors are by and large unable to profit from trading on accruals information due to the high transaction and information costs associated with implementing a consistently profitable accruals strategy. Consequently, the accruals anomaly persists, and will probably endure.

Other Papers

LaFond: Is the Accrual Anomaly a Global Anomaly?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=782726
Abstract:
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.

Dechow, Khimich, Sloan: The Accrual Anomaly
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1793364
Abstract:
This paper provides a practitioner-oriented review of the accrual anomaly in Sloan (1996) and related subsequent research. We begin with two simple examples that illustrate the computation and interpretation of accruals. We next review Sloan's (1996) original paper and related subsequent research corroborating Sloan's interpretation of the accrual anomaly. We next summarize research providing alternative explanations for the accrual anomaly. We finish with a brief discussion of the practical implications of this research.

Beneish, Lee, Nichols: In Short Supply: Equity Overvaluation and Short Selling
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362971
Abstract:
We use detailed security lending data to examine the relation between short sale constraints and equity overvaluation. We find that stocks’ “special” status exhibits a non‐linear (U‐shaped) relation with their short interest ratio (SIR), and that a stock’s special status, rather than its SIR, predicts negative returns. We show that short‐sellers trade on a variety of firm characteristics and against high sentiment. Specifically, we find: (1) the abnormal returns to the short‐side of nine market ‘anomalies’ identified in prior work are attributable to special stocks; and (2) future negative returns to special stocks are directly related to the lendable inventory in each stock rather than to its shares borrowed. Overall, our results suggest returns to the short side of documented ‘anomalies’ may not be obtainable without significant cost, and that the supply (available inventory) of lendable shares is the primary binding constraint to informational arbitrage in the case of equity overvaluation.

Mohanram: Analysts’ Cash Flow Forecasts and the Decline of the Accruals Anomaly
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2386210
Abstract:
The accruals anomaly, demonstrated by Sloan (1996), generated significant excess returns consistently for over four decades until 2002, but has apparently weakened in the subsequent period. In this paper, I argue that one factor responsible for this decline is the increasing incidence of analysts’ cash flow forecasts that provides markets with forecasts of future accruals. The negative relationship between accruals and future returns is significantly weaker in the presence of cash flow forecasts. This anomalous relationship becomes weaker with the initiation cash flow forecasts but continues after cash flow forecasts are terminated. Further, the mitigating effect of cash flow forecasts is greater for forecasts that are more accurate. The results are incremental to explanations based on the improved accrual quality, reduced manipulation of special items and restructuring charges and greater investment in accruals strategies by hedge funds and highlight the increasing importance of analysts’ cash flow forecasts in the appropriate valuation of stocks.

Bender, Nielsen: Earnings Quality Revisited
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2543996
Abstract:
Earnings quality as an investment signal has been popular among equity portfolio managers for the last decade. The basic idea behind this “accruals anomaly” is that stocks with high and increasing accruals tend to have low earnings quality while stocks with low and decreasing accruals tend to have high earnings quality. The earnings quality signal stopped working in the mid-2000s but since the end of 2008 has staged a remarkable rebound. Here we evaluate whether earnings quality is a true alpha signal, whether it is a risk factor, or both. We find that in the periods where the signal worked, the strategy was largely driven by stock selection, suggesting earnings quality is indeed an alpha signal. Second, we find that earnings quality is not a good risk factor, in that it does not have high statistical significance when regressed cross-sectionally on returns along with other well-known risk factors and is not very volatile over time. Overall our results indicate that earnings quality may have really been that rare example of a “pure alpha” factor.

Guo, Maio: A Simple Model that Helps Explaining the Accruals Anomaly
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2559458
Abstract:
We propose a new multifactor model to price the cross-section of average excess returns associated with accruals portfolios, and hence explain the accruals anomaly. Our model represents an application of the Intertemporal CAPM from Merton (1973), where the key factors are the innovations on the term spread and value spread. The model clearly outperforms the simple CAPM, and shows large explanatory power for the cross-sectional risk premia associated with three different groups of accrual portfolios. Moreover, the model compares favorably with alternative multifactor models widely used in the literature. Our results remain robust by using equal-weighted accruals portfolios.

Fan, Opsal, Yu: Equity Anomalies and Idiosyncratic Risk Around the World
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2611047
Abstract:
In this study, we examine how idiosyncratic risk is correlated with a wide array of anomalies, including asset growth, book-to-market, investment-to-assets, momentum, net stock issues, size, and total accruals, in international equity markets. We use zero-cost trading strategy and multifactor models to show that these anomalies produce significant abnormal returns. The abnormal returns vary dramatically among different countries and between developed and emerging countries. We provide strong evidence to support the limits of arbitrage theory across countries by documenting a positive correlation between idiosyncratic risk and abnormal return. It suggests that the existence of these well-known anomalies is due to idiosyncratic risk. In addition, we find that idiosyncratic risk has less impact on abnormal return in developed countries than emerging countries. Our results support the mispricing explanation of the existence of various anomalies across global markets.

Patatoukas: Asymmetrically Timely Loss Recognition and the Accrual Anomaly
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.

Lu, Stambaugh, Yuan: Anomalies Abroad: Beyond Data Mining
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3012923
Abstract:
A pre-specified set of nine prominent U.S. equity return anomalies produce significant alphas in Canada, France, Germany, Japan, and the U.K. All of the anomalies are consistently significant across these five countries, whose developed stock markets afford the most extensive data. The anomalies remain significant even in a test that assumes their true alphas equal zero in the U.S. Consistent with the view that anomalies reflect mispricing, idiosyncratic volatility exhibits a strong negative relation to return among stocks that the anomalies collectively identify as overpriced, similar to results in the U.S.

Detzel, Schaberl, Strauss: There are Two Very Different Accruals Anomalies
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3069688
Abstract:
We document that several well known asset-pricing implications of accruals differ for investment and non-investment-related components. Exposure to an investment-accruals factor explains the cross-section of returns better than the accruals themselves, and this factor’s returns are negatively predicted by sentiment. The opposite results hold for non-investment accruals. Further tests show cash profitability only subsumes long-term non-investment accruals in the cross-section of returns and economy-wide investment accruals negatively predict stock-market returns while other accruals do not. These results challenge existing accruals-anomaly theories and help resolve mixed evidence by showing that the anomaly is two separate phenomena: a risk-based investment accruals premium and a mispricing of non-investment accruals.

Hypothetical future performance