The accrual anomaly is deeply connected with the non-cash component of earnings – the accruals. Firstly documented by the Sloan(1996), the accruals anomaly is the negative association between accounting accruals and subsequent stock returns. The theory connected with this particular anomaly is based on the importance of measuring if the company’s earnings (as reported by company management) are based on real cash-flow or questionable accounting practices. According to the research, firms with low levels of accruals are connected with real earnings, and on the other hand, firms with a high level of accruals could be a result of some accounting practice. As a result, stocks with low accruals should earn higher market returns than high accruals stocks. Moreover, according to the LaFond and his work “Is the Accrual Anomaly a Global Anomaly?”, this anomaly is globally present. Quoting the author: ” I investigate the implications of the return of accruals in 17 countries over the 1989 to 2003 time period. In general, the results of the country-specific analysis indicate that the accrual anomaly is a global phenomenon.”
Although this anomaly could be exploited by acquiring a long position in low accruals companies and a short position in high accruals companies, more recent research suggests that a simple accruals strategy not only could but should be enhanced, while using the simple accruals anomaly as a building block. Although the strategy could not be traded away as easily and is connected with the lower institutional interest, this is caused by the characteristics of high accruals stocks. These stocks are often connected with the small-capitalization, some liquidity issues and high transaction costs. For example, Mohanram in the: “Analysts’ Cash Flow Forecasts and the Decline of the Accruals Anomaly”, states that: “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. ” On the other hand, Bender and Nielsen in their paper: “Earnings Quality Revisited”, have found that the earnings quality signal stopped working in the mid-2000s but since the end of 2008 has staged a remarkable rebound.
According to the research, an explanation for the accrual anomaly is the earnings fixation hypothesis. The hypothesis says that investors are fixed upon earnings and fail to pay attention separately to the cash-flow and accrual components of earnings. However, this is the main reason of the functionality of the accruals anomaly. Firstly, the cash-flow component of earnings is a superior and better forecaster of future earnings, if we would compare it with the accrual component of earnings. Therefore, investors who are not able to distinct between true earnings and accruals can become overly optimistic about the future prospects of firms with high accruals. Moreover, they can become even overly pessimistic about the future prospect of firms with low accruals. Naturally, if we take into account that the aforementioned is not correct, this results in overvalued high accruals firms that subsequently earn low abnormal returns. And vice versa, low accruals firms become undervalued, what is followed by the high abnormal returns.
Additionally, a recent research states that there are two different accruals anomalies with interesting implication for the practical usage. Quoting the Detzel, Schaberl and Strauss and their work: “There are Two Very Different Accruals Anomalies”: “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.”
LaFond: Is the Accrual Anomaly a Global Anomaly?
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
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
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
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
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
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
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
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
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
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.