Accruals effect is a stock-picking strategy based on information from “accruals”. Accrual refers to an entry made in the books of accounts related to the recording of revenue or expense paid without any exchange of cash. An example of accrual for revenue involves your electric utility company. The utility used coal and many employees in December to generate electricity that customers received in December. However, the utility doesn’t bill the electric customers for December electricity until the meters are read in January. To have the proper amounts on the utility’s financial statements, there needs to be an adjusting entry to increase revenues that were earned in December and the receivables that the utility has a right to as of December 31. An example of an accrual involving an expense is an employee’s bonus that was earned in 2012 but will not be paid until 2013. The 2012 financial statements need to reflect bonus expense and the bonus liability. Therefore, prior to issuing the 2012 financial statements, an adjusting entry is prepared to record this accrual.
Sloan’s (1996) pioneering documentation of the accruals factor — the negative association between accounting accruals (the non-cash component of earnings) and subsequent stock returns—spawned considerable research. Numerous studies have confirmed the implications of current period accruals for subsequent period returns within the U.S. (Beneish and Vargus, 2002; Bradshaw et al., 2001; Barth and Hutton, 2004; Chan et al., 2004; Collins and Hribar, 2000; Collins et al., 2003; Desai et al., 2004; Pincus et al., 2005; Richardson et al., 2005; Thomas and Zhang, 2002).
Sloan (1996) suggests that the accrual effect is due to investors’ failure to understand the differential persistence of accruals relative to cash flows for future earnings. Chan et al. (2004), Hribar (2000), and Thomas and Zhang (2002) find that Sloan’s results are primarily due to the inventory and accounts receivable accruals. Current research, however, calls into question a persistence-based explanation for the accrual effect. Chambers (2004) finds that larger differences between firm-specific estimates of accrual and cash flow persistence are not associated with greater accrual miss-pricing. Zach (2004) finds that extreme accruals tend to be “sticky” in that they do not reverse in the subsequent period as is predicted by the persistence based explanation. Dechow et al. (2005) find systematic differences between the persistence of the cash components and investors’ estimates of the persistence of the cash components, which indicates that misperceptions of persistence extend beyond the accrual component of earnings. Beaver (2002) conjectures that the accrual anomaly is a value anomaly in disguise. Desai et al. (2004) attributes this to a measurement problem.
Pincus et al. (2005) investigates the implications of the return of total accruals internationally, finding evidence of accrual mispricing in Australia, Canada, the U.K., and the U.S. Pincus et al. (2005) contend that the cross-country variation in the existence of the accrual anomaly is due to differences in institutional features across countries. Other international research has focused on differences in the associations between accounting information and prices and returns across markets (Alford et al., 1993; Ali and Hwang, 2000; Ball et al., 2000; Hung, 2001)
An accrual factor strategy usually goes long on low accrual stocks and short on high accrual stocks. However, Mashruwala, Rajgopal and Shevlin (2006) show that the accrual anomaly is concentrated in small cap thinly traded stocks with volatile stock returns, and so involves considerable arbitrage risk. Lev and Nissim (2006) explain the anomaly due to the small stock high cost of trading for individuals and lack of interest from institutions. Dechow, Khimich and Sloan conclude that accrual anomaly has been diminishing, however, an astute investor will be still able to earn an excess return if he or she uses a rigorous fundamental analysis.