Do Investors Overreact or Underreact to Accruals? A Reexamination of the Accrual Anomaly

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1 Do Invesors Overreac or Underreac o Accruals? A Reexaminaion of he Accrual Anomaly Yong Yu* Smeal College of Business Pennsylvania Sae Universiy This draf: December 30, 2005 Absrac Sloan (996) finds ha he accrual componen of earnings is negaively associaed wih subsequen sock reurns. He inerpres his negaive associaion as evidence ha invesors fail o fully undersand he lower persisence of accruals relaive o cash flows and consequenly overprice accruals. This observed overreacion o accruals has come o be known as he accrual anomaly. This paper reexamines he accrual anomaly, concenraing on how hree differen feaures of Sloan s (996) research design affec inferences regarding he exisence of his anomaly, namely, he omission of cash flows, he use of an annual seing, and he reliance on he full sample of firms in examining invesors reacion o accruals. The main findings of he paper are as follows: Firs, afer conrolling for cash flows and using a quarerly seing, accruals are found o be posiively associaed wih subsequen reurns, suggesing ha invesors underreac o accruals. This posiive associaion is weaker han he posiive associaion beween cash flows and subsequen reurns, suggesing ha invesors underreac o cash flows o a greaer exen. Second, when cash flows are omied, he more pronounced underreacion o cash flows han o accruals, combined wih he negaive correlaion beween accruals and cash flows, resuls in a severe downward bias on he associaion beween accruals and subsequen reurns. This bias conceals he underlying underreacion of invesors o accruals, leading o he observed accrual anomaly repored by Sloan. These resuls hold for he full sample of firms on average and are even sronger for sub-samples of firms where accruals are likely o play a more imporan role in measuring firm performance. Finally, and in line wih he above resuls, afer a proper conrol for cash flows, financial analyss are found o underreac o accruals, in conras o previous finding ha analyss overreac o accruals. *354 Business Building, Smeal College of Business, Universiy Park, PA yuy2@psu.edu Tel: (84) This paper is based on my disseraion, underaken a Pennsylvania Sae Universiy. I appreciae he advice and suggesions of my disseraion commiee: Orie Barron (co-chair), Dan Givoly (co-chair), Bin Ke, Jim McKeown, Karl Muller, and Mark Robers. I hank Donal Byard, Paul Fisher, Carla Hayn, Seve Huddar, Andy Leone, Henock Louis, Shail Pandi, Sanhosh Ramalingegowda, and Hal Whie for helpful commens.

2 . Inroducion Sloan (996) finds ha he accrual componen of earnings is negaively associaed wih subsequen sock reurns. He inerpres his negaive associaion as evidence ha invesors fail o fully undersand he lower persisence of accruals relaive o cash flows and consequenly overprice accruals. Over he pas decade, his observed overreacion o accruals, which has been replicaed by many sudies, has come o be known as he accrual anomaly and has generaed ineres among boh researchers and invesors. 2 Sudies on he accrual anomaly have aken differen pahs. One line of sudies invesigaes how he behavior of financial analyss, shor sellers, and oher hird paries is relaed o his anomaly (e.g., Bradshaw e al., 200; Richardson, 2003). Anoher line examines he role of differen componens of accruals in creaing his anomaly (e.g., Xie, 200; Thomas and Zhang, 2002; Richardson e al., 2005). A hird line of research seeks o relae his anomaly o oher marke anomalies (e.g., Collins and Hribar, 2000; Fairfield e al., 2003; Desai e al., 2004). Some sudies examine he relaion of his anomaly o various firm characerisics and risk measures (e.g., Ali e al., 200; Mashruwala e al., 2004; Khan, 2005). Oher sudies aemp o deermine how widespread his anomaly is (e.g., LaFond, 2005; Pincus e al., 2005). In his sudy, I reexamine he accrual anomaly, concenraing on how hree differen feaures of Sloan s (996) research design affec inferences regarding he exisence of his anomaly. The firs feaure is he omission of cash flows from he Following Sloan (996), he erm overreacion (underreacion) is used o characerize a negaive (posiive) associaion beween accruals or cash flows and subsequen reurns. Accruals and cash flows refer o he accrual and cash flow componens of earnings, and subsequen reurns are he abnormal reurns in he periods following he earnings repor. 2 Following Sloan (996), selling high-accrual firms sock and buying low-accrual firms sock has become a popular rading sraegy (see, e.g., Talley, 2003; Henry, 2004a, 2004b). Reporedly, now invesors are clamoring o exploi his marke inefficiency. (Business Week, Ocober 4, 2004, cover sory)

3 examinaion of he associaion beween accruals and subsequen reurns. This omission is problemaic because cash flows are likely o be a significan correlaed omied variable. More imporanly, given a negaive relaion beween accruals and cash flows and an underreacion o cash flows, he omission of cash flows biases he resuls in favor of he accrual anomaly. I analyze he impac of his correlaed omied variable problem and examine wheher, upon inclusion, he accrual anomaly sill exiss. The second feaure of Sloan s (996) research design is he use of an annual seing whereby annual accruals and reurns subsequen o he annual filing dae are examined. The use of his annual seing o deec invesors reacion o accruals has wo limiaions. Firs, annual accruals are likely o play a relaively minor role in correcing cash flows as a measure of performance as compared o accruals for shorer measuremen inervals (e.g., quarers). This is he case because over longer measuremen inervals, cash flows suffer from fewer iming and maching problems, and he role of accruals diminishes. Second, he reurns over he period following he annual filing dae do no fully capure he poenial mispricing of he firs hree quarers accruals. In his sudy, I examine quarerly accruals and reurns subsequen o he quarerly filing dae. The hird feaure of Sloan s (996) research design addressed in his sudy is he reliance on he full sample of firms (i.e., all firms wih daa available) raher han on firms where accruals are more imporan in measuring performance. For some firms, cash flows and earnings are closely aligned; so any poenial mispricing of accruals is likely o have a relaively minor impac on sock reurns han for oher firms where accruals are more informaive. Conducing he analysis on he full sample of firms is herefore likely o reduce he es s power o deec invesors reacion o accruals. In his sudy, I perform 2

4 ess on sub-samples of firms where accruals are likely o be more informaive. Based on prior research, hese firms are idenified as hose wih more volaile working capial requiremens and invesmen and financing aciviies and hose wih longer operaing cycles (Dechow, 994; Dechow e al., 998). The main findings ha emerge from he analyses are as follows. Firs, afer conrolling for cash flows and using a quarerly seing, accruals are found o be significanly posiively associaed wih subsequen reurns, suggesing ha invesors underreac o accruals. This posiive associaion is weaker han he posiive associaion beween cash flows and subsequen reurns, suggesing ha while invesors underreac o accruals, hey underreac o cash flows o a greaer exen. Second, he resuls indicae ha when cash flows are omied, he sronger underreacion o cash flows han o accruals, combined wih he negaive correlaion beween accruals and cash flows, resuls in a severe downward bias on he associaion beween accruals and subsequen reurns. This bias conceals he underlying underreacion of invesors o accruals, leading o he observed accrual anomaly repored by Sloan. These resuls hold for he full sample of firms on average and, as expeced, are even sronger for sub-samples of firms where accruals are likely o play a more imporan role in measuring firm performance. To ie my resuls o pas research on he manner by which analyss process he accrual anomaly, I examine how financial analyss reac o accruals using heir forecass of fuure earnings. In line wih my earlier resuls on he accrual anomaly, afer a proper conrol for cash flows, financial analyss are found o underreac o accruals and o underreac even more o cash flows. Similarly, he resuls indicae ha Bradshaw e al. s 3

5 (200) finding of analyss overreacion o accruals is driven by he omission of cash flows from heir analyses. This sudy sheds ligh on an imporan opic of how invesors and analyss reac o accruals. I shows ha he observed overreacion o accruals by invesors and analyss (i.e., he accrual anomaly) is driven by a correlaed omied variable problem. Insead, his sudy offers new evidence ha invesors and analyss underreac o accruals. These findings have imporan implicaions for he accrual anomaly lieraure which has largely focused on explaining why invesors overreac o accruals. The challenge now is o explain why invesors underreac o accruals and why invesors underreac more o cash flows han o accruals. (Some possible explanaions are discussed in secion 6.) 3 These resuls also help resolve a puzzling finding by previous sudies of an overreacion o one major componen of earnings (accruals) and an underreacion o he oher major componen of earnings (cash flows). 4 In secion 2, I analyze he hree feaures of Sloan s research design ha are likely o bias his resuls. Daa and variables used in he ess are discussed in secion 3, and he resuls of esing he associaion beween accruals and subsequen sock reurns are presened in secion 4. In secion 5, I examine how financial analyss reac o accruals using heir forecass of fuure earnings. Secion 6 conains conclusions and possible explanaions for he findings in his sudy. 3 The findings in his sudy have implicaions for invesors implemening he accrual anomaly sraegy of selling high-accrual firms and buying low-accrual firms. Because he overreacion o accruals hey aemp o exploi is shown o be only par of he underlying underreacion o cash flows, hese invesors could devise invesmen sraegies superior o ha relying on accruals. This can be accomplished by eiher direcly focusing on he firs order effec, cash flows (i.e., buying high-cash flow firms and selling low-cash flow firms), or using a combined sraegy of buying firms wih boh high cash flows and high accruals and selling firms wih boh low cash flows and low accruals. 4 As noed by Kohari (200), one challenge is o undersand why he marke underreacs o earnings, bu is reacion o is wo componens, cash flows and accruals, is conflicing. 4

6 2. Feaures of Sloan s (996) Research Design 2. Omission of Cash Flows Sloan (996) omis cash flows in his examinaion of he associaion beween accruals and subsequen reurns. 5 This omission is problemaic because cash flows are likely o be a significan correlaed omied variable. To analyze his problem, consider he following model which examines he associaion beween he wo earnings componens and subsequen reurns (firm subscrips are omied for breviy): RETURN + = 0 + *ACCRUALS + 2*CASHFLOWS + + () where RETURN + = abnormal reurns over period +; ACCRUALS = scaled decile porfolio rank based on accruals in period ; CASHFLOWS = scaled decile porfolio rank based on cash flows in period ; + = an error erm. In Equaion (), he accrual (cash flow) decile ranks are scaled o [0,] such ha firms wih he mos posiive accruals (cash flows) have a porfolio rank of and firms wih he mos negaive accruals (cash flows) have a rank of 0. Under his consrucion, he coefficiens can be inerpreed as abnormal reurns on porfolios wih cerain useful properies (see, e.g., Fama and MacBeh, 973; Bernard and Thomas, 990). For example, β ( β 2 ) represens he abnormal reurns earned by a zero-invesmen hedge porfolio sraegy of buying firms in he highes accrual (cash flow) decile and selling firms in he lowes accrual (cash flow) decile. Noe ha he accrual anomaly sraegy 5 Sloan (996) does consider boh cash flows and accruals in comparing a measure of invesors pricing of accruals and cash flows wih a measure of he implicaion of accruals and cash flows for one-year-ahead earnings (i.e., he Mishkin es) (see also Kraf e al., 2005a). However, i is imporan o noe ha Sloan omis cash flows in he examinaion of he associaion beween accruals and subsequen reurns. 5

7 would hen earn an abnormal reurn of β. Consisen wih Sloan, a negaive (posiive) coefficien is inerpreed as an overreacion (underreacion), and he magniude of he coefficien indicaes he economic magniude of he overreacion (underreacion). Sloan (996) finds ha a rading sraegy of selling firms in he highes accrual decile and buying firms in he lowes accrual decile earns significan subsequen abnormal reurns. This is equivalen o esimaing Equaion () excluding and finding ha he esimaed coefficien on However, when CASHFLOWS ACCRUALS is significanly negaive. CASHFLOWS are omied, he esimaed coefficien on ACCRUALS, denoed β, is a biased esimae of β. 6 Specifically, Cov( ACCRUALS, CASHFLOWS ) E β ) = β + * Var( ACCRUALS ) ( β2 (2) where Cov ( ACCRUALS, CASHFLOWS ) is he covariance beween ACCRUALS and CASHFLOWS, and Var( ACCRUALS ) is he variance of ACCRUALS. Since boh ACCRUALS and CASHFLOWS are decile porfolio ranks ranging from [0,], hey have he same variance. Therefore, Equaion (2) can be rewrien as: E ( β) = β + Corr( ACCRUALS, CASHFLOWS ) * β2 (3) where Corr( ACCRUALS, CASHFLOWS ) is he correlaion beween ACCRUALS and CASHFLOWS. Equaion (3) shows ha he bias in β is deermined by wo facors: he correlaion beween accruals and cash flows, and he mispricing of cash flows. 7 6 See Wooldridge (2003, Chaper 3) and Greene (2003, Chaper 8). 7 Similar o he omission of cash flows in examining accruals and subsequen reurns, Sloan (996) also omis accruals in documening a posiive associaion beween cash flows and subsequen reurns. By examining boh accruals and cash flows concurrenly, his sudy also provides evidence ha he omission of 6

8 The primary role of accruals in miigaing iming and maching problems inheren in cash flows resuls in a negaive correlaion beween he wo earnings componens. Given an underreacion o cash flows (i.e., β 2 > 0 ), he omission of cash flows causes a downward bias in β (i.e., Corr ( ACCRUALS, CASHFLOWS ) * β2 < 0). Depending on he severiy of his downward bias, he observed accrual anomaly ( β < 0) is consisen wih hree poenial explanaions: Invesors overreac o accruals (i.e., β < 0 ). The accrual anomaly indeed holds. However, because is magniude is oversaed due o he downward bias, he quesion remains as o wheher or no he anomaly is economically significan. Invesors price accruals correcly (i.e., β = 0 ). The observed overreacion o accruals is driven by he downward bias, and here is no mispricing of accruals. Invesors underreac o accruals (i.e., β > 0 ). There appears o be an accrual anomaly because he downward bias dominaes he posiive coefficien ( β ). Specifically, [ Corr ( ACCRUALS, CASHFLOWS )]* β 2 > β [ Corr ACCRUALS, CASHFLOWS )] (. Because is beween 0 and, his suggess ha β 2 > β, ha is, invesors underreac o cash flows o a greaer exen han hey underreac o accruals. In oher words, he apparen accrual anomaly is driven by he more severe underreacion o cash flows han o accruals, combined wih he negaive correlaion beween accruals and cash flows. accruals biases downward he associaion beween cash flows and subsequen reurns and hus undersaes invesors underreacion o cash flows (see secion 4 for he resuls). 7

9 To summarize, he above analysis shows ha he omission of cash flows from Sloan s analysis leaves he exisence of he accrual anomaly an open quesion. To address his quesion, I examine he associaion beween accruals and subsequen reurns while conrolling for he effec of cash flows Use of an Annual Seing Sloan (996) finds he accrual anomaly in ess using annual accruals and reurns subsequen o he annual filing dae. The use of his annual seing o deec invesors reacion o accruals has wo limiaions. Firs, annual accruals play a lesser role in improving cash flows as a measure of firm performance han accruals over shorer measuremen inervals (e.g., quarers). The accrual process is hypohesized o miigae he iming and maching problems inheren in cash flows over finie measuremen inervals so ha earnings beer approximae firm performance (e.g., Was and Zimmerman, 986; Dechow, 994; Dechow e al., 998). Because cash flows suffer more severely from iming and maching problems and are hus less informaive abou firm performance over shorer inervals, accruals over such inervals are more imporan in providing value-relevan informaion abou firm performance. Over longer inervals, cash flows have fewer problems and converge o earnings; so he role of accruals diminishes. This propery of accruals suggess ha accruals over a quarerly inerval provide a more powerful seing in which o examine invesors reacion o accrual informaion. 8 Desai e al. (2004) also incorporae cash flows in heir es of he accrual anomaly. However, hey are no ineresed in he funcional relaion beween accruals and cash flows. Raher, hey examine wheher he accrual anomaly is subsumed by he value-glamour anomaly. Using cash flows o capure he valueglamour disincion in an annual seing, hey find ha when cash flows are added o accruals in he regression, he coefficien on accruals is negaive bu saisically insignifican. They conclude ha he accrual anomaly is he value-glamour anomaly in disguise. I show ha heir finding of an insignifican negaive relaion beween accruals and subsequen reurns is due o heir use of an annual seing. 8

10 The second limiaion of using an annual seing is ha i ignores accrual informaion provided in inerim repors. This informaion preemps a leas par of he accrual informaion released in annual repors. As a resul, abnormal reurns measured over he period following he annual filing dae reflec primarily he poenial mispricing of he fourh-quarer accruals and fail o fully capure he poenial mispricing of he firs hree quarers accruals. For example, consider he informaion conveyed by firs-quarer accruals. By he fourh monh afer fiscal year-end (when reurns begin o be measured in he ess using he annual seing), firs-quarer accrual informaion has been released for abou one year; so only par, if any, of invesors iniial (anomalous) reacion o his informaion is capured by he pos-annual-repor reurns. To overcome he wo limiaions arising from he use of he annual seing, I examine invesors reacion o accruals in a quarerly seing using quarerly accruals and reurns subsequen o he quarerly filing dae. 2.3 Reliance on he Full Sample of Firms In documening he accrual anomaly, Sloan (996) conducs ess on he enire sample of firms (i.e., all firms wih daa available). However, he imporance of accruals in measuring firm performance is likely o vary across firms. For some firms, cash flows suffer from more iming and maching problems han for oher firms, and herefore heir accruals play a more imporan role in measuring performance. If invesors misprice accruals, his mispricing will be more pronounced (i.e., have a relaively larger impac on sock reurns) for hese firms. However, for some oher firms, cash flows have fewer problems in measuring performance and are closely aligned wih earnings; so he role of accruals diminishes. For hese firms, he mispricing of accruals, if any, is likely o have a 9

11 relaively minor impac on sock reurns and harder o deec saisically. The inclusion of hese firms in he ess reduces he power o deec invesors reacion o accruals. In his sudy, I examine sub-samples of firms where accruals are likely o play a more imporan role in measuring firm performance. These firms are idenified as hose wih more volaile working capial requiremens and invesmen and financing aciviies and hose wih longer operaing cycles. Prior research documens ha for hese firms, cash flows suffer from more iming and maching problems and accruals are herefore more imporan in measuring performance (Dechow, 994; Dechow e al., 998). To summarize, I reexamine he accrual anomaly, modifying he research design of Sloan (996) by conrolling for cash flows, using a quarerly seing, and pariioning he sample according o he imporance of accruals in miigaing he problems of cash flows as a measure of performance. In he following wo secions, I firs examine he associaion beween annual accruals and reurns subsequen o he annual filing dae using he full sample of firms (hereafer, he annual es) o faciliae a comparison wih prior research. I hen conduc he main analysis in a quarerly seing, examining quarerly accruals and reurns subsequen o he quarerly filing dae. This analysis is performed on he full sample firs (hereafer, he quarerly es) and hen on sub-samples of firms where accruals play a more imporan role (hereafer, he sub-sample es). 3. Sample Selecion and Variable Measuremen 3. Sample Selecion The sample used in he annual (quarerly) es consiss of all available NYSE/AMEX firm-years (firm-quarers) from 988 hrough 2002 wih required financial 0

12 saemen daa on he Compusa daabase and monhly reurn daa on he CRSP daabase. 9 In order o ensure ha cash flows and accruals are accuraely measured, he sample period begins in 988 when cash flow saemen daa became available. 0 Following prior research, I exclude closed-end funds, invesmen russ, foreign companies, and financial insiuions (SIC code ) due o he difficuly of inerpreing accruals for financial firms. This resuls in a sample of 25,540 firm-years for he annual es and a sample of 79,809 firm-quarers for he quarerly es, spanning a sixy-quarer period from 988 hrough Variable Measuremen Accruals are measured as he difference beween earnings and cash flows from operaions aken from he saemen of cash flows. Earnings are income from coninuing operaions, and cash flows are cash flows from coninuing operaions. All hree variables are scaled by average oal asses. 2 The abnormal reurn measure is he annual size-adjused buy-and-hold reurns as used in Sloan (996). Raw reurns are obained from he CRSP monhly reurn file. Abnormal reurns are compued by subracing a firm s size-mached buy-and-hold reurns from he raw buy-and-hold reurns. Size porfolio reurns are provided by CRSP 9 NYSE/AMEX firms are idenified using he hisorical exchange code (EXCHCD) from he CRSP monhly even file in he monh before he reurn calculaion. Using curren exchange lising (e.g., Compusa s Zlis or CRSP s header exchange code) inroduces a selecion bias because changes in exchange lising are correlaed wih firm performance and a firm currenly on he NYSE/AMEX may be raded on oher exchanges in he pas. Using EXCHCD avoids his selecion bias (Kraf e al., 2005b). 0 Sloan (996) uses a balance shee approach o measure accruals. This approach inroduces measuremen errors ino he accruals measure, paricularly when a firm has been involved in mergers, acquisiions, or divesiures. Measuring accruals using cash flows saemen daa is more precise (see, e.g., Drina and Largay, 985; Hribar and Collins, 2002). The resuls are similar if hese observaions are included. 2 For he annual sample, earnings are Compusa Annual Iem 23, cash flows are Compusa Annual (Iem 308 Iem 24), and oal asses are Compusa Annual Iem 6. For he quarerly sample, earnings are Compusa Quarerly Iem 76, cash flows are Compusa Quarerly (Iem 08 Iem 78), and oal asses are Compusa Quarerly Iem 44. Noe ha for quarerly cash flow saemen iems, Compusa repors daa for he cumulaive inerim period year o dae.

13 and calculaed using all NYSE/AMEX firms based on heir beginning-of-year marke capializaions. A firm s reurn is se o zero for any monh if i is missing due o lack of rading. 3 If a firm is delised during he reurn accumulaion period, he delising reurn as repored in he CRSP even file for he delising period is used, and a reurn equal o he firm s size porfolio reurn for he res of he accumulaion period is employed. If a firm is delised due o liquidaion or a forced delising by eiher he exchange or he SEC and he delising reurn is missing, he delising reurn is se o -00%. 4 Following Sloan (996), he fuure buy-and-hold abnormal reurns in he annual es, denoed BHAR ANN, are measured from four monhs afer he fiscal year-end hrough he fourh monh of he subsequen fiscal year. Similarly, he fuure buy-and-hold abnormal reurns in he quarerly es, denoed BHAR QTR, span he welve-monh period beginning wo monhs afer he fiscal quarer-end for he firs hree fiscal quarers and four monhs afer he fiscal quarer-end for he fourh fiscal quarer. 5 Wihin his womonh inerval, almos all firms have filed 0-Q repors for he firs hree fiscal quarers, and wihin he four-monh inerval, almos all firms have filed 0-K repors (Eason and Zmijewski, 993). 3 This is idenified using CRSP code.b in he reurn field. Excluding firms wih missing reurns due o a lack of rading aciviy disproporionaely affecs firms wih bad sock performance, and hus excluding heir reurns imposes an upward bias in measuring abnormal reurns (Kraf e al., 2005b). Neverheless, he resuls are robus o excluding hese observaions or replacing hese missing reurns wih he corresponding size decile reurns. 4 The resuls remain unchanged if I delee hese delising firms or assume a delising reurn of zero. 5 I repea he analyses using 3- and 6-monh windows. The resuls using hese shorer reurn windows are sronger (see Secion 4.5 for a discussion and resuls). 2

14 4. Resuls of Examining he Associaion beween Accruals and Subsequen Reurns 4. Descripive Saisics and Correlaions Table provides descripive saisics (Panel A) and a correlaion analysis (Panel B) for boh he annual and quarerly samples. Panel A indicaes ha on average accruals are negaive and cash flows are posiive. Panel B shows ha accruals are highly negaively correlaed wih cash flows, consisen wih he primary role of accruals in miigaing he iming and maching problems inheren in cash flows. Moreover, he magniude of he negaive correlaion beween cash flows and accruals is larger in he quarerly sample (Spearman = ) han in he annual sample (Spearman = -0.5), consisen wih cash flows suffering more severely from iming and maching problems and accruals playing a more imporan role in miigaing hese problems over shorer performance measuremen inervals (Dechow, 994). 4.2 Annual Tes Table 2, Panel A replicaes he accrual anomaly using he annual sample. To conduc his analysis, each year firms are ranked by heir prior annual accruals and placed ino en equal-size porfolios, denoed A o A0. An equally-weighed abnormal reurn is compued for each porfolio. The repored -saisics are calculaed using he Fama- MacBeh (973) mehod and correced for auo-correlaion using Newey and Wes (987) sandard errors. Panel A presens he average porfolio reurns, accruals, and cash flows over fifeen years for each of he en accrual porfolios. The resuls are consisen wih he accrual anomaly: a hedge porfolio sraegy of selling he mos posiive accrual firms (porfolio A0) and buying he mos negaive accrual firms (porfolio A) yields an annual abnormal reurn of 9.3%. On he oher hand, 3

15 given he srong negaive correlaion beween accruals and cash flows, i is no surprising o find ha firms in he mos posiive (negaive) accrual porfolio also have exremely negaive (posiive) cash flows. Because his univariae analysis does no conrol for he effec of cash flows, he negaive associaion beween accruals and subsequen reurns canno be unambiguously inerpreed as evidence ha invesors overreac o accruals. Panel B repeas he above analysis on cash flows. The resuls indicae ha a sraegy of selling he mos negaive cash flow firms (porfolio C) and buying he mos posiive cash flow firms (porfolio C0) yields an annual abnormal reurn of.9%. To conrol for he effec of cash flows, I regress subsequen reurns on he scaled accrual decile ranks (ACCRUALS) and he scaled cash flow decile ranks (CASHFLOWS). The scaled decile ranks are consruced by ranking all firms in each period independenly on accruals and cash flows ino deciles 0-9 and hen dividing he decile ranks by 9 so ha hey range from 0 (for he lowes decile) o (for he highes decile). Under his consrucion, he coefficien on ACCRUALS can be inerpreed as he abnormal reurns o a zero-invesmen rading sraegy of buying firms in he highes accrual decile and selling firms in he lowes accrual decile (Bernard and Thomas, 990). The coefficien on CASHFLOWS can be inerpreed similarly. To ensure ha he resuls are no merely driven by he size or marke-o-book effecs, he scaled decile ranks for size (SIZE) and marke-o-book raios (MB), consruced in a similar way, are included as addiional conrols (see Kohari, 200, for a discussion). 6 6 Size is included as an addiional conrol because size-adjused reurns may no fully conrol for he size effec (Bernard, 987). The resuls are similar if hese conrols are no included. The resuls are robus o conrolling for he marke bea calculaed using he prior 60-monh reurn period. Noe ha conrolling for he momenum facor is inappropriae because he underreacion o accruals and cash flows examined in his sudy is a momenum (drif) phenomenon. 4

16 regressions of Table 3, Panel A repors Fama-MacBeh mean coefficien esimaes from annual ANN BHAR on he scaled decile ranks based on prior annual accruals (ACCRUALS) and cash flows (CASHFLOWS). The coefficien on ACCRUALS, before conrolling for cash flows, is (significan a he 0.0 level), consisen wih he accrual anomaly. However, afer conrolling for cash flows, he coefficien on ACCRUALS decreases o and becomes saisically insignifican (-sa = -0.93). 7 The omission of cash flows causes a downward bias of (significan a he 0.0 level) in he coefficien on ACCRUALS. 8 This insignifican relaion beween accruals and subsequen reurns afer conrolling for cash flows is consisen wih wo poenial explanaions: () invesors price accruals correcly, or (2) he annual es has limied abiliy o deec he mispricing of accruals. The analyses in Panel A consrain he coefficiens on he quarerly componens of annual accruals o be equal. As discussed in secion 2.2, one problem ha arises wih he use of his annual seing is ha he dependen variable, BHAR ANN, reflecs primarily he poenial mispricing of he fourh-quarer accruals and fails o fully capure he poenial mispricing of he firs hree quarers accruals. In Table 3, Panel B, I allow he coefficien o vary across he quarerly componens of annual accruals and focus on he associaion beween BHAR ANN esimaes from annual regressions of and he fourh-quarer accruals. Column repors he mean coefficien ANN BHAR on he scaled decile ranks based on he 7 Unabulaed analyses indicae ha his resul is sensiive o some possible ouliers. Afer deleing % of he annual sample wih he larges squared residuals (Knez and Ready, 997), I find ha he coefficien on ACCRUALS is (-sa = 2.8) afer conrolling for cash flows. 8 To assess poenial mulicollineariy for he regression analyses including boh accruals and cash flows, I compue he variance-inflaion facor (VIF) for all he regressions. A general rule of humb is ha a VIF less han 20 does no indicae severe mulicollineariy. Unabulaed resuls show ha no variable in any regression has a VIF more han 0 (e.g., in he 60 quarerly regressions including boh accruals and cash flows as repored in Table 5, he median (maximum) VIF for ACCRUALS and CASHFLOWS is 2.43 (5.4) and 2.58 (5.66) respecively), indicaing mulicollineariy is no a problem. (For a discussion abou mulicollineariy, see Maddala, 200, and Greene, 2003). 5

17 prior year s fourh-quarer accruals (Q 4 ACCRUALS) and cash flows (Q 4 CASHFLOWS). The sample consiss of all he firm-years in he annual sample wih he required fourhquarer daa for ha firm-year. The coefficien on Q 4 ACCRUALS (afer conrolling Q 4 CASHFLOWS) is (significan a he 0.05 level). The coefficien on Q 4 CASHFLOWS is also significanly posiive (0.43, significan a he 0.0 level) and almos wice as large as he coefficien on Q 4 ACCRUALS. In Column 2, I repea he analyses in Column bu conrol for he firs hree quarers accruals and cash flows. The resuls are very similar: he coefficien on Q 4 ACCRUALS is significanly posiive (0.075, significan a he 0.0 level), and he coefficien on Q 4 CASHFLOWS is wice as large as he coefficien on Q 4 ACCRUALS (0.54, significan a he 0.0 level). 9 The resuls in Panel B sugges ha he insignifican relaion beween annual accruals and subsequen reurns in Panel A is likely driven by he limied abiliy of he annual es o deec invesors reacion o accruals. Allowing coefficiens o vary across he quarerly componens of annual accruals gives evidence consisen wih invesors underreacing o accruals (see Panel B). 4.3 Quarerly Tes Table 4 replicaes he accrual anomaly using he quarerly sample. To conduc his analysis, en equal-sized porfolios are formed each quarer based on prior quarerly accruals, and an equally-weighed abnormal reurn ( BHAR QTR ) is hen compued for each porfolio. T-saisics are calculaed using Fama-MacBeh ype ime-series mean porfolio reurns wih Newey-Wes (987) sandard errors. Panel A of Table 4 repors he average porfolio reurn and accruals and cash flows over sixy quarers for each of he en 9 The coefficiens on Q i ACCRUALS (i =,2,3) are generally no significan excep Q 2 ACCRUAL (-0.067, -sa = -2.86). Furher analyses indicae ha his is caused by a few exreme observaions. Afer deleing % of he sample wih he larges squared residuals, his coefficien becomes (-sa = -0.88). 6

18 porfolios. The resuls are consisen wih he accrual anomaly: a rading sraegy of selling he mos posiive accrual firms and buying he mos negaive accrual firms yields a significan annual abnormal reurn of 6.8%. Panel B indicaes ha a rading sraegy of selling firms wih he mos negaive cash flow and buying firms wih he mos posiive cash flow yields an even greaer abnormal reurn, 3.% per year. Table 5 repors Fama-MacBeh mean coefficien esimaes from quarerly regression analyses of QTR BHAR on he scaled decile ranks based on prior quarerly accrual (ACCRUALS) and cash flow (CASHFLOWS). When cash flows are omied, he coefficien on ACCRUALS is (significan a he 0.0 level), consisen wih he accrual anomaly. However, he sign of he coefficien on ACCRUALS, afer conrolling for cash flows, becomes posiive, and his posiive coefficien is boh economically and saisically significan (0.084, significan a he 0.05 level). Thus, when cash flows are omied, he omission of cash flows causes a downward bias (-0.46, significan a he 0.0 level) in he coefficien on ACCRUALS. This bias is so severe ha i dominaes he underlying posiive relaion beween accruals and subsequen reurns. Similarly, he resuls indicae ha he omission of accruals also biases downward (bu does no dominae) he associaion beween cash flows and subsequen reurns. Specifically, he coefficien on CASHFLOWS is 0.96 when accruals are conrolled for, bu is reduced o 0.30 by he omission of accruals. The relaive magniude of he coefficiens on ACCRUALS and CASHFLOWS is noeworhy. When boh are included in he regression, he posiive coefficien on CASHFLOWS is more han wice as large as he posiive coefficien on ACCRUALS, wih he difference of 0.2 beween he wo coefficiens (significan a he 0.0 level). This 7

19 large difference beween he wo coefficiens explains why he omission of cash flows no only biases downward he coefficien on accruals bu urns i negaive and significan (see secion 2.). 20 These resuls sugges: () invesors underreac o accruals; (2) while underreacing o accruals, invesors underreac even more o cash flows; and (3) when cash flows are omied from he analysis, he sronger underreacion o cash flows han o accruals, combined wih he negaive correlaion beween he wo, imposes a downward bias on he associaion beween accruals and subsequen reurns. This bias dominaes he underlying underreacion o accruals, leading o he observed accrual anomaly Sub-sample Tes The sub-sample es, like he quarerly es above, also examines quarerly accruals and reurns subsequen o he quarerly filing dae. However, insead of using he full sample of firms, he sub-sample es examines sub-samples of firms where cash flows are likely o suffer from more iming and maching problems and where accruals herefore play a more imporan role in measuring firm performance. Based on prior research, hese firms are idenified as hose wih more volaile working capial requiremens and invesmen and financing aciviies and hose wih longer operaing cycles. Because examining hese firms provides a relaively more powerful es of invesors reacion o accruals han examining all firms, I expec o find even sronger evidence of invesors underreacing o accruals in his sub-sample es. 20 To ensure ha he resuls are no driven by paricular fiscal quarers, I repea he analyses separaely for each fiscal quarer and find ha he resuls for he whole sample hold for each fiscal-quarer sample. 2 Xie (200) finds ha he negaive associaion beween accruals and subsequen reurns is primarily aribuable o abnormal accruals calculaed from he Jones model. This finding is no surprising given ha he negaive correlaion beween accruals and cash flows is primarily aribuable o he abnormal accruals (see, e.g., Xie, 200, Table ). Therefore, he downward bias caused by he omission of cash flows is expeced o be largely capured by he abnormal accruals. The unabulaed resuls indicae his is he case. 8

20 Following Dechow (994), he volailiy of working capial requiremens and invesmen and financing aciviies is measured by he absolue magniude of accruals, and he lengh of operaing cycles is measured each quarer as follows: Operaing cycle ( AR + AR ) / 2 ( INV + INV ) / 2 + SALES / 90 COST of GOODS SOLD / 90 = (5) where AR is accouns receivable (Compusa Quarerly Iem 37), INV is invenory (Compusa Quarerly Iem 38), SALES are ne sales (Compusa Quarerly Iem 2), and COST of GOODS SOLD is cos of good sold (Compusa Quarerly Iem 30). In Equaion (5), he firs componen capures he speed of convering credi sales ino cash, and he second measures he number of days i akes o produce and sell producs. 22 Table 6, Panel A repors he resuls for sub-samples pariioned based on he absolue magniude of accruals (a measure of he volailiy of working capial requiremens and invesmen and financing aciviies). The quarerly sample is pariioned ino wo sub-samples wih an equal number of firms based on firms median absolue magniudes of quarerly accruals. The same analysis as in Table 5 is performed separaely for he wo sub-samples. Compared wih he resuls based on he full quarerly sample (see Table 5), he es based on a sub-sample of firms wih larger magniudes of accruals yields sronger evidence of invesors underreacing o accruals. For his sub-sample of firms, he coefficien on ACCRUALS, afer conrolling for cash flows, is 0.55 (significan a he 0.0 level), and much larger compared wih ha for he full sample 22 I also use a second measure proposed by Dechow (994) for he lengh of operaing cycles, which is calculaed as: ( AR + AR ) / 2 ( INV + INV ) / 2 ( AP + AP ) / 2 Trade cycle = + SALES / 90 COST of GOODS SOLD / 90 PURCHASES / 90 where AP is accouns payable. The resuls using his second measure are similar o hose using he firs measure. 9

21 (0.084, Table 5). For oher firms wih smaller magniudes of accruals, he coefficien on ACCRUALS, afer conrolling for cash flows, is only weakly posiive and saisically insignifican (0.04, -sa = 0.56). In addiion, when cash flows are omied, he downward bias in he coefficien on ACCRUALS is more severe for firms wih larger magniudes of accruals (-0.22) han for oher firms (-0.075). Table 6, Panel B repors he resuls for sub-samples pariioned based on he lengh of operaing cycles. For each firm-quarer, an operaing cycle is compued using Equaion (5). A firm-specific operaing cycle is calculaed as he median of all he compued operaing cycles for his firm. The quarerly sample is hen pariioned ino wo sub-samples wih an equal number of firms based on firm-specific operaing cycles. The analyses are conduced separaely for he wo sub-samples. As expeced, he es using firms wih longer operaing cycles provides sronger evidence of an underreacion of invesors o accruals. For firms wih longer operaing cycles, he coefficien on ACCRUALS, afer cash flows are conrolled for, is 0.20 (significan a he 0.0 level), compared wih for he full sample (Table 5) and for firms wih shorer operaing cycles. Also, he downward bias in he coefficien on ACCRUALS caused by he omission of cash flows is more severe for firms wih longer operaing cycles (-0.95) han for firms wih shorer operaing cycles (-0.02). 4.5 Addiional Analyses Shorer reurn windows The analyses so far have used a 2-monh reurn window, in line wih Sloan (996). However, previous sudies show ha mos of he marke s delayed response (drif) occurs in he subsequen 3 o 6-monh period (see, e.g., Bernard and Thomas, 20

22 989; Jegadeesh and Timan, 993), suggesing ha ess using a shorer reurn window are relaively more powerful. I repea he analyses using 3- and 6-monh reurn windows. Panel A and B of Table 7 repor he resuls of repeaing he analyses in Table 5 using a 3- monh window and a 6-monh window respecively. As expeced, he resuls for hese shorer windows show sronger evidence of an underreacion of invesors o accruals. December year-end firms The analyses so far have used firms wih all fiscal year-ends o maximize sample size. One poenial concern is ha he porfolio assignmen is based on he disribuion for all firms in each period, including some ha have no ye repored heir accruals for ha period. If he disribuion of accruals varies sysemaically wih fiscal year-end, his may cause a hindsigh problem. I repea he analyses using only December year-end firms and find ha my inferences remain unalered (see Panel C of Table 7). Influenial observaions To ensure ha he resuls are no driven by a small number of influenial observaions, I repea he analyses afer excluding % of observaions wih he larges squared residuals (Knez and Ready, 997) and find ha my inferences remain unchanged (see Panel D of Table 7). Small and illiquid firms To invesigae wheher he resuls are primarily driven by small, illiquid firms, I repea he analyses afer excluding all firms wih sock prices lower han $5, and all firms wih a marke capializaion ha would pu hem ino he smalles NYSE/AMEX size decile (Jegadeesh and Timan, 200). I find ha my inferences remain unchanged afer excluding hese small, illiquid socks (see Panel E of Table 7). 2

23 5. Tess of Analyss Earnings Forecass In his secion, I invesigae financial analyss reacion o accruals hrough he examinaion of he relaion beween accruals and heir forecass of fuure earnings. To he exen ha analyss forecass of fuure earnings can be used as a proxy for invesors expecaions (e.g., Brown and Rozeff, 978; Fried and Givoly, 982; O Brien, 988), his analysis provides me a seing o direcly examine he link beween accruals and invesors expecaions of fuure firm performance. Since his analysis does no rely on sock prices, i helps miigae some of he concerns ha unknown risk facors or research design flaws may confound he reurn-based ess repored in Secion 4. Bradshaw e al. (200) also invesigae how analyss reac o accruals. They find a negaive associaion beween accruals and errors in analyss forecass of fuure earnings (defined as acual earnings minus forecas earnings). They inerpre his negaive associaion as evidence ha financial analyss, like invesors, also overreac o accruals. They conclude ha his evidence confirms and complemens he accrual anomaly repored by Sloan (996). However, Bradshaw e al. (200) omi cash flows in heir examinaion of he associaion beween accruals and analys forecass. So heir resul is poenially biased by a similar correlaed omied variable problem ha affecs he inferences concerning he accrual anomaly. To assess he presence and exen of such a bias, I examine he associaion beween accruals and analyss forecas errors while conrolling for he effec of cash flows. Specially, I esimae he following model: FERROR + = α 0 + α ACCRUALS + α 2 CASHFLOWS + υ+ (6) 22

24 where FERROR+ is forecas errors for earnings in period +, ACCRUALS is accruals in period, and CASHFLOWS is cash flows in period. If analyss incorporae he informaion in accruals efficienly, here should be no relaion beween accruals and forecas errors. Oherwise, consisen wih Bradshaw e al. (200), a negaive (posiive) coefficien on accruals is inerpreed as an overreacion (underreacion) o accruals by financial analyss. A similar inerpreaion applies o cash flows. The sample used for esimaing Equaion (6) consiss of all he observaions in he quarerly sample for which analyss median consensus forecass and IBES acual earnings are available on he IBES summary saisics file. Following Bradshaw e al. (200), he equaion is esimaed for each fiscal monh from he monh following quarer earnings announcemen hrough he monh before quarer + earnings announcemen. Specifically, I iniially measure he forecas for quarer + earnings in he firs monh afer he quarer s earnings announcemen and hen rack forecas errors over he monhs leading up o he quarer + s earnings announcemen. I use Monh, Monh 2, and Monh 3 o denoe he firs, second, and hird monh afer he quarer announcemen bu before he quarer + announcemen. Forecas errors are calculaed as he difference beween IBES realized earnings and analyss median consensus forecass, scaled by he sock price a he end of quarer. There are 53,923, 52,36 and 42,327 observaions in he samples for Monh, 2, and 3 respecively. Table 8 repors he summary saisics of he hree monhly samples. The mean forecass sugges ha analyss are opimisic. This opimism declines from Monh o Monh 3. The median forecas, however, does no show any obvious opimism or pessimism. These paerns are consisen wih prior findings (e.g., O Brien, 988; 23

25 Abarbanell and Lehavy, 2003). For all hree samples, he Spearman correlaion beween accruals and forecas errors is consisenly negaive and significan, while he Spearman correlaion beween cash flows and forecas errors is consisenly posiive and significan. Table 9 repors he resuls from esimaing Equaion (6). To miigae he influence of poenial ouliers caused by daa error or exreme forecas errors (e.g., Abarbanell and Lehavy, 2003; Gu and Wu, 2003), I perform a rank regression analysis using scaled decile ranks for all he variables. 23 Forecas errors, accruals, and cash flows are assigned ino deciles each quarer, and he quarerly decile ranks are scaled o he range [0,] as before. A separae esimaion of Equaion (6) is performed for each quarer, and he mean coefficiens, Fama-MacBeh -saisics wih Newey-Wes sandard errors, and average R- squares for he 60 quarerly esimaions are repored in Table 9. The ess on he hree monhly samples (Monh, 2, and 3) generae similar findings. Specifically, when he effec of cash flows is conrolled for, he associaion beween accruals and forecas errors is posiive and significan. This posiive associaion is significanly smaller han he posiive associaion beween cash flows and forecas errors. When cash flows are omied, he associaion beween accruals and forecas errors is biased downward o such an exen ha his associaion becomes negaive and significan, consisen wih Bradshaw e al. (200). These resuls complemen and reinforce he evidence concerning invesors reacion o accruals repored in Secion 4. The resuls sugges: () financial analyss underreac o accruals; (2) analyss underreac o cash flows o a greaer exen; and (3) when cash flows are omied, he sronger underreacion o cash flows han o accruals, combined wih he negaive correlaion beween accruals and cash flows, produces a 23 The inferences are unchanged if I use winsorized raw forecas errors insead of ranks. 24

26 severe downward bias on he associaion beween accruals and forecas errors. This bias dominaes he underlying underreacion of analyss o accruals, leading o Bradshaw e al. s (200) finding ha analyss overreac o accruals. 6. Conclusion In his sudy, I reexamine he accrual anomaly, focusing on how hree feaures of Sloan s (996) research design affec inferences regarding he exisence of he accrual anomaly. The firs is he omission of cash flows from he examinaion of he associaion beween accruals and subsequen reurns, which creaes a correlaed omied variable problem. The second is he use of an annual seing, which limis he es s abiliy o deec invesors reacion o accruals. The hird design feaure is he reliance on he full sample of firms, which reduces he es s power. Afer conrolling for cash flows and conducing he es of he anomaly in a quarerly seing, he evidence shows ha invesors underreac o accruals and hey underreac o cash flows o a greaer exen. When cash flows are omied from he analyses, he sronger underreacion o cash flows han o accruals, combined wih he negaive correlaion beween he wo, imposes a severe downward bias on he associaion beween accruals and subsequen reurns. This bias conceals he underlying underreacion of invesors o accruals, leading o he observed accrual anomaly repored by Sloan (996). These resuls hold on average for he full sample of firms and, as expeced, are even sronger for firms where accruals play a relaively more imporan role in measuring firm performance. Similarly, financial analyss are found o underreac o accruals once cash flows are accouned for, reversing he previous finding ha analyss ac in accordance wih he accrual anomaly. 25

27 The challenge presened by he findings in his paper is o explain why invesors and analyss appear o underreac o boh accruals and cash flows and why hey appear o underreac more o cash flows han o accruals. Possible explanaions include risk mismeasuremen or unknown research design flaws. Anoher possibiliy is ha invesors do no fully undersand he ime-series properies of quarerly earnings (see, e.g., Bernard and Thomas, 989, 990; Ball and Barov, 996). Invesors may ac as if quarerly earnings follow a seasonal random walk process, while he rue earnings process migh be a seasonally differenced firs-order auo-regressive process wih a seasonal movingaverage erm o reflec he seasonal negaive auocorrelaion (Brown and Rozeff, 979). Alhough his explanaion was originally proposed for invesors underreacion o earnings informaion in he pos-earnings-announcemen-drif lieraure, i also provides a possible explanaion for he findings in his sudy. Assuming ha cash flows are more persisen han accruals, when earnings surprises consis relaively more of cash flow (accrual) surprises, he posiive auocorrelaion beween adjacen earnings surprises is relaively sronger (weaker). If invesors ignore his auocorrelaion when forming heir expecaions of fuure earnings, we would observe a sronger (weaker) underreacion (or drif) when earnings surprises are due more o cash flow (accrual) surprises. The invesigaion of hese and oher possible explanaions for wha appears o be an underreacion o accruals and cash flows represens ferile avenues for furher work aimed a undersanding how invesors value accruals and cash flows. 26