Sanjay Sehgal (India), Srividya Subramaniam (India), Floren Deising (France) Accruals and cash flows anomalies: evidence from he Indian sock marke Absrac This sudy examines he persisence of earnings performance, he conribuion of accruals and cash flows in he persisence of earnings and wheher invesors correcly value he informaion conained in earnings, accruals and cash flows for equiy pricing. Thr auhors use daa for 493 companies on he BSE from January 1997 o December 21. The resuls suppor he high persisence of earnings for he sample firms and ha he sock prices correcly reflec he implicaions of curren earnings for fuure earnings. I is found ha earnings persisence is more aribuable o cash flows han accruals. However, he Indian invesors seem o under price accruals and overprice cash flows which is in conras o findings for maure markes. Accruals are found o be posiively associaed wih fuure reurns. The accrual anomaly is no capured by one facor CAPM bu is fully explained by he hree facor Fama French model due o risk premium on he size facor. A negaive relaionship is repored beween cash flows and reurns which is again conrary o he resuls for maure markes. The cash flow anomaly which is no absorbed by CAPM is explained by he size and value facors of he Fama French model. Hence accruals and cash flow anomalies do no pose serious challenge o popular asse pricing models in he Indian conex. The findings will be highly useful for invesmen analyss and porfolio managers who are in pursui of rading sraegies ha promise exra normal reurns. The research conribues o asse pricing and behavioral finance lieraure especially for emerging markes. Keywords: accruals, cash flows, earnings persisence, CAPM, Fama French model. JEL Classificaion: C22, C33, G12, G14, M41. Inroducion In a seminal paper, Sloan (1996) ess he heory ha invesors fixae oo heavily on corporae earnings in esablishing sock prices. He finds ha invesors focus on curren earnings o predic fuure earnings and fail o fully realize he informaion conveyed by he wo componens of earnings which are accruals and cash flows from operaions. Alhough boh componens conribue o curren earnings hey have differen implicaions for he assessmen of fuure earnings. The persisence of curren earnings is decreasing in he magniude of he accrual componen of earnings and increasing in he magniude of he cash flow componen of earnings. In oher words accruals are less persisen han cash flows (Barh & Huon, 24; and Bradshaw, Richardson & Sloan, 21). If invesors do no foresee he lower persisence of earnings performance aribuable o he accruals componen of earnings and naively fixae on earnings hen hey will be likely o overprice (underprice) socks in which he accrual componen is relaively high (low). This occurs because hey do no anicipae he lower persisence of earnings performance aribuable o he accruals componen of earnings. This mispricing will be correced when fuure earnings are realized o be lower (higher) han expeced. When his happens he marke reacs negaively (posiively) o he earnings announcemen resuling in predicable negaive (posiive) abnormal sock reurns. This is he accrual anomaly which was firs documened by Sloan (1996). A rading sraegy aking a long posiion in he sock of firms reporing relaively low levels of accruals and a shor posiion in he sock of firms reporing relaively high level of accruals generaes posiive sock reurns. Sloan (1996) shows ha for he US marke low (high) accrual socks generae posiive (negaive) abnormal fuure reurns and a hedge sraegy ha explois his anomaly generaes a significan annual abnormal reurn of 1.4%. Sloan (1996) and Bradshaw e al. (21) examine he relaion beween componens of curren earnings and fuure earnings. They find ha he coefficiens of accruals and cash flows are significan beween and 1 which implies ha wo componens conribue o he mean reversion of earnings. The coefficien of accruals is smaller han ha of cash flows indicaing he faser mean reversion of accruals han ha of cash flows. Hence high earnings performance aribuable o he cash flows componen of earnings is more likely o persis han he high earnings performance ha is aribuable o he accrual componen of earnings. The accrual anomaly has been exended and furher researched by several sudies. Xie (21) uses he Jones model 1 o decompose accruals ino normal and abnormal accruals and shows ha he overpricing of accruals which Sloan (1996) documens is due largely o abnormal accruals which capure accruals arising from mana- Sanjay Sehgal, Srividya Subramaniam, Floren Deising, 212. 1 See Xie (21, p. 368). 49
gerial discreion. He provides evidence ha use he abnormal accruals o consruc hedge porfolios resuls in higher abnormal reurns han hose generaed by firms pariioned on he basis of accruals more generally. Beneish and Vargus (22) sugges ha accrual mispricing is largely due o mispricing of income increasing accruals and ha one-year ahead hedge reurns o rading sraegies based on he direcion of accruals and insider rading are higher han hose based on accruals alone. They find some evidence supporing Xie (21) ha high accruals are relaed o earnings managemen. Richardson, Sloan, Soliman and Tuna (24) caegorize accruals according o heir reliabiliy and find ha he accruals mispricing is more severe for he less reliable caegories of accruals (working capial accruals and non curren operaing accruals). Raionalizing he accrual anomaly from a disress risk perspecive Ng (24) finds ha a high level of accruals is a signal of low disress risk and a low level of accruals is a signal of high disress risk. Zach (23) documens ha relaive o firms in high accruals porfolios, firms in low accruals porfolios have lower profis, lower sales growh, lower fiscal year cumulaive reurns, more resrucurings and divesiures, less mergers and acquisiions, and higher disress risk based on Z-score and O-score. Desai e al. (24) find ha he accrual anomaly vanishes when conrolling for value glamour effecs, provided he value glamour effec is proxied by he raio of operaing cash flow o price. Collins and Hribar (2) find ha he accrual anomaly and he pos-earnings announcemen drif are disinc from each oher and hey repor ha a combined sraegy ha explois boh anomalies generaes higher reurns han each individual sraegy. Pincus e al. (27) using daa of weny counries confirm ha he anomaly is more likely o occur in counries having a common law radiion and also in counries allowing exensive use of accrual accouning and a lower concenraion of share ownership. However, Leippold and Lohre (21) who es he anomaly for weny-six equiy markes, afer examining he robusness of he resuls o muliple hypohesis esing, find ha few of he risk adjused reurns from accrual based hedge sraegy coninue o be anomalous in his seing and he reurns o he hedge sraegy are diminishing in recen imes. Some researchers have inerpreed findings in Sloan (1996) and Xie (21) as evidence ha he sock marke does no see hrough managers aemp o manipulae repored earnings. Mashruwala e al. (26) sae ha even if smar arbirageurs see hrough he implicaions of accruals for fuure earnings, hey would find eliminaing such mispricing difficul. They sugges wo sources of barriers o arbirage i.e. lack of close subsiues and ransacion coss which preven arbirageurs from eliminaing accrual mispricing. Lev and Nissim (26) show ha exreme accrual firms have characerisics such as small size and low sock price and book-o-marke raio, which insiuions end o avoid. Trading in he socks of exreme accrual firms enails for individuals subsanial informaion processing and ransacion coss likely deerring hem from exploiing he accruals gains. Consequenly he anomaly persiss. Since accruals and cash flows are negaively relaed, Sloan (1996) argues ha a rading sraegy of simulaneously buying high cash flows and selling low cash flows socks will also generae a posiive abnormal reurn. He posulaes ha he cash flow anomaly coexiss wih he accrual anomaly. Empirical evidence on his conjecure is mixed. Houge and Loughran (2) and Collins and Hribar (2) provide evidence on he coexisence of he accrual and he cash flow anomaly. Pincus e al. (27) find ha he occurrence of he accrual anomaly in a counry does no always imply ha he cash flow anomaly coexiss or vice versa. Fama and French (28) poin ou ha he accrual anomaly is he mos pervasive reurn anomaly as i remains srong in all size groups, in cross-secional regressions, and in ess based on porfolio sors. The accrual anomaly has been widely researched for he US marke. Some of he sudies on oher counries include Farshid, Mirza and Yao (26) for China, Kho and Kim (27) for Korea, Koerniadi and Tourani-Rad (25) for New Zealand, Clinch, Fuller, Govendir and Wells (21) for Ausralia, Pasaribu (29) for Indonesia and Fazeli and Aflaooni (21) for Iran. While he persisence of earnings and is componens i.e. cash flow and accruals and heir role in equiy pricing has been widely researched in he developed markes, he exen of heir presence in an emerging marke like India is relaively unexplored. The objecive of his paper is wofold: firs we invesigae he persisence of earnings repored by he firms in our sample. Consisen wih prior research, we measure earning persisence in he conex of persisence from one period o he nex. We hen es wheher earnings persisence is more aribued o cash flow or accrual componen of earnings. Secondly we examine if informaion inermediaries in India anicipae he informaion in earnings persisence and wheher invesors price accruals and cash flows relaive o heir conribuion in projecion of earnings one year ahead. 5
This paper conribues o he exising lieraure in several imporan ways. Pincus e al. (27) and Leippold and Lohre (21) include he Indian case o sudy he accrual anomaly, hey cover an earlier ime period. We re-examine he accrual anomaly for a longer ime period including he more recen ime period. Nex o calculae accruals we use boh balance shee and he cash flow saemen definiions and verify if our resuls are robus o choice of accrual measure. When creaing accrual sored porfolios we use boh a mixed model (Sloan, 1996) as well as one in which disincion is made beween posiive and negaive values of accruals (Fama & French, 28). However he mos imporan conribuion of he paper is he es of he presence of cash flow anomaly which has ill now no been researched in he Indian conex. This also has been examined using definiions based on boh balance shee and cash flow saemen. The paper is organized as follows. In Secion 1 we develop he hypohesis. Secion 2 describes he daa and heir sources. Secion 3 explains he mehodology followed. Secion 4 gives he empirical resuls. The las secion conains summary, policy implicaions and concluding remarks. 1. Tesable hypohesis The sudy aemps o es he following hypoheses. Hypohesis 1: There is persisence in curren earnings performance. Hypohesis 2: Curren earnings performance is less persisen if i is aribuable o he accrual componen of earnings han o he cash flow componen of earnings. Hypohesis 3: Sock prices anicipae he average persisence of earnings performance. Hypohesis 4: The earnings expecaions rooed in sock prices fail o reveal fully he higher earnings persisence aribuable o he cash flow componen of earnings and lower earnings persisence aribuable o he accrual componen of earnings. We nex assess wheher abnormal reurns can be earned by aking rading posiions on he accrual and cash flows variable o provide addiional confirmaory evidence on hypohesis 3 and 4. Hypohesis 5: The observed accrual anomaly is fully capured by sandard risk models like CAPM or FF hree facor model. Hypohesis 6: The cash flow anomaly is capured by sandard risk models like CAPM or FF hree facor model. 2. Daa The sample used consiss of 493 companies ha form par of BSE-5 equiy index. The sudy uses monh end closing adjused share prices (adjused for capializaion such as bonus, righs and sock splis) from January 1997 o December 21 (168 monhly observaions). BSE-5 index represens nearly 93% of he oal marke capializaion, accouns for 95% of rading aciviy, and covers all 2 major indusries of he economy. Hence, he sample is fairly represenaive of marke performance. The Bombay Sock Exchange (BSE)-2 index is used as he marke proxy. I is a broad based value weighed index which is consruced on he lines of S&P5 (USA). The monh end share price series have been convered ino percenage reurn series for furher esimaion. Marke capializaion (used as he size proxy) is oal marke value of all he company s ousanding shares. I is calculaed as he naural log of price imes shares ousanding a he end of December of year -1. Price-o-book value (inverse of BE/ME) per share (used as value proxy) represens he securiy price over a company s book value. Daa on share prices, marke index, and all company characerisics required for calculaion of accruals has been obained from he Thomson ONE daabase of Thomson Reuers. The implici yields on 91-day reasury bills have been used as a risk-free proxy as is he sandard pracice in finance lieraure. The daa for his has been aken from he RBI monhly handbook of saisics and RBI websie. We primarily use he balance shee mehod for he measuremen of accruals, o guaranee comparabiliy wih oher inernaional sudies and wih he original sudy of Sloan (1996). Accruals ( CA Cash) (1) ( CL STD TP) Dep, where CA is he change in curren asses; Cash is he change in cash or cash equivalen; CL is he change in curren liabiliies; STD is he change in deb included in curren liabiliies; TP is he change in ax payables, and Dep is he depreciaion and amorizaion expense. Earnings are measured as ne operaing income before exraordinary iems. The cash flow componen of earnings is measured as he difference beween earnings and he accrual componen of earnings. Earnings, and is componens i.e. accruals and cashflows are sandardized by he average oal asses i.e. average of he beginning and he end of calendar year book value of oal asses. Collins and Hribar (22) repor ha he balance shee approach of measuring accruals inroduces 51
measuremen error ino he accrual esimae, primarily due o mergers and acquisiions and disconinued operaions. When such evens occur, he parameer esimaes are biased owards he exisence of earnings managemen. However, he cash flow based measure of accruals is no affeced by such corporae evens. To avoid his source of poenial error we esimae accruals using cash flow approach o measure accruals. Accruals are calculaed as he difference beween earnings and operaing cash flows. Operaing cash flow daa is obained from saemens of cash flows. Earnings are he same as defined above. All hree variables are sandardized by average oal asses. 3. Mehodology and esimaion procedure This sudy applies he balance shee approach in compuing accruals for esing he above four hypohesis. Tess of he las wo hypoheses are reconfirmed by using he cash flow saemen definiion of accruals. 3.1. Tes of persisence in earnings and is componens. Following Sloan (1996) we use a model ha esimaes he average persisence of curren earnings on fuure earnings and anoher model ha does no resric he accruals and cash flows componens of curren earnings o be equal o examine he differen persisence of accruals and cash flows componens of curren earnings. Earnings 1 1 Earnings 1, (2) Earnings 1 1 Accrualsi (3) 2 Cashflowsi 1. Equaion (2) esimaes he average persisence of curren earnings on fuure earnings. Since earnings are defined as operaing income scaled by oal asses so 1 measures he persisence of he accouning rae of reurn on asses. As accouning raes of reurn are mean revering, 1 is less han uniy (Sloan, 1996, p. 297). This equaion consrains he coefficiens on he cash and he accrual componens of earnings o be equal. However, he accrual anomaly arises from he differen persisence of accruals and cash flows componens of earnings. The specificaion is required o es he equaion (3) which decomposes curren earnings ino accruals and cash flows componens of earnings.. The smaller coefficien on accruals ( 1 ) relaive o cash flows ( 2 ) reflecs he lower persisence of earnings performance aribuable o he accrual componen of earnings. If cash flows have greaer implicaions for fuure earnings we expec ha 2 > 1. 3.2. Marke efficiency ess. We apply Mishkin es as discussed in Sloan (1996) and Kraf, Leone and Wasley (27, p. 7) o es he second hypohesis as follows: 52 E m( 1 Earnings 1 ) E( Earnings ), (4) where is he informaion available a ime, Em( Earnings 1 ) is he marke s subjecive expecaion of earnings for period + 1 and E( Earnings 1 ) is he objecive expecaion of Earnings 1 condiional on. Equaion (4) indicaes ha he marke s expecaion of earnings is equal o he rue expecaion of earnings condiional on all pas informaion. Marke efficiency implies E R ) R E ( R ), (5) ( 1 1 m 1 where R +1 is he reurn in year + 1 and E m (R +1 ) is he marke s subjecive expecaion of R +1 condiional on informaion available a ime. Equaion (5) implies R +1 should be uncorrelaed wih pas informaion. From equaions (4) and (5), he efficien markes condiion can be wrien as: R 1 [ 1 1 1 ( Earnings E( Earnings )] e, (6) where e +1 is a disurbance erm and E(e +1 ) =, is a valuaion muliplier. Assuming marke efficiency, R +1 should only be relaed o unexpeced earnings and no o any pas informaion. Combining he earnings forecasing in equaion (2) and he raional pricing in equaion (6) he es for marke raionaliy is based on he following sysem of equaions: Earnings AR 1 1Earnings v 1, (7) 1 ( Earnings * Earnings ) 1 1. 1 (8) AR is a sock s abnormal reurn defined as he difference beween he sock reurn and he size mached porfolio reurn. I is calculaed by aking he buyhold sock reurn and subracing he buy-hold reurn on a size mached equal weighed porfolio of firms. The size porfolios are based on marke value of equiy quiniles of BSE-5 firms. The earnings forecasing in equaion (7) uses pas informaion (Earnings ) o forecas fuure earnings, Earnings +1. The weigh placed on pas earnings, 1, is an objecive measure of how earnings is relaed o fuure earnings. By join nonlinear esimaion of equaions (7) and (8) one can use informaion in reurns o infer how he marke used informaion in Earnings o forecas Earnings +1. Equaion (4) implies ha he marke s subjecive expecaion of earnings condiional on pas informaion (which one infers from equaion (7)), should be equal o he objecive expecaion of earnings which one can
esimae in equaion (8). A es for raionaliy is ha 1 = 1 *. This non-linear consrain requires ha sock prices correcly anicipae he average persisence of earnings performance. When earnings are broken down ino accruals and cash flow from operaions he forecasing specificaion for fuure earning (equaion (9)) and he raional expecaions pricing specificaion (equaion (1) provides he following sysem: Earnings 1 1accruals 2cashflows 1, 2 1 (9) AR 1 ( Earnings 1 1 * accruals (1) * cashflows ). Equaion (9) is a forecasing equaion which esimaes he forecasing coefficien of accruals and cash flows componen for predicing earnings one year ahead. Equaion (1) is valuaion equaion ha esimaes he valuaion coefficien ha he marke assigns o accruals and cash flow componens of earnings. The sarred coefficiens represen esimaes of persisence implici in sock reurns while unsarred coefficiens are esimaed direcly from earnings, accruals and cash flow daa. The objecive is o see if invesors assign a higher valuaion coefficien o accruals han he one expeced in he associaion beween accruals and fuure earnings. The dual consrains for marke efficiency are 1 * from he reurns equaion (1) is no differen han 1 from he forecasing equaion (9) and 2 * from he reurns equaion (1) is no differen han 2 from he forecasing equaion (9) i.e., he weigh applied o cash flow and accruals in he forecasing equaion are he same as he weigh applied by he marke o hese componens in he equilibrium pricing equaion. This means no securiies mispricing would occur and herefore no abnormal reurns would be available on accrual sored porfolios. If his condiion is defied accrual anomaly will occur. The wo sysems (equaions (7) and (8)) and (equaions (9) and (1)) are esimaed using non-linear Generalized Leas Squares (GLS). Marke efficiency is esed using he following likelihood raio es (asympoically disribued as 2 (q) under he null hypohesis): 2n ln(ssr c /SSR u ), (11) where q is he number of raional pricing consrains imposed, n is he number of observaions in each equaion (2n is he number of observaions in he sacked regression), SSR c is he sum of squared residuals from he consrained sysem and SSR u is he sum of squared residuals from he unconsrained sysem. 3.3. Asse pricing ess. While Mishkin es idenified wheher he accrual anomaly exis in a saisical sense, i provides no indicaion of is economic significance. To address his we nex perform he asse pricing ess. We group socks ino five porfolios based on he magniude of accruals as per he balance shee definiion. In December of year -1, he securiies are ranked on he basis of accruals. The ranked securiies are hen classified ino five porfolios P1 o P5 and equallyweighed monhly excess reurns are esimaed for hese porfolios for he nex 12 monhs (). P1 is he porfolio consising of 2% of companies wih he lowes aribue while P5 consiss of op 2% companies wih he highes aribue under consideraion. The porfolios are re-balanced a he end of December of year. Sample securiies are sored in December of each year beginning from December 1996 and porfolio formaion process repeaed ill we reach December 29. Companies wih missing value of he characerisic are excluded from he analysis. We find ha a large number of firms have negaive accruals. While forming accrual sored porfolios we have used wo mehods. Following Sloan (1996) and a number of oher sudies we use a mixed model wherein all he socks have been sored ino quiniles on basis of all values of accruals aken ogeher wihou any disincion beween posiive and negaive values. In he second mehod we form separae porfolios for firms wih negaive and posiive values of accruals (similar o he mehodology adoped by Fama and French (28)). We sor socks wih posiive values and negaive values ino 5 porfolios each 1. In he firs sep of our mehodology we observe he unadjused mean excess reurns across he accrual sored porfolios. If we find a paern in he unadjused excess reurns, hen here exiss an anomaly. Nex, CAPM regressions are run on each of he five porfolios using familiar excess reurn version of he marke model equaion: R p R a b R R ) e, (12) f ( m f where R p R f is he monhly excess reurn on he porfolio i.e. reurn on porfolio P minus risk-free reurn (R f ), R m R f is he excess marke reurn i.e reurn on marke facor minus risk-free reurn, e is he error erm, a (inercep) is a measure of abnormal profis and b is he sensiiviy coefficien of marke facor. 1 Daa is from 26:1 o 21:12. 53
The CAPM implies ha excess reurns on a porfolio should be fully explained by excess marke reurns. Hence, he expeced value of a (he inercep erm) should be. A significanly posiive (negaive) value of a (inercep) implies exra-normal profis (losses). If here is a significan posiive or negaive inercep in he CAPM specificaion, hen a CAPM anomaly exiss. Then we aemp o evaluae if he excess reurns of he sylized porfolios ha are missed by CAPM can be explained using he hree facor model of Fama and French (1993) specified as follows. The FF model is given by Rp Rf a b( Rm Rf ) s( SMB ) (13) h( LMH ) e, where SMB is he monhly reurn on he size mimicking porfolio, LMH is he monhly reurn on he price-o-book mimicking porfolio, s and h are he sensiiviy coefficiens of SMB and LMH. The oher wo erms are he same as defined in equaion (12). We esimae SMB and LMH as follows. In each year of he sample period, he socks are spli ino wo groups big (B) and small (S) based on wheher heir marke capializaion a he end of December of every year in he sample period is above or below he median for he socks of he companies included. The price o book equiy raio is calculaed in his monh for all he companies. The socks are now spli ino wo equal P/B groups (L and H). Then we consruc four porfolios, namely S/L, S/H, B/L, B/H from he inersecion of he wo sizes and wo P/B groups. Monhly equallyweighed reurn series are calculaed for all porfolios from January of year o December of year (see Sehgal, Subramaniam and Morandiere (212) for deails). The Fama and French model uses hree explanaory variables for explaining he cross secion of sock reurns. The firs is he excess marke reurn facor ha is he marke index reurn minus he risk-free reurn. The second is he risk facor in reurns relaing o size small minus big (SMB). The simple average of he monhly reurns of he wo big size porfolios (B/L, B/H) is subraced from he average of he wo small size porfolios (S/L, S/H) o ge he monhly reurn of he SMB facor. This facor is free from value effecs as i has abou he same weighed-average price o book. SMB ( S / L S / H) / 2 ( B / L B / H) / 2. (14) The hird facor is relaed o value. LMH is consruced as follows such ha i is independen of size facor: LMH ( S / L B / L) / 2 ( S / H B / H ) / 2. (15) If he inerceps from he FF regressions are insignifican and he inerceps from he CAPM regressions are significan, hen his implies ha he FF specificaion is able o capure cross secional paerns in average sock reurns ha are missed by CAPM. On he oher hand, saisically significan inerceps of FF model shall sugges missing risk facors which one needs o idenify for creaing a complee facor srucure. Nex we form cash sored porfolios based on boh balance shee and cash flow saemen definiions and conduc he asse pricing ess as has been explained above. To es he aribues of he corner porfolios formed on accruals and cash flows we compue he average marke cap, P/B, liquidiy, profiabiliy for he corner porfolios. 4. Empirical resuls We begin he empirical resuls by providing mean values of earnings and is componens on accrual sored porfolios. We find evidence of a srong negaive relaion beween accruals and cash flows, which is consisen wih exising sudies. The mean value of cash flows falls from.29 for he lowes accrual porfolio o -.47 for he highes accrual porfolio. In conras earnings performance is posiively relaed o accrual which is also in conformiy wih prior work. The mean value of earnings is.76 for he lowes accruals porfolio and.19 for he highes accruals porfolio. The above relaionships are reconfirmed by he values of he correlaion coefficiens calculaed among earnings and is componens. The correlaion coefficien beween earnings and accruals and beween accruals and cash flows is.156 and -.813, respecively. Table 1. Mean value of earnings and is componens for accrual sored porfolios Porfolio accrual ranking P1 P2 P3 P4 P5 Accruals -.132 -.4 -.39.37.1567 Cash flows.29.112.79.55 -.47 Earnings.76.71.74.91.19 Table 2 provides he resuls relaed o he firs wo hypoheses. Panel A saes resuls from he esimaion of equaion (2) o esablish he average level of persisence in earnings performance. The esimae of 1 is.748. This is verifies ha earnings performance is slowly mean revering. The null hypohesis ha earnings performance is purely ransiory ( 1 = ) is rejeced by a -saisic of 67.388). Panel B provides he resuls for equaion (3). We find ha he coefficiens of boh accruals and cash flows are significan beween zero and one, which means ha 54
he wo componens conribue o he mean reversion of earnings. The coefficien of accruals (.797) is smaller han ha of cash flows (.83) indicaing ha he mean reversion of accruals is faser han ha for cash flows. A -es rejecs he hypohesis ha he coefficiens are equal. This evidence suppors he hypohesis ha accruals are less persisen han cash flows in shaping fuure earnings. Table 2. Empirical resuls of he ess of persisence of earnings and is componens Panel A. Resuls of ess of persisence of earnings 1 Adj. R 2.19.742.547 (14.62)* (66.142)* Panel B. Resuls of he es of persisence of accruals and cash flow componens 1 2.12.784.828 6.279* 45.694* 53.321* Noes: -saisics are in parenheses. *Denoes significance a he 5% level using wo ailed -es. T-es of 1 = 2, -3.34*, p-value =.. Wheher he marke accuraely anicipaes he persisence of earnings is considered firs in Table 3, Panel A. The difference in he wo esimaed coefficiens 1 =.748 and 1 * = 1.4 is saisically insignifican using a LR es saisic (Chi-sq = 3.414, p-value =..65). This indicaes ha sock prices anicipae he average persisence of earnings performance, since he null hypohesis of marke efficiency is no rejeced. This is in line wih resuls in Sloan (1996) where here is no evidence of a difference. Since sock prices correcly reflec he implicaions of curren annual earnings for fuure annual earnings, i poins owards he absence of a pos earnings announcemen drif in annual earnings. This means ha he drif documened in Bernard and Thomas (199) is probably unique o quarerly earnings changes and needs o be invesigaed in he Indian conex. Having esablished ha accruals and cash flows have differen implicaions for he persisence of earnings we invesigae wheher hese implicaions are refleced in share reurns, wih he resuls repored in Table 3 Panel B. In he forecasing equaion (equaion 4), he coefficien on accruals is.779 and he coefficien on cash flows is.827. Marke efficiency implies ha he differing implicaions of he accrual and cash flow componens of curren earnings for fuure earnings should be refleced in sock prices i.e. 1 * < 2 *. The resuls from he sock reurn equaion (equaion (5)) suppor his saemen. In he sock reurn equaion he coefficien on accruals * 1 is.471 and he coefficien on cash flows is.961. The LR saisic is 4.97 acceping he null hypohesis of marke efficiency. Therefore he resuls from Mishkin es indicae ha on average he invesors in India under price he informaion in accrual componen of earnings ( * 1 < 1 ) and overprice he informaion in he cash flow componen of earnings ( * 2 > 2 ). Table 3. Empirical resuls of he ess of marke efficiency Panel A. Tes of marke efficiency using earnings Asympoic sandard Parameer Esimae error p-value.19.1. 1.748.11. 1* 1.49.162. 2.116.466. Panel B. Tess of marke efficiency using accruals and cash flows Parameer Esimae Asympoic sandard error p-value.12.2.* 1.78.17.* 2.828.15.* 1*.472.281.935** 2 *.961.239.1* 1.638.583.5* Marke efficiency ess 1 = 1* 2 = 2* Null hypohesis LR es saisic p-value 1 = 1* and 2 = 2* 2 1 = 1.1955.2742 2 1 =.3125.5762 2 2 = 4.977.132 Noes: Tes of marke efficiency 1 = 1 *. Likelihood raio saisic chi-sq(1) = 3.41, p-value =.65. Chi-sq(1) = 3.84, Chi-sq(2) = 5.99. * Denoes significance a he 5% level. ** Denoes significance a he 1% level. Since 1 * < 2 * invesors hink he accrual componen of earnings is less persisen han he cash componen. Hence invesors seem o undersand he lower qualiy of he accrual componen of earnings and higher qualiy of he cash flow componen of earnings. We find ha he relaive difference beween 1 and 1 * is far greaer han he difference beween 2 and 2 *. This shows ha invesors who develop forecass end o underesimae he lower level of persisence in accruals and overesimae he higher level of persisence in cash flows. However, he level of underesimaion in he former seems o be far sronger han he level of overesimaion in laer. This pushes prices up resuling in higher reurns for higher accruals porfolio. A similar case of accruals under weighing and cash flows overweighing is also found in he case of he Indonesian marke by Pincus e al. (25) and accruals under weighing by Farshid e al. (26) for China. Since Mishkin ess indicae accrual underweighing, hence here is evidence of posiive reurns 55
for an accrual underweighing sraegy in India. We confirm his nex by conducing he asse pricing ess on accrual sored porfolios in Table 4. Panel A shows he unadjused excess reurns obained on accrual sored porfolios. Conrary o exising sudies on maure markes we find ha accruals are posiively associaed wih average reurns. The high Table 4. Empirical resuls for accrual sored porfolios Panel A. Unadjused average monhly excess reurns on accruals sored porfolios accrual firms repor an average monhly excess reurn of 2.3% (-sa = 2.54) while low accrual firms provide a monhly reurn of 1.9 % (-sa = 2.53). This reieraes our resuls obained from Mishkin ess which show ha here is accruals underweighing. However he reurn differenial of.4% beween high and low accrual firms is no saisically significan. P1 P2 P3 P4 P5 Mean -sa Mean -sa Mean -sa Mean -sa Mean -sa.19 2.533.15 2.5.19 2.51.19 2.384.23 2.542 Panel B. Empirical resuls based on one facor CAPM Porfolio a b (a) (b) Adj. R 2 P1.8.972 2.92 19.514.694 P2.5.948 1.221 18.974.682 P3.8 1.18 2.84 2.475.714 P4.8 1.65 1.838 2.13.75 Panel C. Empirical resuls for he hree facor Fama French model based on marke, size & value facors Porfolio a b S H (a) (b) (s) (h) Adj. R 2 P1..927.487.13.17 21.22 6.414 1.648.769 P2 -.3.897.444.29 -.771 2.279 5.82 2.635.76 P3 -.3.962.55.221 -.94 22.911 6.974 2.943.83 P4 1.1.443.331 -.193 21.847 5.614 4.29.789 P5. 1.151.623.29.158 25.237 7.934.363.823 We nex assess wheher he accrual rading sraegy is robus o reurn predicabiliy associaed wih CAPM bea (Panel B) and hree facor FF model (Panel C). The marke model resuls show ha an abnormal reurn of.8% per monh ( = 2.9) is generaed on low accrual firms and significan abnormal excess reurn of 1% per monh on high accrual firms (-sa = 2.22). The marke bea is lower for he low accrual porfolio as compared o he high accrual porfolio, which is in conras o equally high beas found by Sloan (1996) for exreme quiniles for he US. The CAPM fails o explain he reurns in exreme quinile accrual sored porfolios. Hence accruals seem o be an equiy marke anomaly when one uses he CAPM framework. Panel C shows ha he FF model is successful in absorbing he exra normal reurns ha are missed by CAPM. This is made possible by addiional conribuion of he size facor. Slope of SMB value is low for low accrual porfolios vis-a-vis high accrual porfolios indicaing ha low accrual porfolios are big socks conrary o small size firms in low accrual socks found by oher sudies for maure markes. This is reconfirmed by looking a he average marke cap of he corner porfolios (Table 5). LMH however does no play any significan role in explaining reurns on accrual sored porfolios. We find ha low accrual socks are low P/B, illiquid bu no small as compared o he high accrual socks (see Table 5). This is undersandable as big fundamenally srong firms have sronger bargaining power compared o small firms and hence can generae more cash sales from cusomers. The corner porfolios do no provide significan abnormal reurns in FF framework. Thus he accrual anomaly does no pose any serious challenge o asse pricing in he Indian conex provided one uses mulifacor benchmarks. In fac he role of accrual facor seems o be absorbed by role of size facor in reurns. Our resuls are in line wih Pincus e al. (27) who did no find he presence of a significan accrual anomaly for India. Table 5. Mean value of seleced characerisics for five porfolios formed annually by assigning firms o quiniles based on he magniude of accruals Porfolio accrual ranking Lowes P2 P3 P4 Highes Size 23.388 23.37 23.25 23.231 23.17 Value 4.39 4.79 3.123 3.748 4.835 Liquidiy.196.196.261.226.324 However our findings are in conras wih Sloan (1996) who finds ha lower accrual based porfolios provide higher reurns han higher accrual based porfolios. The Sloan (1996) resuls are an oucome of he fac ha invesors in general over esimae he lower persisence in accrual componen and underesimae he higher persisence in cash componen, he former being sronger han he laer resuling in overall overesimaion of earnings. 56
When we repeaed he asse pricing ess based on he cash flow saemen definiion for accruals, we find ha resuls are similar 1. The accrual anomaly seems o be explained by he Fama French model. Resuls are robus when we form separae porfolios based on posiive and negaive values of accruals 2. Soring firms based on he magniude of cash flows presens a differen picure. Table 6 presens mean values of earnings and is componens on cash sored porfolios. Earnings are posiively relaed wih cash flows and accruals are negaively relaed wih cash flows. We find ha reurns are negaively relaed wih cash flows which is in conras o resuls obained for he maure markes. Table 7 (Panel A) shows he unadjused average monhly excess reurn of high cash flow firm (.144) is significanly lower vis-a-vis ha of low cash flow firm (.257). A hedge sraegy simulaneously aking a long posiion in he low cash flow porfolio and a shor posiion in he high cash flow porfolio generaes a significan posiive abnormal reurn of 1.1% per monh (-sa = 2.23). This suggess he invesors overweigh he persisence of cash flow componen of curren earnings. However hese posiive abnormal reurns may also reflec oher unidenified risk facors. Table 6. Mean value of earnings and is componens for cash flows sored porfolios Lowes P2 P3 P4 Highes Cash flows -.84.28.76.13.26 Accruals.126.21 -.4 -.34 -.94 Earnings.415.49.71.96.1664 Table 7. Empirical resuls for cash flows sored porfolios Panel A. Unadjused average monhly excess reurns on cash flows sored porfolios P1 P2 P3 P4 P5 Mean -sa Mean -sa Mean -sa Mean -sa Mean -sa.26 2.625.22 2.478.16 2.58.2 2.695.14 2.187 Panel B. Empirical resuls based on one facor CAPM Porfolio a b (a) (b) Adj. R 2 P1.12 1.224 2.23 18.915.681 P2.1 1.99 1.949 18.176.663 P3.5 1.2 1.248 2.99.723 P4.9.979 2.488 21.667.738 P5.5.878 1.542 23.577.768 Panel C. Empirical resuls for he hree facor Fama French model based on marke, size & value facors Porfolio a b S H (a) (b) (s) (h) Adj. R 2 P1 1.14.631.42 -.31 21.524 6.918 4.239.794 P2 -.1 1.24.574.356 -.272 2.292 6.64 3.94.774 P3 -.3.969.418.231 -.736 22.453 5.62 2.984.791 P4.2.942.443.84.67 23.311 6.37 1.16.797 P5.868.426 -.157 -.75 26.381 7.519-2.666.825 We es wheher he cash flow rading sraegy is robus o reurn predicabiliy associaed wih he CAPM (Panel B) and he hree facor FF model (Panel C). The CAPM is unable o explain he abnormal reurns on he low cash flow porfolio. We hen assess if he FF hree facor model could absorb he reurns on hese cash flows sored porfolios. 1 The FF model is successful in absorbing he exra normal reurns ha are missed by CAPM. This is made possible by addiional conribuion of boh size and value facors. Slope 2 of SMB is high for low cash flow porfolios visa-vis high cash flow porfolios indicaing ha low cash flow porfolios are small socks. The coefficien of LMH is also high for low cash flow socks vis-a-vis high cash flow socks implying ha low cash flow socks are value socks and high cash flow firms are growh socks. This is validaed by looking a he aver- 1 Resuls have no been repored due o space consrains. 2 Resuls have no been repored due o space consrains. age marke cap and price-o-book raios of he corner porfolios (Table 8). The corner porfolios do no provide significan abnormal reurns in FF framework. Hence he cash flow anomaly is no very relevan in Indian marke. We find ha he characerisics of cash flow sored porfolios are differen from hose based on accruals. While high accrual socks are small, low cash socks are small and value socks. Table 8. Mean value of seleced characerisics for cash sored porfolios Cash flows sored porfolio Lowes P2 P3 P4 Highes Size 22.742 22.879 23.313 23.446 24.26 Value 3.489 2.83 3.42 3.786 6.995 Liquidiy.289.183.278.176.286 Summary and concluding remarks Our resuls poin owards a high level of earnings persisence and ha his persisence is more aribu- 57
able o he cash flows componen han he accruals componen. Resuls from Mishkin ess indicae ha informaion in earnings persisence is used by invesors promply since sock prices correcly reflec he implicaions of curren earnings for fuure earnings. We find ha on average invesors in India underprice he informaion in accruals componen of earnings and overprice he informaion in cash flows componen of earnings which is in conras o findings for developed markes. This accruals underweighing paves way for an accruals underweighing sraegy in India. We find ha high accrual porfolios end o provide higher reurns as compared o low accrual porfolios which is in conras wih he findings for developed markes. The accrual anomaly is no capured by one facor CAPM bu is fully explained by he hree facor Fama French model due o risk premiums on he size facor. Thus he accrual anomaly seems o be absorbed by he role of he size facor in reurns in he Indian conex. The resuls of he accrual anomaly are robus o choice of accrual measure (balance shee or cash flow saemen based). Invesigaing References 58 he cash flow anomaly, we find ha reurns are negaively relaed wih he level of cash flows which is again in conras o he findings for developed markes. However he anomaly is again missed by CAPM, bu is absorbed by he conribuion of boh size and value facors in he Fama French model. Hence boh he accrual anomaly and he cash flow anomaly do no pose serious challenge o asse pricing if one uses a mulifacor framework. From he perspecive of porfolio managers, informaion in accruals/cash flows does no hold srong promise of providing exra normal reurns in he Indian conex. I may, herefore, be more relevan for hem o pay aenion o oher prominen equiy marke anomalies such as size and momenum (see Sehgal e al. 212). From he academic poin of view, our resuls are in conflic wih he findings for developed markes, suggesing differences in invesor behaviour across markes. The presen research conribues o asse pricing and behavior finance lieraure for emerging markes. 1. Barh, M.E. & Huon, A.P. (24). Analys earnings forecas revisions and he pricing of accruals, Review of Accouning Sudies, 9, pp. 59-96. 2. Beneish, M., and Vargus, M. (22). Insider rading, earnings qualiy and accrual mispricing, The Accouning Review, 75, pp. 755-791. 3. Bradshaw, M.T., Richardson, S.A. & Sloan, R.G. (21). Do analyss and audiors use informaion in accruals? Journal of Accouning Research, 39 (1), pp. 45-74. 4. Clinch, G., Fuller, D., Govendir, B. & Wells, P. (21). The accrual anomaly: Ausralian evidence. Rerieved from hp://ssrn.com/absrac=1722992. 5. Collins, D. & Hribar, P. (2). Earnings-based and accrual-based marke anomalies: One effec or wo? Journal of Accouning and Economics, 29, pp. 11-123. 6. Desai, H., Rajgopal, S. & Venkaachalam, M. (24). Value-glamour and accruals mispricing: one anomaly or wo? The Accouning Review, 79 (2), pp. 355-385. 7. Fama, Eugene F. & Kenneh R. French (1993). Common risk facors in he reurns on socks and bonds, Journal of Financial Economics, 33, pp. 3-56. 8. Fama, Eugene F. & Kenneh R. French (1996). Muli-facor expalnaion of asse pricing anomalies, Journal of Finance, 51, pp. 55-84. 9. Fama, Eugene F. & Kenneh R. French (28).Dissecing Anomalies, Journal of Finance, Vol. 63, No. 4, pp. 1653-1678. 1. Farshid, N., Mirza, M. & Yao, I. (26). Do sock prices in china reflec informaion in earnings persisence? Paper presened a ACESA 26 conference held a Vicoria Universiy, Melbourne. 11. Fazeli, Y.S. & Aflaooni, A. (21). The mispricing of earnings componens: new evidences from Iran, Inernaional Research Journal of Finance and Economics, 59, pp. 42-49. 12. Houge, T. & Loughran, T. (2). Cash flow is king: cogniive errors by invesors, Journal of Psychology and Financial Markes, 1, pp. 161-175. 13. Kho, B. & Kim, J. (27). Does he accrual anomaly reflec a risk facor? The case of he Korean sock marke, Asia-Pacific Journal of Financial Sudies, 36 (3), pp. 425-461. 14. Koerniadi, H. & Tourani-Rad, A. (25). Accruals and cash flows anomalies: evidence from he New Zealand sock marke. Research Paper, 24-25, Faculy of Business, Auckland Universiy of Technology. 15. Kraf, A., A.J. Leone, and C.E. Wasley (27). Regression-Based Tess of he Marke pricing of accouning numbers: he Mishkin es and ordinary leas squares. Rerieved from hp://ssrn.com/absrac= 95694. 16. Lakonishok, J., Shliefer, A. and Vishny, R.W. (1994). Conrarian invesmen, exrapolaion and risk, Journal of Finance, 49, pp. 1541-1578. 17. Leippold, M. & Lohre, H. (21). Daa snooping and he global accrual anomaly. Rerieved from: hp://ssrn.com/ absrac=962867. 18. Lev, B. & Nissim, D. (26). The persisence of he accruals anomaly, Conemporary Accouning Research, 23 (1), pp. 1-34.
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