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THE ACCOUNTING REVIEW
Vol. 81, No. 5
2006
pp. 1151–1167
Evidence of the Abnormal
Accrual Anomaly Incremental to
Operating Cash Flows
C. S. Agnes Cheng
University of Houston
Securities and Exchange Commission
Wayne B. Thomas
University of Oklahoma
ABSTRACT: Recent research provides evidence that the operating cash flows-to-price
ratio subsumes accruals in explaining future annual returns. This suggests that the
accrual anomaly is part of the overall value-glamour anomaly and does not represent
the mispricing of earnings. We extend the literature by using multiple measures of
abnormal accruals and separate analyses of future annual returns and future earnings
announcement returns. The results reveal that the operating cash flows-to-price ratio
does not subsume abnormal accruals in explaining future annual returns or future announcement returns. We also find that the operating cash flows-to-price ratio does not
subsume total accruals in explaining future announcement returns. These results are
not consistent with accruals being a manifestation of the value-glamour anomaly. Our
study contributes to the current debate on the existence and the extent of the (abnormal) accrual anomaly. Moreover, the methodology employed can help researchers in
exploring mispricing phenomena.
Keywords: abnormal accruals; market mispricing; operating cash flows-to-price ratio;
value-glamour anomaly.
Data Availability: All data are from public sources.
We are thankful for comments received from two anonymous reviewers. We also thank Kriengkrai Boonlert-UThai, Ilia Dichev, Yeyun Sejati, Terry Shevlin, Glyn Winterbotham, Hong Xie, and workshop participants at American University, Baruch College–CUNY, Oklahoma State University, Singapore Management University, City University of Hong Kong, and National Chengchi University for useful suggestions.
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private
publication or statement by any of its employees. The views expressed herein are those of the author and do not
necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.
Editor’s note: This paper was accepted by Dan Dhaliwal.
Submitted June 2005
Accepted April 2006
1151
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Cheng and Thomas
I. INTRODUCTION
his study tests the relation between future returns and current period abnormal accruals.1 Previous research documents that total accruals relate negatively to future
returns (i.e., the accrual anomaly documented by Sloan [1996]), and the negative
relation is due primarily to abnormal accruals (Xie 2001). Desai et al. (2004) provide
evidence that the ability of (abnormal) accruals to explain future returns is subsumed by
the operating cash flows-to-price ratio (OCF/P). They conclude that the accrual anomaly
is part of the overall value-glamour anomaly. We extend this line of research by employing
multiple measures of abnormal accruals and testing their relation with both future annual
returns and future earnings announcement returns. Using multiple measures of abnormal
accruals increases the robustness of conclusions as to whether the abnormal accrual anomaly
is part of the overall value-glamour anomaly.2 Moreover, separately analyzing future annual
returns and future announcement returns provides additional insight on whether OCF/P and
abnormal accruals represent the same underlying phenomenon. Returns to an earnings-based
anomaly are more likely to concentrate around events related to realizations of future earnings (e.g., year-ahead quarterly earnings announcements), whereas returns to a risk-based
strategy are more likely to occur evenly over the annual window (Bernard et al. 1997).3
We estimate abnormal accruals using the modified Jones model (Dechow et al. 1995).4
We use different accrual measures, including total and working capital accruals derived
from the cash flow statement, and apply different estimation procedures, including industryand firm-specific regression. We also employ rank models to control for any nonlinearity
in the estimation of abnormal accruals. For mispricing tests, we employ univariate and
multivariate regression analyses and zero-investment portfolio analyses for both annual
returns and announcement returns. For the zero-investment portfolio analysis, we report the
mean and standard deviation of abnormal returns across 13 years (1989 to 2001) and
document the number of years that have positive abnormal returns. We do this for both
annual returns and announcement returns. Furthermore, we test if the 12-day announcement
period return (i.e., three-day windows around four quarterly announcements) is significantly
greater than random 12-day non-announcement returns for the same firm during the same
year.
To control for risk, we follow Sloan (1986), Xie (2001), and Desai et al. (2004) by
employing size-adjusted abnormal returns. However, size may not fully control for risk. In
our multiple regression tests, we control for additional risk factors. In addition, for our
T
1
2
3
4
Prior research uses the terms ‘‘abnormal’’ or ‘‘discretionary’’ accruals to label the difference between reported
and expected accruals. In this paper, we use the term ‘‘abnormal’’ since it is less suggestive as to whether
unusual accruals arise from intentional versus unintentional actions of managers.
Desai et al. (2004) use the industry-specific Jones model to estimate abnormal accruals. Xie (2001) uses a total
of six different estimates and employs both industry and firm-specific estimates.
Current finance research has not concluded that the value-glamour anomaly, as reflected by variables such as
book-to-market, sales growth, and operating cash flows-to-price (OCF / P), is purely related to risk. We find that
OCF / P does not relate to future announcement returns, leading us to conclude that OCF / P is not an earningsbased anomaly. However, we do not intend to claim that the OCF / P anomaly is purely risk-based.
Since there is no generally agreed ‘‘best’’ estimate of abnormal accruals in the literature, we initially considered
a large number of abnormal accrual models. We considered two classes of accrual expectation models: Jonesbased and operating cash flows-based. Our Jones-based models were based on the model derived in Jones (1991)
and further modified by Dechow et al. (1995) and Kothari et al. (2005). Our operating cash flows-based models
were derived from Dechow and Dichev (2002). Also, as suggested by McNichols (2002), we examined several
combinations of the Jones-based models and the operating cash flows-based models. In total, we examined 22
accrual expectation models. For brevity, we report results only for the modified Jones model (Dechow et al.
1995). Interested readers may obtain the full set of results by contacting the authors.
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zero-investment portfolio analysis, we calculate returns for randomly generated sizematched portfolios. The procedure involves randomly matching each firm in the long or
short position of the abnormal accrual strategy to a firm in the same size decile in the same
year. We perform this randomization procedure 100 times and then compare results for
abnormal accrual portfolios to results for random size-matched portfolios (see Section II
for a more detailed discussion of this procedure).5
We document that OCF/P does not subsume the abnormal accrual anomaly. Abnormal
accruals relate to both future annual returns and future announcement returns, even after
controlling for OCF/P. Similar to Desai et al. (2004), we find that OCF/P subsumes total
accruals in explaining future annual returns. However, we discover that OCF/P does not
subsume total accruals in explaining future announcement returns. In fact, we find that
OCF/P has no explanatory power for future announcement returns. These results make it
difficult to conclude convincingly that accruals are simply a manifestation of the valueglamour anomaly. Returns to accrual strategies tend to cluster around future earnings announcements, while returns to the OCF/P strategy occur smoothly over the year. Return
behavior of this type is consistent with accruals being more of an earnings-based anomaly
and OCF/P being more of a risk-based anomaly.
In the next section, we describe the accrual expectation model and detail the tests of
investor mispricing. In Section III, we outline the sample and data, and Section IV reports
results. A summary is provided in Section V.
II. RESEARCH DESIGN
Estimation of Abnormal Accruals
To estimate abnormal accruals, we employ the modified Jones model (Dechow et al.
1995):6
ACCi,t
1
(⌬REVi,t ⫺ ⌬RECi,t)
PPEi,t
⫽ ␣1
⫹ ␣2
⫹ ␣3
⫹ εi,t
ATAi,t
ATAi,t
ATAi,t
ATAi,t
(1)
where:
ACC
ATA
⌬REV
⌬REC
PPE
⫽
⫽
⫽
⫽
⫽
total accruals;
average total assets;
change in total revenue;
change in accounts receivable; and
property, plant, and equipment.
Subscripts i and t indicate firm and time, respectively. To reduce measurement error, we
employ accrual data as reported on the statement of cash flows (Hribar and Collins 2002).
Total accruals ⫽ income before extraordinary items (Compustat #18) less operating cash
flows (#308 ⫺ #124). Equation (1) is estimated within two-digit SIC code each year, and
the residuals (ε) estimate abnormal accruals. In our sensitivity tests, we also use working
capital accruals for ACC in estimating abnormal accruals. Working capital accruals ⫽ increase in accounts receivable ⫹ increase in inventory ⫺ decrease in accounts payable
5
6
We are indebted to one of our reviewers for proposing the procedures related to random size-matched portfolios
and random non-announcement returns. Future research that examines accounting-based market anomalies
should consider this approach.
We have analyzed a total of 22 accrual expectation models (see footnote 4) and we find that our main conclusion
is robust. We choose to report only the modified Jones model.
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Cheng and Thomas
⫺ decrease in income taxes payable ⫹ increase in other current net assets.7 We also estimate
Equation (1) using rank regressions and firm-specific estimation.
Measuring the Relation between Abnormal Accruals and Future Returns
To examine the nature of the abnormal accrual anomaly, we measure the relation between abnormal accruals and future returns using several tests. Basing conclusions on several tests provides the advantage of not over-relying on a single approach. Tests involving
unobservable measures (i.e., abnormal accruals and abnormal returns) are inherently subject
to estimation error, and providing results across multiple approaches helps to alleviate some
of this uncertainty. In addition, the different approaches employed can provide unique insights and therefore help in making stronger conclusions.
Our first test of investor mispricing involves a simple regression of returns in year t⫹1
on the decile rank of abnormal accruals in year t:8
Returnt⫹1 ⫽ ␤0 ⫹ ␤1(⫺Rank of Abnormal Accrualst) ⫹ εt⫹1.
(Test 1)
In each year, abnormal accruals are ranked evenly into deciles from 0 to 9. These ranks
are divided by 9 to create a variable ranging from 0 to 1. We multiply the decile rank by
⫺1 so that ␤1 is expected to be positive. The coefficient is interpreted as the return to a
zero-investment portfolio, assuming a linear relation across the deciles. A long (short)
position is taken in firms with low (high) abnormal accruals. Thus, more positive values of
␤1 imply greater mispricing identified by the estimation procedure.
For our second test, we consider the extent to which abnormal accruals relate to future
returns, after controlling for other variables. If mispricing relates to abnormal accruals,
then abnormal accruals should remain significantly related to future returns in the presence
of other variables. We estimate the following multivariate model:
Returnt⫹1 ⫽ ␤0 ⫹ ␤1(⫺Rank of Abnormal Accrualst)
⫹ ␤n(Rank of Controln,t) ⫹ εt⫹1.
(Test 2)
In our tests, we include three control variables: (1) OCF/P, (2) book-to-market ratio,
and (3) sales growth. Each of these variables has been shown by prior research to explain
future abnormal returns (e.g., Lakonishok et al. 1994; Desai et al. 2004).9 Firms with higher
OCF/P, higher book-to-market ratios, and lower sales growth are labeled ‘‘value’’ stocks
and have historically outperformed ‘‘glamour’’ stocks. Researchers differ on whether these
findings relate to investor mispricing (e.g., Lakonishok et al. 1994; La Porta et al. 1997;
Dechow and Sloan 1997) or compensation for risk (Fama and French 1992, 1996; Doukas
et al. 2002). We are particularly interested in controlling for OCF/P. Desai et al. (2004)
report that the total accrual anomaly persists after controlling for the book-to-market ratio
and sales growth, but not after controlling for OCF/P. The purpose of our paper is to
determine whether abnormal accruals are part of the overall value-glamour anomaly as
well.
7
8
9
That is, working capital accruals ⫽ ⫺(#302 ⫹ #303 ⫹ #304 ⫹ #305 ⫹ #307). Compustat reports the indirect
method adjustments from the statement of cash flows. Hence, a negative sign is needed for generating accruals.
As discussed later, we measure annual returns as the 12-month buy-and-hold size-adjusted return beginning
three months after the fiscal year-end. We measure announcement period returns over the four three-day periods
surrounding next year’s quarterly earnings announcements (i.e., a 12-day interval).
In additional tests, we also control for market beta. Results when including this additional control variable are
similar to those reported.
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Our third test involves the usual calculation of the return to a zero-investment portfolio.
We take a long position in firms in the most negative abnormal accrual decile in year t and
a short position in firms in the most positive abnormal accrual decile in year t:
Portfolio Returnt⫹1 ⫽ Low Decile Returnt⫹1 ⫺ High Decile Returnt⫹1.
(Test 3)
The more positive the portfolio return, the greater the evidence of mispricing. In interpreting the results of Tests 1–3, an important caveat is that a significant relation with future
abnormal returns may not be evidence of investor mispricing. The abnormal accrual estimates examined in this study may rank firms according to cross-sectional differences in
risk, instead of identifying mispriced securities. Since firms with greater risk are expected
to earn a higher rate of return, a relation between future returns and current accounting
information could be found in the absence of investor mispricing. While we attempt to
control for cross-sectional differences in risk by using size-adjusted returns in our analyses
and explicitly controlling for other variables (i.e., Test 2), it is always the case that ‘‘other’’
risk factors may provide the explanation. We are interested in identifying abnormal accruals
that appear to relate to investors’ inability to accurately understand the implication of current
earnings for future earnings, causing securities to be temporarily mispriced. Therefore, we
deem it important to determine whether results occur because of risk-based explanations
or investor mispricing. We test this in three ways: (1) examine the relation between current
variables and future earnings announcement returns, (2) test if abnormal returns are generated consistently across years, and (3) compare actual zero-investment portfolio returns
with returns from random size-matched portfolios.
The first two tests are proposed by Bernard et al. (1997). First, they suggest that if
anomalous results occur due to investor mispricing and this mispricing relates to an
earnings-based anomaly, then abnormal returns should concentrate around future earnings
announcement dates. It is the release of future earnings when investors are more likely to
realize any prior mispricing related to earnings, and prices will correct. Accordingly, we
extend Tests 1, 2, and 3 to announcement returns. For Test 3, we note the percentage of
the portfolio’s annual return occurring during earnings announcements. The announcement
interval consists of the four three-day periods surrounding next year’s quarterly earnings
announcements (i.e., 12 days), which comprises approximately 5 percent of the annual
interval. According to Bernard et al. (1997), if the relation with returns in year t⫹1 is the
result of an earnings-based anomaly, then the portion of abnormal returns occurring at the
earnings announcement will likely be greater than 5 percent. If the anomalous results are
risk-based, then abnormal returns are more likely to occur evenly throughout the period
and not concentrate around earnings announcement dates.10 We extend Bernard et al.’s
(1997) announcement return test by also comparing announcement returns with randomly
generated 12-day non-announcement returns for the same firm in the same year. We refer
to this as the excess announcement returns.
The second test proposed by Bernard et al. (1997) relates to the consistency in portfolio
returns. They suggest that anomalous returns from a zero-investment portfolio are more
10
Bernard et al. (1997) attempt to distinguish between market mispricing and compensation for risk for six
anomalies identified in the literature. Two of the variables relate to the value-glamour anomaly: book-to-market
ratio and price-to-earnings ratio. They find that announcement returns to the book-to-market ratio are opposite
to that predicted by unexpected changes in earnings, and announcement returns to the earnings-to-price ratio
are negligible. The fact that both variables produce significantly positive annual returns but do not have significant announcement returns in the predicted direction leads them to conclude that both variables ‘‘are more
likely to represent risk premia’’ (Bernard et al. 1997, 89). They do not evaluate OCF / P.
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Cheng and Thomas
representative of investor mispricing when the annual return is consistently positive. A zeroinvestment portfolio that produces a positive return because of cross-sectional differences
in risk will show variability in annual returns (i.e., some years will be positive while others
will be negative). Therefore, we also examine the number of years that the zero-investment
portfolio produces positive returns. We do this test using annual returns (as suggested by
Bernard et al. [1997]) and using announcement period returns:
Years Portfolio Positivet⫹1 ⫽ Number of Positive Portfolio Returnst⫹1.
(Test 4)
Our final test for determining whether anomalous returns relate to cross-sectional differences in risk or investor mispricing is to examine returns to random size-matched portfolios. While the returns employed in our analyses are size-adjusted, this may not
sufficiently control for risk. Generating returns from random size-matched portfolios provides evidence of whether returns to the abnormal accrual strategy are what one might
expect from a risk-based strategy. This randomization procedure involves randomly matching each firm in the long or short position to a firm in the same size decile in the same
year. We then subtract the average return of the random stocks in the short position from
the average return of the random stocks in the long position. We do this each year and
calculate the mean of the annual zero-investment portfolio returns over our 13-year sample
period. We perform this randomization procedure 100 times and then compare results for
abnormal accrual portfolios to results for random size-matched portfolios for Tests 3 and
4. If returns to abnormal accrual portfolios and to random size-matched portfolios are
similar, then this suggests that it is the size-related risk component that drives returns to
the abnormal accrual anomaly. In addition to comparing means and number of years with
positive returns, we also compare standard deviations in returns between the abnormal
accrual portfolios and random size-matched portfolios. Standard deviations provide additional evidence of the risk nature (i.e., variance) of portfolio returns.
III. DATA AND SAMPLE PROCEDURES
Our sample includes all firm-year observations that have the necessary financial data
from Compustat and stock return data from CRSP to generate our mispricing tests over the
1989–2001 period, excluding firms with SIC codes 6000–6999, firms with negative book
values, or firms with sales less than 1 million.11 Year-ahead abnormal returns are calculated
as the 12-month buy-and-hold size-adjusted return beginning three months after the yearend.12 We winsorize size-adjusted returns greater than 225 percent, as large returns can
cause misleading inferences in tests of mispricing (Kraft et al. 2006). Approximately 1
percent of our observations meet this criterion.
The control variables used in our study are OCF/P, book-to-market ratio, and sales
growth. OCF/P is operating cash flows reported from the statement of cash flows over the
market value at the end of the third month following the fiscal year-end; book-to-market
ratio is the ratio of the fiscal year-end book value of equity to the market value at the end
11
12
Our sample selection is similar to Desai et al. (2004) except that we also restrict our observations to have data
from the statement of cash flows.
We use Eventus to generate size-adjusted return. Eventus uses the equally weighted method to calculate sizeportfolio returns. Many studies calculate returns beginning three months after fiscal year-end. Our results are
similar when we change the return calculation period to begin four months after the fiscal year-end. Based on
an untabulated analysis, we find that calculating returns three months after the year-end (instead of four months)
results in a higher correlation with the return extending from the first quarter’s earnings announcement through
the fourth quarter’s earnings announcement. We choose to use the return interval beginning three months after
the fiscal year-end to better align with the year-to-year earnings announcement return.
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Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
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of the third month after fiscal year-end; sales growth is the average of annual growth in
sales over the previous three years. The final sample size for our primary test is 25,018
firm/year observations over the period 1989–2001.
Panel A in Table 1 reports descriptive statistics. Annual abnormal returns and announcement abnormal returns have similar means (0.025 and 0.024, respectively), but the
variance is much higher for annual returns. The higher variance is expected given that
announcement returns reflect primarily accounting information, while non-announcement
returns are also affected by cross-sectional differences in risk. Total accruals have a negative
mean and median (⫺0.054 and ⫺0.046) and working capital accruals have a positive mean
and median (0.023 and 0.015). This occurs primarily because total accruals include depreciation. Total accruals also include special items, which are negative on average. OCF/P
TABLE 1
Descriptive Statisticsa
Panel A: Distributions
Variablesb
Mean
Standard
Deviation
Q1
Median
Q3
Annual Abnormal Returnst⫹1
Annc. Abnormal Returnst⫹1
Total Accrualst
Working Capital Accrualst
Operating Cash Flowst / Pricet
Abnormal Accrualst
0.025
0.024
⫺0.054
0.023
0.094
0.000
1.078
0.198
0.153
0.096
3.146
0.389
⫺0.422
⫺0.080
⫺0.100
⫺0.018
⫺0.005
⫺0.047
⫺0.120
0.215
0.103
0.006
0.060
0.143
0.071
0.004
⫺0.046
0.015
0.060
0.009
Panel B: Correlationsc
Variables
Annual Abnormal
Returnst⫹1
Annc. Abnormal
Returnst⫹1
Total Accrualst
Working Capital
Accrualst
Operating Cash
Flowst / Pricet
Abnormal Accrualst
Annual
Abnormal
Returnstⴙ1
Annc.
Abnormal
Returnstⴙ1
0.279
0.308
Total
Accrualst
Working
Capital
Accrualst
Operating
Cash
Flowst / Pricet
Abnormal
Accrualst
⫺0.052
⫺0.051
⫺0.006#
⫺0.039
⫺0.063
⫺0.047
0.031#
⫺0.056
⫺0.052
⫺0.071
⫺0.050
⫺0.033
0.772
0.155
0.039
⫺0.417
⫺0.456
⫺0.068
⫺0.047
0.747
0.619
0.692
⫺0.212
⫺0.291
0.663
0.476
⫺0.166
⫺0.331
a
The sample period is 1989–2001.
Annual Abnormal Returns ⫽ size-adjusted returns over the 12-month period beginning three months after the
fiscal year-end; Annc. Abnormal Returns ⫽ 12-day size-adjusted returns, consisting of the four three-day
periods surrounding quarterly earnings announcements in year t⫹1. Accruals and operating cash flows are
amounts from the statement of cash flows; Total accruals ⫽ income before extraordinary items (Compustat
#18) less operating cash flows (#308 ⫺ #124); Working Capital Accruals ⫽ ⫺(#302 ⫹ #303 ⫹ #304 ⫹ #305
⫹ #307). Abnormal Accruals are residuals from the modified Jones model (Dechow et al. 1995), estimated
within two-digit SIC code each year.
c
The upper-right corner represents the average Pearson correlation coefficient across sample years. The lowerleft corner represents average Spearman correlation coefficients. All correlation coefficients are significantly
different from zero at the 0.05 level, except those with a ‘‘#,’’ which are not significant.
b
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Cheng and Thomas
has a positive mean and median (0.094 and 0.060). Abnormal accruals from the modified
Jones model have a mean of zero and a slightly positive median (0.009).
Panel B of Table 1 reports the average of yearly correlation coefficients. Pearson correlation coefficients are reported on the upper-right corner and Spearman correlation coefficients are reported on the lower-left corner. The Spearman correlation coefficient between annual returns and announcement returns is 30.8 percent. Both returns are negatively
related with total accruals, working capital accruals, and abnormal accruals and positively related with OCF/P. All of the accrual measures (i.e., total accruals, working capital
accruals, and abnormal accruals) are positively correlated, and they are all negatively correlated with OCF/P. The Spearman correlation coefficients are all significant and they are
higher in magnitude than their corresponding Pearson correlation coefficients. Interestingly,
the Pearson coefficients for the OCF/P and returns variables are not significant. This confirms the importance of using ranks of OCF/P in our regression analysis reported later in
the paper.
IV. RESULTS
Tests of the Accrual Anomaly
In this section we first provide results of the accrual anomaly to establish consistency
with prior research. Sloan (1996) concludes that investors overestimate the persistence of
total accruals, leading to a negative relation between accruals and future abnormal returns.13
In Panel A of Table 2, we report tests using annual returns, as is commonly done in the
literature. In Panel B, we replicate all of our tests using announcement returns. For comparison, we provide analyses for both total accruals and working capital accruals and all
inferences are the same between the two.
The univariate regression coefficient is 0.079 for total accruals and 0.093 for working
capital accruals, each of which is significant. Recall that we multiply the rank of accruals
by ⫺1 so that the expected relation is positive. Similar to previous findings, firms with low
accruals have a higher price performance in the following year than do firms with high
accruals. The annual returns to the zero-investment portfolio (0.090 and 0.091 for total and
working capital accruals, respectively) are similar in magnitude to the regression coefficients
and are significant. The standard deviations of the annual returns to the zero-investment
portfolios for total accruals and working capital accruals are 0.086 and 0.093, respectively.
As discussed before, we also report (in parentheses) average abnormal returns and their
standard deviation for 100 randomly generated size-matched portfolios. The average annual
returns to the random zero-investment portfolios are negative and close to zero (⫺0.020
and ⫺0.021). This confirms that significantly positive returns of the accrual strategy represent anomalous market behavior. The average standard deviations for the random portfolios (0.072 and 0.071) are slightly smaller in magnitude than the standard deviations for
the accrual portfolios, but these differences are small compared to the differences in average
returns. Overall, comparisons to the random portfolios strengthen our conclusion that the
significant relation between current year accruals and future annual returns occurs because
of accruals.
We show the number of years that annual returns to the zero-investment portfolio are
positive and the average number of years that annual returns to the 100 randomly generated
13
Zach (2003) provides a number of alternative measurement and sampling approaches to determine the robustness
of the accrual anomaly. He finds that certain factors (e.g., mergers, divestitures, abnormal return calculation,
return interval, and non-NYSE / AMEX firms) play a part in explaining the accrual anomaly. However, he concludes that a substantial portion of the accrual anomaly remains unexplained.
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Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
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TABLE 2
Relation between Accruals and Future Returnsa
Regressionsb
Coef.
with
Coef.
Controls
Mean
Zero-Investment Portfoliosc
Standard
Years
Deviation
Positive
Excess
d
Panel A: Annual Returns
Total Accruals
Working Capital
Accruals
Operating Cash
Flows / Price
0.079*
0.093*
0.009
0.014
0.205*
0.090* (⫺0.020)
0.091* (⫺0.021)
0.086 (0.072)
0.093 (0.071)
12 (6)
12 (6)
0.176*
(0.020)
0.168 (0.069)
12 (8)
0.058*
0.051*
(0.002)
(0.003)
0.020 (0.031)
0.028 (0.032)
12 (7)
12 (7)
0.017⵩ (⫺0.003)
0.044 (0.035)
6 (6)
Panel B: Announcement Returnse
Total Accruals
Working Capital
Accruals
Operating Cash
Flows / Price
0.036*
0.024*
0.015⵩
0.034*
0.019*
0.056*
0.047*
⫺0.008
*, ⵩ Significant at the 0.05 and 0.10 levels, respectively, using a one-tailed t-test that the mean is greater than
zero.
a
The sample period is 1989–2001. Accruals and operating cash flows are amounts from the statement of cash
flows.
b
‘‘Coef.’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile ranks
of the variable. Decile ranks are 0 to 9, scaled by 9. For total accruals and working capital accruals, decile
ranks are multiplied by ⫺1. ‘‘Coef. with Controls’’ represents the average annual coefficient in a regression of
future size-adjusted returns on decile ranks of the variable when decile ranks of operating cash flows-to-price
ratio, book-to-market ratio, and sales growth are included in the model.
c
Zero-investment portfolio returns in year t⫹1 are calculated by subtracting the average size-adjusted return of
firms in the highest abnormal accruals decile (i.e., short position) from the average size-adjusted return of firms
in the lowest abnormal accruals decile (i.e., long position). For operating cash flows-to-price, the long (short)
position is the highest (lowest) decile. The ‘‘Mean’’ amount is the average return to the portfolio over the
sample period. The ‘‘Standard Deviation’’ is the standard deviation of the portfolio’s returns. ‘‘Years Positive’’
represents the number of years (out of a possible 13) that the zero-investment portfolio produces a positive
return in year t⫹1. ‘‘Excess’’ is calculated by taking the announcement return of each firm in the zeroinvestment portfolio and subtracting a random 12-day non-announcement return for the same firm in the same
year. Amounts in parentheses represent averages for 100 random size-matched zero-investment portfolios (see
Section II for a description of the randomization procedure).
d
Annual returns are measured as size-adjusted returns over the 12-month period beginning three months after
the fiscal year-end.
e
Announcement returns are calculated as the 12-day size-adjusted return, consisting of the four three-day periods
surrounding quarterly earnings announcements in year t⫹1.
size-matched portfolios are positive. If investors consistently misprice securities, then returns should be positive in all years. If the accrual anomaly reflects risk, then the sign of
returns should show variation across years. Comparison to the number of years that the
random size-matched portfolios produce positive returns provides some expectation for
assessing the anomalous behavior of accruals. Based on random size-matched portfolios,
the number of positive years is six (out of 13), which is much smaller than the number of
positive years for the total accrual portfolio (12) or the working capital accrual portfolio
(12). These results provide evidence consistent with abnormal returns to the accrual strategy
not being risk-based.
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Cheng and Thomas
We are primarily interested in whether the accrual anomaly remains once controlling
for OCF/P, book-to-market ratio, and sales growth. As shown in the second column of
results, the coefficients on accruals (total and working capital) are no longer significant
when adding control variables. Untabulated results reveal that it is OCF/P, rather than the
book-to-market ratio or sales growth, that subsumes the accrual anomaly. Consistent with
results in Desai et al. (2004), our evidence suggests that the ability of accruals to explain
future annual returns is subsumed by OCF/P.
In Panel B of Table 2, we turn to analyses for announcement period returns. The
announcement period consists of the four three-day periods surrounding the quarterly earnings announcements. Both total accruals and working capital accruals are significantly related to future announcement returns. The coefficients on total accruals and working capital
accruals are 0.036 and 0.024, respectively. The returns to zero-investment portfolios are
also significant and of similar magnitude. Approximately 64.4 percent (⫽ 0.058/0.090) of
the annual abnormal return of the zero-investment portfolio occurs during earnings announcements, which comprise approximately 5 percent of the annual interval (12/250 ⫽ 5
percent of the trading days). The mean announcement return for the random portfolios is
very close to zero. Moreover, we find that excess announcement returns, measured as the
actual announcement return minus the random non-announcement return for each firm in
the same year, are similar to the actual announcement returns for both total and working
capital accruals. Random non-announcement 12-day abnormal returns to the zeroinvestment portfolio are close to zero, while returns during earnings announcements appear
to be ‘‘large.’’ The fact that most of the annual return to the accrual anomaly is concentrated
during events related to the realization of future earnings suggests that investors misprice
current year accruals and correct their beliefs in the following year as future earnings
become known (Bernard et al. 1997). The standard deviations in announcement returns are
0.020 and 0.028 for total accruals and working capital accruals, respectively, which are
lower than the average standard deviations for the random portfolios (0.031 and 0.032,
respectively). These results also suggest that returns to the accrual portfolio are not sizerelated and are less likely to represent cross-sectional differences in risk.
Most importantly for our study is that accruals continue to relate to future announcement returns after controlling for OCF/P. As shown in the first two columns, the coefficient
on accruals is significant and of similar magnitude whether controlling for OCF/P or not.14
The coefficient on total accruals (working capital accruals) is 0.036 (0.024) in the univariate
regression, while the coefficient is 0.034 (0.019) after controlling for OCF/P. In addition,
untabulated results show that OCF/P is not significantly related to announcement period
returns. While OCF/P subsumes accruals when explaining future annual returns, the opposite is true when explaining future announcement returns.
Finally, we provide results for the OCF/P strategy in Table 2. The analyses are similar
to those reported for accruals with the portfolio ranks based on the ascending (instead of
descending) order of OCF/P. There are two noticeable differences in results. First, the zeroinvestment portfolio returns are approximately twice that of the accrual anomaly (0.176),
but the announcement period returns are only one-third that of the accrual anomaly (0.017).
While approximately 9.7 percent of the zero-investment portfolio returns to OCF/P occurs
during earnings announcements, it is much lower than the 64.4 percent for the accrual
strategy. After controlling for non-announcement returns, we find that excess announcement
returns are no longer significant. This implies that OCF/P will not subsume the ability of
14
Note that we have also included other control variables such as the book-to-market ratio and sales growth.
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Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
1161
accruals to explain future announcement returns, as shown by the multiple regression analysis discussed previously.
The second difference in results relates to the standard deviation of returns. For OCF/
P, the standard deviation of annual returns and the standard deviation of announcement
returns are substantially higher than their random size-matched portfolios. This is not the
case for accruals. Similarly, the standard deviation of returns from the OCF/P portfolio is
about twice that of accrual portfolios (0.168 versus 0.086 and 0.093 for annual returns and
0.044 versus 0.020 and 0.028 for announcement returns). The results for standard deviation
of returns imply that the OCF/P anomaly reflects more of a risk-based anomaly than does
the accrual anomaly. Portfolios constructed using OCF/P produce positive (and volatile)
returns compared to random size-matched portfolios.
In summary, the results in Table 2 reveal that the return behavior of OCF/P is different
than that of accruals. OCF/P behaves more like a risk-based proxy than do accruals. Returns
to the OCF/P strategy are positive and volatile and do not cluster around future earnings
announcements. On the other hand, returns to the accrual strategy appear to be more
earnings-based, as they cluster around future earnings announcements. However, it is still
noted that OCF/P subsumes total accruals in explaining future annual returns. Next, we
repeat these tests for abnormal accruals, our variable of primary interest.
Test of the Abnormal Accrual Anomaly
We report test of the abnormal accrual anomaly in Table 3. Similar to Table 2, we
report results for our regression tests and also compare results between the abnormal accrual
portfolio and the 100 random size-matched portfolios (in parentheses). As shown in the
first column, the coefficient on abnormal accruals in a univariate regression with future
returns is positive and significant. The coefficient is similar in magnitude to the zeroinvestment portfolio return. Of primary interest to our study, the coefficient on abnormal
accruals remains positive and significant after controlling for OCF/P. In other words, OCF/
P does not subsume abnormal accruals in explaining future annual returns.15 This conclusion is different from that of total accruals in Table 2.
Panel B of Table 3 shows that the inability of OCF/P to subsume abnormal accruals
is especially apparent for announcement returns. In the univariate regression, the coefficient
on abnormal accruals is 0.030 and significant. After controlling for OCF/P (and the bookto-market ratio and sales growth), the coefficient on abnormal accruals reduces to only
0.024 and easily remains significant. The mean return to the zero-investment portfolio is
quite high (0.050) for a 12-day interval, and returns do not appear risk-related, as the mean
returns to the size-matched portfolios is zero. The standard deviation of the announcement returns to the zero-investment portfolio is approximately one-half that of the random
portfolios, and announcement returns to the abnormal accrual strategy are positive in 12
out of 13 years. Moreover, the excess announcement return is significantly positive.
The results in Table 3 provide the conclusion that abnormal accruals are incremental
to OCF/P in explaining future returns. Abnormal accruals are not a simple manifestation
of the value-glamour anomaly as captured by OCF/P, the book-to-market ratio, and sales
growth. This conclusion is especially apparent by noting the clustering of annual returns
15
Desai et al. (2004) also conduct a multivariate regression test of annual abnormal returns on abnormal accruals
estimated using the industry-specific Jones model. Recall that we present results using the industry-specific
modified Jones model. They report a t-statistic of 1.74, which is insignificant at the 5 percent level. When we
estimate abnormal accruals using the Jones model, our t-statistic is 1.98, which is significant at the 5 percent
level. The relatively small difference between our results and theirs is likely to be sample specific. Desai et al.
(2004) do not test announcement period abnormal returns.
The Accounting Review, October 2006
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Cheng and Thomas
TABLE 3
Relation between Abnormal Accruals and Future Returnsa
Regressionsb
Coef.
with
Coef.
Controls
Mean
Zero-Investment Portfoliosc
Standard
Years
Deviation
Positive
Excess
d
Panel A: Annual Returns
0.103*
0.051*
0.098* (⫺0.001)
0.097 (0.069)
11 (6)
0.016 (0.030)
12 (7)
Panel B: Announcement Returnse
0.030*
0.024*
0.050*
(0.000)
0.048*
* Significant at the 0.05 level using a one-tailed t-test that the mean is greater than zero.
a
The sample period is 1989–2001. Accruals and operating cash flows are amounts from the statement of cash
flows. Abnormal accruals are estimated using the modified Jones model within each two-digit SIC code each
year.
b
‘‘Coef.’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile ranks
of abnormal accruals. Decile ranks are 0 to 9, scaled by 9. Decile ranks are multiplied by ⫺1. ‘‘Coef. with
Controls’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile
ranks of abnormal accruals when decile ranks of operating cash flows-to-price ratio, book-to-market ratio, and
sales growth are included in the model.
c
Zero-investment portfolio returns in year t⫹1 are calculated by subtracting the average size-adjusted return of
firms in the highest abnormal accruals decile (i.e., short position) from the average size-adjusted return of firms
in the lowest abnormal accruals decile (i.e., long position). The ‘‘Mean’’ amount is the average return to the
portfolio over the sample period. The ‘‘Standard Deviation’’ is the standard deviation of the portfolio’s returns.
‘‘Years Positive’’ represents the number of years (out of a possible 13) that the zero-investment portfolio
produces a positive return in year t⫹1. ‘‘Excess’’ is calculated by taking the announcement return of each firm
in the zero-investment portfolio and subtracting a random 12-day non-announcement return for the same firm
in the same year. Amounts in parentheses represent averages for 100 random size-matched zero-investment
portfolios (see Section II for a description of the randomization procedure).
d
Annual returns are measured as size-adjusted returns over the 12-month period beginning three months after
the fiscal year-end.
e
Announcement returns are calculated as the 12-day size-adjusted return, consisting of the four three-day periods
surrounding quarterly earnings announcements in year t⫹1.
to the abnormal accruals strategy during earnings announcements. Annual returns to the
OCF/P strategy do not cluster around future earnings announcements. In untabulated results
we find that OCF/P is not incrementally significant in explaining future announcement
returns, once controlling for abnormal accruals.
Abnormal Accruals Estimation Using Working Capital Accruals
In the previous section, we estimate abnormal accruals as a portion of total accruals.
As a sensitivity test, in this section we estimate abnormal accruals as a portion of working
capital accruals. These results are reported in Table 4. The overall tenor of the results is
similar to that in Table 3. In univariate tests, abnormal accruals have a significant relation
with future abnormal returns. After controlling for OCF/P, evidence of the abnormal accrual
anomaly remains for both annual returns and announcement period returns.
Abnormal Accruals Estimation Using Rank Models
In this section, we consider the use of rank models to estimate abnormal accruals.
Recall that the results in Tables 3 and 4 are based on the traditional approach to estimating
abnormal accruals, which assumes a linear relation (i.e., OLS regression) between accruals
and financial variables. Those results are reported using raw measures in the first stage
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Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
1163
TABLE 4
Relation between Abnormal Accruals and Future Returns Using Working Capital Accruals
to Estimate Abnormal Accrualsa
Regressionsb
Coef.
with
Coef.
Controls
Mean
Zero-Investment Portfoliosc
Standard
Years
Deviation
Positive
Excess
d
Panel A: Annual Returns
0.118*
0.052*
0.086* (⫺0.010)
0.087 (0.069)
11 (6)
0.023 (0.034)
11 (7)
Panel B: Announcement Returnse
0.027*
0.023*
0.046*
(0.001)
0.041*
* Significant at the 0.05 level using a one-tailed t-test that the mean is greater than zero.
a
The sample period is 1989–2001. Accruals and operating cash flows are amounts from the statement of cash
flows. Abnormal accruals are estimated using the modified Jones model within each two-digit SIC code each
year.
b
‘‘Coef.’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile ranks
of abnormal accruals. Decile ranks are 0 to 9, scaled by 9. Decile ranks are multiplied by ⫺1. ‘‘Coef. with
Controls’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile
ranks of abnormal accruals when decile ranks of operating cash flows-to-price ratio, book-to-market ratio, and
sales growth are included in the model.
c
Zero-investment portfolio returns in year t⫹1 are calculated by subtracting the average size-adjusted return of
firms in the highest abnormal accruals decile (i.e., short position) from the average size-adjusted return of firms
in the lowest abnormal accruals decile (i.e., long position). The ‘‘Mean’’ amount is the average return to the
portfolio over the sample period. The ‘‘Standard Deviation’’ is the standard deviation of the portfolio’s returns.
‘‘Years Positive’’ represents the number of years (out of a possible 13) that the zero-investment portfolio
produces a positive return in year t⫹1. ‘‘Excess’’ is calculated by taking the announcement return of each firm
in the zero-investment portfolio and subtracting a random 12-day non-announcement return for the same firm
in the same year. Amounts in parentheses represent averages for 100 random size-matched zero-investment
portfolios (see Section II for a description of the randomization procedure).
d
Annual returns are measured as size-adjusted returns over the 12-month period beginning three months after
the fiscal year-end.
e
Announcement returns are calculated as the 12-day size-adjusted return, consisting of the four three-day periods
surrounding quarterly earnings announcements in year t⫹1.
modified Jones model and decile rank measures of abnormal accruals in the second stage
return regressions. To be complete, we also apply decile rank measures to the first stage
accruals expectation model.16 Accruals and financial variables are decile ranked within each
industry in each year. The resulting abnormal accrual estimate is then ranked into deciles
for the second stage return regression. Rank models help to control for possible nonlinearity
between accruals and financial variables and for the undue influence that extreme observations may have. As shown in Table 5, we find that results are quite similar to those
reported previously. All tests continue to support the incremental existence of the abnormal
accrual anomaly.
Abnormal Accruals Estimation Using Firm-Specific Models
To this point, results are presented using cross-sectional industry-specific regressions
to estimate abnormal accruals. This is comparable to the majority of prior research. In this
section, we consider estimation of abnormal accruals using firm-specific models, where
16
We also consider using full rank models (instead of deciles). Results are similar to those reported.
The Accounting Review, October 2006
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Cheng and Thomas
TABLE 5
Relation between Abnormal Accruals and Future Returns Using Rank Models to Estimate
Abnormal Accrualsa
Regressionsb
Coef.
with
Coef.
Controls
Mean
Zero-Investment Portfoliosc
Standard
Years
Deviation
Positive
Excess
d
Panel A: Annual Returns
0.091*
0.053**
0.098* (⫺0.005)
0.108 (0.076)
12 (6)
0.032 (0.030)
13 (7)
Panel B: Announcement Returnse
0.034*
0.034*
0.036*
(0.000)
0.027*
*,** Significant at the 0.05 and 0.10 levels, respectively, using a one-tailed t-test that the mean is greater than zero.
a
The sample period is 1989–2001. Accruals and operating cash flows are amounts from the statement of cash
flows. Abnormal accruals are estimated using the modified Jones model within each two-digit SIC code each
year using decile ranks of the dependent and independent variables.
b
‘‘Coef.’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile ranks
of abnormal accruals. Decile ranks are 0 to 9, scaled by 9. Decile ranks are multiplied by ⫺1. ‘‘Coef. with
Controls’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile
ranks of abnormal accruals when decile ranks of operating cash flows-to-price ratio, book-to-market ratio, and
sales growth are included in the model.
c
Zero-investment portfolio returns in year t⫹1 are calculated by subtracting the average size-adjusted return of
firms in the highest abnormal accruals decile (i.e., short position) from the average size-adjusted return of firms
in the lowest abnormal accruals decile (i.e., long position). The ‘‘Mean’’ amount is the average return to the
portfolio over the sample period. The ‘‘Standard Deviation’’ is the standard deviation of the portfolio’s returns.
‘‘Years Positive’’ represents the number of years (out of a possible 13) that the zero-investment portfolio
produces a positive return in year t⫹1. ‘‘Excess’’ is calculated by taking the announcement return of each firm
in the zero-investment portfolio and subtracting a random 12-day non-announcement return for the same firm
in the same year. Amounts in parentheses represent averages for 100 random size-matched zero-investment
portfolios (see Section II for a description of the randomization procedure).
d
Annual returns are measured as size-adjusted returns over the 12-month period beginning three months after
the fiscal year-end.
e
Announcement returns are calculated as the 12-day size-adjusted return, consisting of the four three-day periods
surrounding quarterly earnings announcements in year t⫹1.
firm observations over the entire sample period are employed. If the relation between financial variables and normal accruals is firm-specific, then industry-specific models lead to
measurement error. However, to the extent that the relation between financial variables and
normal accruals is also time-specific, firm-specific estimation will contain measurement
error.
In addition, we note that firm-specific estimation is problematic for our tests of mispricing for two reasons. First, data from the statement of cash flows have been provided
for a relatively small number of years. In generating abnormal accruals, we restrict each
model by requiring at least three degrees of freedom.17 The low number of time-series
observations reduces the efficiency in estimating abnormal accruals. Second, and perhaps
more importantly, ex post data must be used (i.e., data for the entire sample period are used
to estimate abnormal accruals in each year). This introduces a potential look-ahead bias
since data used to calculate abnormal accruals are not available to investors at the time
17
This reduces the overall sample to 16,906 firm / year observations.
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Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
1165
they are setting prices. We caution the reader to keep these potential shortcomings in mind
when interpreting the results.18
As shown in Table 6, conclusions remain when using firm-specific estimation. Abnormal accruals continue to relate to future returns incremental to OCF/P, and this relation is
especially apparent during earnings announcements. We also note that if a look-ahead bias
exists because of using firm-specific observations over the entire sample period to estimate
abnormal accruals, then abnormal returns should be more pronounced in earlier years.
Closer examination of the performance of our firm-specific models (untabulated) shows that
this is not the case. As an additional robustness test, we perform out-of-sample tests by
using past information only. We restrict our analyses from 13 years to the last five years,
requiring at least eight years of past data to estimate firm-specific parameters. Using pooled
regressions over this smaller sample period (untabulated), we continue to find evidence that
abnormal accruals relate to future returns incremental to OCF/P.
TABLE 6
Relation between Abnormal Accruals and Future Returns Using Firm-Specific Models to
Estimate Abnormal Accrualsa
Regressionsb
Coef.
with
Coef.
Controls
Mean
Zero-Investment Portfoliosc
Standard
Years
Deviation
Positive
Excess
d
Panel A: Annual Returns
0.117*
0.069*
0.137* (⫺0.008)
0.067 (0.083)
13 (6)
0.026 (0.035)
13 (7)
Panel B: Announcement Returnse
0.032*
0.030*
0.043*
(0.002)
0.044*
* Significant at the 0.05 level using a one-tailed t-test that the mean is greater than zero.
a
The sample period is 1989–2001. Accruals and operating cash flows are amounts from the statement of cash
flows. Abnormal accruals are estimated using the modified Jones model within each firm over the entire sample
period.
b
‘‘Coef.’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile ranks
of abnormal accruals. Decile ranks are 0 to 9, scaled by 9. Decile ranks are multiplied by ⫺1. ‘‘Coef. with
Controls’’ represents the average annual coefficient in a regression of future size-adjusted returns on decile
ranks of abnormal accruals when decile ranks of operating cash flows-to-price ratio, book-to-market ratio, and
sales growth are included in the model.
c
Zero-investment portfolio returns in year t⫹1 are calculated by subtracting the average size-adjusted return of
firms in the highest abnormal accruals decile (i.e., short position) from the average size-adjusted return of firms
in the lowest abnormal accruals decile (i.e., long position). The ‘‘Mean’’ amount is the average return to the
portfolio over the sample period. The ‘‘Standard Deviation’’ is the standard deviation of the portfolio’s returns.
‘‘Years Positive’’ represents the number of years (out of a possible 13) that the zero-investment portfolio
produces a positive return in year t⫹1. ‘‘Excess’’ is calculated by taking the announcement return of each firm
in the zero-investment portfolio and subtracting a random 12-day non-announcement return for the same firm
in the same year. Amounts in parentheses represent averages for 100 random size-matched zero-investment
portfolios (see text for description of the randomization procedure).
d
Annual returns are measured as size-adjusted returns over the 12-month period beginning three months after
the fiscal year-end.
e
Announcement returns are calculated as the 12-day size-adjusted return, consisting of the four three-day periods
surrounding quarterly earnings announcements in year t⫹1.
18
See DeFond and Jiambalvo (1994) and Xie (2001) for examples of studies that employ both industry-specific
and firm-specific estimation.
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Cheng and Thomas
V. SUMMARY
Desai et al. (2004) provide evidence that the ability of accruals to explain future returns
is subsumed by the operating cash flows-to-price ratio (OCF/P). They suggest that returns
to an accrual strategy represent returns to the overall value-glamour anomaly and do not
likely represent the mispricing of earnings. We extend this line of research in two ways.
First, we employ multiple measures of abnormal accruals. Second, we test the relation
between (abnormal) accruals and both future annual returns and future earnings announcement returns. Returns to risk-based strategies are more likely to occur smoothly over the
year (Bernard et al. 1997). In contrast, returns related to the mispricing of earnings are
more likely to concentrate around events related to realizations of future earnings (e.g.,
year-ahead quarterly earnings announcements). Thus, an analysis of announcement returns
relative to annual returns may provide deeper insights into the anomalous behavior of
accruals.
We employ a number of tests of the relation between abnormal accruals and future
returns, including univariate and multivariate regression analyses and zero-investment portfolio analyses. We also compare the results of our zero-investment portfolio analyses to
randomly generated returns for size-matched portfolios. The procedure involves randomly
matching each firm in the long or short position of the abnormal accrual strategy to a firm
in the same size decile in the same year. We then compare annual returns and announcement
returns (e.g., means, standard deviations, and number of years that have positive returns)
of the accrual strategy to those of the random size-matched strategy. To provide further
evidence of anomalous behavior, we compare the 12-day announcement return to random
12-day non-announcement returns.
Consistent with results reported in Desai et al. (2004), we find that OCF/P subsumes
total accruals in explaining future annual return. However, we note that OCF/P does not
subsume total accruals in explaining future announcement returns. While future returns to
the OCF/P strategy occur smoothly over the following year, returns to the total accrual
strategy cluster around dates corresponding to the release of future earnings information.
We find that abnormal accruals, our variable of primary interest, are not subsumed by OCF/
P. Abnormal accruals continue to have significant explanatory power for future annual
returns, even after controlling for OCF/P. Furthermore, we find that returns to the abnormal
accrual strategy concentrate around quarterly earnings announcements. In a multiple regression of future announcement returns on abnormal accruals and control variables including OCF/P, book-to-market ratio, and sales growth, the coefficient on abnormal accruals
is significant and the coefficient on OCF/P has no significance. These results make it
difficult to conclude convincingly that (abnormal) accruals are purely a manifestation of
the value-glamour anomaly.
Results are robust to a number of sensitivity tests. We estimate abnormal accruals with
the modified Jones model (Dechow et al. 1995) using both industry-specific models each
year and using firm-specific models over the sample period. We estimate abnormal accruals
from both total accruals and working capital accruals. We also consider rank regressions
in the estimation of abnormal accruals to control for possible nonlinear effects. In all
specifications, we note that abnormal accruals have incremental explanatory power for future returns beyond OCF/P, and returns to the abnormal accrual strategy are disproportionately high during year-ahead quarterly earnings announcements.
Our study contributes to the current debate on the existence and the extent of the accrual
anomaly by providing robust evidence of the incremental relation between abnormal accruals and future returns. Moreover, the methodology employed in this paper, such as
analyzing earnings announcement returns and comparing accrual-based portfolio returns to
The Accounting Review, October 2006
Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows
1167
randomly matched portfolio returns, should be considered by researchers in exploring further mispricing phenomena.
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