Cash Flows, Accruals, and Future Returns

Abstract

This study explored the “accrual anomaly.” The study is unique because it analyzed originally reported—unrestated—quarterly data for 1991 through the first quarter of 2004 to calculate accruals and used U.S. SEC filing dates to identify the day on which investors first obtained information about accruals. The study found that the accrual anomaly exists for quarterly accruals as has been found for annual accruals. Future quarterly earnings were found to be more highly associated with current net operating cash flows than with accruals because accruals have less persistence than cash flows. Companies with extremely high (low) current quarterly accruals have significant and negative (positive) abnormal returns through the subsequent four quarters.

Rigorous studies have documented that net operating cash flow is more closely associated with future income and stock returns than are accruals—which represent roughly the difference between income and net operating cash flows. Accruals are likely to reverse in subsequent periods whereas net operating cash flows tend to persist—which leads to mispricing known as the “accrual anomaly.”

Researchers have found that when annual data are used, a trading strategy that holds long positions in companies with extremely low accruals and short positions in companies with high accruals produces significantly high abnormal returns over the subsequent three years. Because practitioners are unlikely to wait a whole year for the annual accrual data in order to make portfolio decisions or forecasts of future earnings, we investigated whether the accrual anomaly can be found in quarterly data. We discuss the persistence of quarterly cash flows and accruals and the implications of our findings for future returns to portfolio strategies.

For the study, we used the quarterly original and unrestated Compustat data provided by Charter Oak Investment Systems. This database contains three numbers for each company for each Compustat line item in each quarter. The period covered was the first quarter of 1991 through the second quarter of 2004. The initial population consisted of all company-quarter observations for which earnings and net operating cash flows were available for the current quarter, the market value of equity at quarter-end was at least $50 million, and total assets were available for the “current” and prior quarter.

We first investigated whether quarterly net operating cash flows are more persistent than quarterly accruals and found a negative and statistically significant association between current accruals and subsequent abnormal stock returns through all four quarters subsequent to the quarter in which the company filed financial forms with the U.S. SEC. In addition, we found for the quarterly data that, consistent with findings about annual accruals, net operating cash flow is more persistent than accruals. Current accruals are likely to reverse within one quarter.

Next, to focus on the companies that would be more likely to have extremely high or low accruals, we required that all observations in the bottom two deciles of accruals (i.e., the most negative accruals) have both positive incomes and positive net operating cash flows. Company-quarter observations were sorted each quarter into deciles according to accruals, and we examined the differential future returns to the extreme-decile portfolios. We found the lowest returns for the portfolio that shorted the highest-accrual decile, higher returns for the portfolio that went long the lowest-accrual decile, and the highest returns for the hedge portfolio that combined those positions.

The study documents that future abnormal returns are significantly more closely associated with current net operating cash flows than with current accruals. The study also shows that there is a negative association between current accruals and subsequent abnormal stock returns. It shows that a hedge portfolio that holds long positions in companies with the most extreme negative accruals and short positions in companies with the most extreme positive accruals yields positive and significant abnormal returns, whether held for one, two, three, or even four quarters.

These results indicate the importance of a careful examination and breakdown of quarterly net operating cash flows and accruals when an analyst is interpreting current quarterly earnings. Portfolio managers and other investors are likely to benefit from incorporating quarterly accruals and net operating cash flows in their portfolio decisions. Similarly, security analysts may improve their forecasts of future quarterly earnings by incorporating the information in current cash flows and accruals.

The authors gratefully acknowledge provision of the preliminary and original Compustat quarterly data by Charter Oak Investment Systems and provision of the SEC filing dates by Standard & Poor’s Compustat. The authors also thank Chiara Szczesny for copy editing. This research project is an outcome of work done by the S&P Equity Research Group.

Notes

¹ Appendix A provides detailed examples of these two cases.

² Of course, managers can also affect current income through simple accounting choices that do not involve real economic transactions, such as the selection of aggressive accounting methods and estimates. For example, if bad-debt expense in the current period is too low, it will probably lead to higher bad-debt expense in the future and lower future income.

³ They mentioned that their results from robustness checks were weaker for a subsample of companies that included balance sheet information in the preliminary earnings announcement. They also reported that their results did not change when they used abnormal returns cumulated from the preliminary earnings announcement through the next 20 trading days, which presumably would include the SEC filing date. They reported that their results held for the first three fiscal quarters but not for the fourth.

⁴ SEC filing dates are available from 1991 on.

⁵ This procedure was used by Kraft et al. (2004).

⁶ Available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

⁷ Scaling by net operating assets in subsequent quarters can introduce a bias because of growth in total assets, as shown in Fairfield et al. (2003).

⁸ The assignment to accrual deciles was based on all available observations, even if they did not have SEC filing dates or abnormal returns. As Sloan (1996) and others documented, companies in the extreme-accrual deciles tend to be smaller than other companies.

⁹ The higher persistence of earnings at quarter t into quartert + 4 is evidence of seasonality, which is expected in quarterly data.