Earnings Quality and Stock Returns: The Evidence from Accruals

An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flow) are reliably, negatively associated with future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses — earnings manipulation, extrapolative biases about future growth, and under-reaction to business conditions — to explain accruals’ predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, and discretionary versus nondiscretionary components of accruals. Security analysts, firm managers, and investors all devote a great deal of attention to firms’ reported earnings. Forecasts of earnings are widely disseminated in the financial press, and revisions in analysts’ forecasts are closely followed. Managers are keenly interested in maintaining growth in earnings because their compensations are often tied to their firms’ earnings. News that a firm has fallen short of earnings expectations can immediately send its stock price plummeting; firms that beat expectations, on the other hand, are handsomely rewarded by investors. With the advent of round-the-clock financial news reporting as well as expanded trading venues, the market’s obsession with earnings performance is not likely to diminish. The focus on earnings is so great that it has been suggested that the market fixates on firms’ bottom line income, to the exclusion of other indicators of operating performance. Such single-minded attention fails to recognize that reported net income is the final result of an extended accounting process with considerable room for managerial discretion at every step. For example, accounting rules give some leeway with respect to the timing and measurement of revenues and expenses. Further, special items such as restructuring charges and write-offs can have large temporary effects on earnings. Given the heightened attention to accounting income, managers may have an incentive to be aggressive in applying accounting rules in order to maintain steady growth in earnings. Empirical evidence supporting the existence of managerial manipulation of earnings is provided in Degeorge, Patel and Zeckhauser (1999), and Teoh, Welch and Wong (1998a, 1998b). More generally, there has been growing concern about firms’ “quality of earnings,” or the extent to which reported earnings reflect operating fundamentals. The financial press has noted managers’ tendencies to put a good face on earnings, and the SEC has initiated a research program on earnings management. In the context of stock prices, to the extent that the market fixates on reported income and does not take into account the quality of firms’ historical earnings, there may be temporary deviations of prices away from their correct values. Put another way, measures of earnings quality may have predictive power for future movements in stock prices. If market participants can be accused of fixating on earnings, a similar charge might also apply to academic empirical research on stock returns. A large literature documents that firm characteristics based on accounting data help predict the cross-section of future stock returns. Few if any studies, however, venture beyond net income or cash flow (net income plus depreciation). In so doing, researchers may be making the