Cash Flows, Accruals, and Future Returns

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.