Question

Explain the findings of Sloan (1996) in relation to discretionary accruals.

Answer 1

Findings of sloan’s accruals

Starting with the article of Sloan (1996) titled “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings”, the cash flow and accrual components of earnings have been frequently used in testing stock market efficiency. Sloan (1996) examines the impact of different persistence degrees of cash flow and accrual components of earnings on the persistence of earnings and its reflection on stock prices. The author asserts that when market participants create an expectation of future period earnings, they overestimate the persistence of accruals and underestimate the persistence of cash flows. Consequently, the author indicates that firms with high (low) accruals earn negative (positive) abnormal returns in the future periods. This condition signifies that markets overprice accruals and is defined as the “accrual anomaly”.

The existence of the accrual anomaly is primarily introduced by Sloan (1996). This study examines the quality of information contained in the accrual and cash flow components of current earnings and the extent to which this information is reflected in stock prices. The author indicates that the persistence of current earnings performance is decreasing the magnitude of the total accrual component of earnings and increasing the magnitude of cash flow component of earnings. However, the author states that investors cannot distinguish the different properties of total accrual and cash flow components of current earnings. Therefore, applying both the Mishkin and hedge portfolio tests, Sloan (1996) demonstrates that investors misprice the total accrual components of current earnings between the years 1962–1991 in the U.S. According to Mishkin test results, investors overprice the persistence of total accruals and underprice the persistence of cash flows. In order to corroborate Mishkin's test results, Sloan (1996) develops a trading strategy that requires taking a long position in the portfolio consisting of stocks of firms reporting a relatively low level of total accruals and a short position in the portfolio consisting of stocks of firms reporting a relatively high level of total accruals. Sloan (1996) shows that hedge portfolio strategy generates annual abnormal returns of 0.104, on average.

According to the research, an explanation for the accrual anomaly is the earnings fixation hypothesis. The hypothesis says that investors are fixed upon earnings and fail to pay attention separately to the cash-flow and accrual components of earnings. However, this is the main reason for the functionality of the accruals anomaly. Firstly, the cash-flow component of earnings is a superior and better forecaster of future earnings if we would compare it with the accrual component of earnings. Therefore, investors who are not able to distinguish between actual earnings and accruals can become overly optimistic about the prospects of firms with high accruals.

The investment universe consists of all stocks on NYSE, AMEX, and NASDAQ. Balance sheet based accruals (the non-cash component of earnings) are calculated as:

BS_ACC = ( ∆CA – ∆Cash) – ( ∆CL – ∆STD – ∆ITP) – Dep
Where:
∆CA   = annual change in current assets
∆Cash = change in cash and cash equivalents
∆CL   = change in current liabilities
∆STD = change in debt included in current liabilities
∆ITP = change in income taxes payable
Dep = annual depreciation and amortization expense

Stocks are then sorted into deciles and investor goes long stocks with the lowest accruals and short stocks with the highest accruals. The portfolio is rebalanced yearly during May (after all companies publish their earnings).

The accruals anomaly – the negative relationship between accounting accruals and subsequent stock returns – has been well documented in the academic and practitioner literatures for almost a decade. To the extent that this anomaly represents market inefficiency, one would expect sophisticated investors to learn about it and arbitrage the anomaly away. Yet, we show that the accruals anomaly still persists and its magnitude has not declined over time. While we find that institutional investors react promptly to accruals information, it is clear that their reaction is rather weak and is primarily characteristic of active investors who constitute a minority of institutions. The main reason: Extreme accruals firms have characteristics which are unattractive to most institutional investors. Individual investors are by and large unable to profit from trading on accruals information due to the high transaction and information costs associated with implementing a consistently profitable accruals strategy. Consequently, the accruals anomaly persists, and will probably endure.