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Review of Accounting Studies

Erschienen in:

01.09.2006

The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly

verfasst von: Patricia M. Dechow, Weili Ge

Erschienen in: Review of Accounting Studies | Ausgabe 2-3/2006

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Abstract

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

Vorheriger Artikel Discussion of “Which approach to accounting for employee stock options best reflects market pricing?”

Nächster Artikel Discussion of “The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly”

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Merton (1987) argues that investors only use securities that they know about in constructing their optimal portfolios. Therefore, firms with low investor recognition will earn higher returns than firms with high investor recognition.

This result is consistent with Bradshaw, Richardson, and Sloan (2001) who focus on annual earnings forecasts. It is also consistent with Bradshaw, Richardson, and Sloan (2003) that focus on external financing that is highly negatively correlated with total accruals.

If bankruptcy risk is a priced source of risk, firms with higher bankruptcy risk should earn higher future returns to compensate for this risk. However, Dichev (1998) provides evidence that firms with high bankruptcy risk earn lower future returns (inconsistent with bankruptcy risk being a priced source of risk). His results suggest that investors do not require a premium for holding stock with high bankruptcy risk. Alternatively, Kahn (2005) provides descriptive evidence that low accrual firms are more financially distressed. However, Kahn provides no formal evidence that bankruptcy risk is a priced source of risk.

See Watts (2003) for a discussion of the differential verification of gains and losses and the role of conservatism in accounting; see also Ball and Shivakumar (2005).

The sample is not restricted to only NYSE/AMEX firms; therefore, it does not have the exchange listing bias suggested by Kraft, Leone, and Wasley (2005).

Our results are similar when we subtract the cash portion of discontinued operations and extraordinary items (Compustat item #124) from cash from operations to calculate operating accruals according to Hribar and Collins (2002). The Spearman correlation between the measures is 0.99.

Our definition of FCF includes some financing charges such as interest paid and received and certain effects related to the tax effects of stock options (e.g., Hanlon & Shevlin, 2002) and changes in some financial assets such as marketable securities.

We thank Reuvan Lehavy and Richard Sloan for providing us with their data on quarterly changes in institutional holdings.

Compustat has the following classifications for special items: Acquisition/merger pretax (Data item #360); Gain/loss pretax (Data item #364); Impairments of goodwill pretax (Data item #368); settlement (litigation/insurance) Pretax (Data item #372); Restructuring costs pretax (Data item #376); Write-down pretax (Data item #380); Other special items pretax (Data item #384). We calculate the accrual component of special items as the sum of gain/loss, impairments of goodwill, restructuring costs, and write-downs.

We attempted to reconcile the non-cash fund number reported by Compustat to the Statement of Cash Flows for the 20 firms identified in Appendix. We found this number more difficult to identify and reconcile to underlying accruals than the special item number.

When earnings and cash flows at t+1 are missing because the firm has been delisted for performance related reasons we make the following adjustment: we assume that firm has liquidated and so investors lose all their invested capital (i.e., the book value of equity). Therefore, we substitute the negative of the book value of equity as the future performance metric. When the book value is negative, we substitute zero as the future performance metric. We do this adjustment to avoid survivorship bias upwardly biasing our measures of persistence. In addition, we include delisted firms in our stock returns tests so the adjustment makes results comparable across tables.

When we make no adjustments for missing earnings and cash flows at t+1, earnings persistence is 0.60 and is still lower than CFO’s persistence of 0.68.

We also investigated positive special items; however, there is little variation across accrual deciles. For our entire sample, 3.8% of firms report positive special items greater than 2% of assets. Nine percent of high accrual firms have positive special items versus 3% for low accrual firms.

One issue of concern is whether to use earnings on a before or after-tax basis since special items and accruals are on a before-tax basis. Appendix A examines whether special items affected the tax expense/benefit reported by a random sample of low accrual firms. We find that in most cases the special items did not affect reported taxes since most of the firms were reporting losses and had a 100% deferred tax asset valuation allowance. In unreported tests, we also ran regressions using pretax income and adjusting cash flows for tax effects. The tenor of the results reported in Table 2 does not change.

Thomas and Zhang (2002) document that the negative relation between accruals and future abnormal returns is driven by inventory changes. We find that our results are not driven by inventory changes. In addition, Bradshaw et al. (2001) compare the hedge return for working capital accruals and operating accruals. Accrual adjustments excluded from working capital accruals but included in operating accruals include depreciation, amortization and special items. They find that the hedge returns based on working capital accruals is slightly higher than the returns based on operating accruals (a size-adjusted return of 11.1% vs. 10.3%). However, they do not investigate the specific role of special items.

Elliott and Hanna (1996) show that investors place less weight on write-offs than pre-special item earnings. However, they do not examine whether investors correctly weigh special items.

We delete observations where share price is less than $1 and find that the percentage of firms delisted declines from 18.39% to 13.03% for special item-low accrual firms and from 15.92% to 11.18% for other low accrual firms. The Shumway Score declines from 1.28% to 0.63% for special item firms and is no longer significantly different from other low accrual firms. We also remove stock with average daily dollar trading volume (share price × shares traded) and relative trading volume (dollar trading volume/market value) less than the bottom 10% of the sample. The tenor of the results does not change. The difference in size-adjusted returns for the two groups is unaffected by these adjustments.

The distribution of stock returns is positively skewed. Core (2005) suggests that the approach used in Kraft et al. (2005) is inappropriate because trimming skewed stock return results in biased estimates. See also, Teoh and Zhang (2005).

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Titel: The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly
verfasst von: Patricia M. Dechow
Weili Ge
Publikationsdatum: 01.09.2006
Verlag: Kluwer Academic Publishers-Plenum Publishers
Erschienen in: Review of Accounting Studies / Ausgabe 2-3/2006
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-006-9004-1

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