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Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about…

- - - - Firm-years are ranked annually and assigned in equal numbers to the ten portfolios. Panel A reports the portfolio mean and median values for the magnitudes of earnings and its two Consistent with research components. Prior (Dechow there is evidence of a 1994), strong negative relation between accruals and cash flows. The mean (median) value of cash flow falls from 0.22 (0.23) for the lowest accrual portfolio to 0.00 (0.00) for the highest accrual portfolio. In contrast, earnings performance is positively related to accruals. The mean (median) value of earnings is 0.07 (0.07) for the lowest accrual portfolio and 0.15 (0.13) for the highest accrual portfolio.
      - Panel B of table 1 provides statistics on two potential risk factors in order to assess the possibility that systematic variation in future stock returns across the accrual portfolios may be attributable to incomplete adjustment for risk.
      - There is evidence shaped" pattern in the betas: the beta is 1.25 for the lowest accrual portfolio, falls to 0.86 for portfolio 4 and then gradually increases to 1.23 for the highest accrual portfolio.
      - Panel C of table 1 investigates the importance of the major components of accruals in explaining variation in the accrual component of earnings.
      - The results in panel C raise the possibility that a sort on accruals may be very similar to a sort on the current asset component of accruals, given the lack of significant variation in the other two components of accruals. However, this is not the case. The current asset and current liability components of accruals are strongly negatively correlated, reflecting the fact that growing firms, with increasing working capital requirements, tend to experience increases in both their current asset and their current liability accounts.
  - - - The second hypothesis concerns whether stock prices reflect the different properties of the accrual and cash flow components of earnings.
      - Results from the estimation of the system in equations (8) and (9) are reported in table 4. Panel A contains results using the actual values of the financial variables, while the results in panel B use decile rankings to control for outliers. The coefficient on earnings in the forecasting equation, a1, is as in table 2. The coefficient on in the stock 0.841, earnings price equation, is 0.840, a*,, which is extremely close to its counterpart in the forecasting equation and indicates that stock prices anticipate the average persistence of earnings performance. The likelihood test for market = efficiency is 0.007 (marginal significance level 0.933) and the null hypothesis of market efficiency is not rejected. The results in panel B yield much the same conclusions. The persistence of earnings is somewhat weaker using the decile rankings, but is still anticipated rationally in the pricing equation. These results can be interpreted as indicating the absence of a post-earnings announcement drift in annual earnings. Stock prices correctly reflect the implications of current annual earnings for future annual earnings. The drift documented in Bernard and Thomas ( 1990) is unique to quarterly earnings changes.
      - Overall, the results in table 5 indicate that stock prices act as if investors fail to anticipate fully the lower (higher) persistence of earnings performance attributable to the accrual (cash flow) component of earnings. The earnings expectations embedded in stock prices consistently deviate from rational expectations in the direction predicted by naive fixation on earnings. However, precise inferences as to whether the magnitudes of the deviations from rational expectations are consistent with a naive fixation on earnings are sensitive to model specification.
    - - The results from tests of H2(i) imply that abnormal stock returns can be earned by exploiting investors' inability to distinguish correctly between the accrual and cash flow components of earnings. In particular, a long position in firms reporting low levels of accruals relative to cash flows and a short position in firms reporting high levels of accruals relative to cash flows should yield positive abnormal stock returns.
      - Figure 2 provides evidence on the stability of the abnormal returns to the trading strategy. It plots the annual hedge portfolio return for each of the 30 fiscal years in the sample. The returns used to produce the plot are size-adjusted returns from the first year subsequent to portfolio formation.
      - Table 7 provides additional evidence on the robustness of the relation between the accrual component of earnings and future stock returns. This table reports the means of the coefficient estimates from Fama and MacBeth (1973) regressions of stock returns on accruals and a variety of control variables. A separate cross-sectional regression is estimated for each of the 30 calendar years represented in the sample.
      - Panel B of table 7 conducts similar regressions, but allows the coefficient on the accrual component of earnings to vary across the current asset, current liability and depreciation components of accruals. The coefficients on each of the accrual components are negative in all three years. The coefficients on the current asset component are the largest in magnitude and most statistically significant, perhaps because the current asset component of accruals explains most of the variation in accruals (table 1).
      - Panel C of table 7 regresses stock returns on the accrual component of earnings and a variety of other variables that have been shown to predict future stock returns (Fama and French 1992). The objective of the regressions is to demonstrate that the predictive ability of accruals is not subsumed by these other variables.
      - The magnitude and statistical significance of the coefficients on accruals are very similar in panel C to those reported for the univariate regressions in panel A. Thus, the ability of accruals to predict future returns is incremental to these previously documented effects.
    - - The first hypothesis is that earnings performance attributable to the accrual component of earnings is less persistent than earnings performance attributable to the cash flow component of earnings.
      - Table 3 provides parameter estimates for equation (5), which does not constrain the persistence coefficients on the accrual and cash components of earnings to be equal. The first column of panel A provides the pooled regression results. The coefficient on the accrual component of earnings, y,, is 0.765, while the coefficient on the cash component of earnings, y2, = is 0.855. An F-test rejects the hypothesis that the coefficients are equal (F 614.01). The remainder of panel A provides statistics from the distributions of the coefficients from the industry level regressions. The coefficient is y, consistently smaller than the coefficient. In industry y2 specific comparisons of and is less than in y2, y, 86 percent of the industries examined, and yl y2 the null hypothesis of equality is rejected with a sign test. The rank regression results reported in panel B provide corroborating evidence that is less than y2. The pooled regression yields a yl Xl estimate of 0.565 versus a estimate of 0.838. Equality of these two coefficients is strongly y2 rejected (F=4894.24). The industry level regressions confirm that is centered between 0.5 and yl 0.6, while centered around 0.8. The is y, coefficient is less than the coefficient in 99 percent y2 y2 of the industries, and the null hypothesis of equality is rejected using a sign test. The results in table 3 therefore provide strong evidence in support of H1.
      - The first graph plots earnings performance for firms with extreme earnings in year zero. Consistent with the results in table 2, earnings performance reverts slowly to the mean. Mean reversion is gradual and far from complete by the fifth year. This graph provides a benchmark against which to compare the rates of mean reversion in earnings documented in the second and third graphs. The second graph plots earning performance for firms with extreme accruals. Mean reversion takes place more rapidly in this graph. Most of the mean reversion takes place in the first year, and mean reversion is essentially complete by the third year. The third and final graph plots earnings performance for firms with extreme cash flows. Mean reversion takes place gradually, as in the first graph, and is far from complete by the fifth year.
    - - The final prediction is that the abnormal stock returns documented in H2(ii) are clustered around the subsequent year's earnings announcements. Earnings are announced on a quarterly basis, so the tests aggregate across the announcement periods of the four quarterly earnings' numbers that together comprise the annual earnings number.
      - The results from the announcement period tests are presented in table 8. The first column reports the total annual size-adjusted return in the year following portfolio formation. The negative relation between accruals and abnormal stock returns is clearly evident and the magnitudes of the abnormal returns are almost identical to those reported in table 6. The next two columns of table 8 report the amounts of the total annual return that are attributable to the announcement and non-announcement period respectively. The negative association between operating accruals and abnormal stock returns is evident in both the announcement and non-announcement periods.
      - The individual portfolio results reveal additional information. The lowest accrual portfolio, for which good earnings news is forecast, has an announcement period return of 4.5% and a non-announcement period return of 0.9%. Thus, over 80 percent of the predictable stock returns are concentrated around subsequent earnings announcements for this "good news" portfolio.
      - The asymmetry of the results for good and bad news announcements is consistent with the evidence in Chambers and Penman ( 1984) and Skinner (1994) that bad news earnings announcements are more likely to be preempted. Evidence of this nature is provided by the proportion of late reporters statistics in the final column of table 8, where 34.5% of the firm years in the highest accrual portfolio miss at least one quarterly earnings announcement compared to 28.5% for the lowest accrual portfolio. These results are consistent with preemption of earnings announcements causing some of the predictable stock returns to be realized in the non-announcement period.