What Is Accrual Effect?
The accrual effect refers to the observed market anomaly where companies with high levels of accruals tend to exhibit lower future stock returns compared to companies with low levels of accruals. This phenomenon falls under the broader category of behavioral finance. It suggests that investors may not fully account for the differing implications of accrual-based earnings versus cash-based earnings when making investment decisions. The accrual effect highlights that the reported earnings, which include non-cash items, may not always be a reliable indicator of a company's true economic performance or its future profitability.
History and Origin
The concept of the accrual effect gained significant attention with the seminal work of Professor Richard Sloan in his 1996 paper, "Do stock prices fully reflect information in accruals and cash flows about future earnings?"19, 20. Sloan's research documented that the market appeared to "fixate" on total earnings and failed to sufficiently differentiate between the cash flow and accrual components of those earnings. This "earnings fixation hypothesis" posits that investors may overestimate the persistence of the accrual component of earnings, leading to an overvaluation of companies with high accruals and an undervaluation of those with low accruals16, 17, 18. This mispricing, which could be exploited by a trading strategy, came to be known as the "accrual anomaly." Subsequent research has explored this anomaly internationally, finding evidence of its presence in various global markets, particularly in countries with common law traditions and extensive use of accrual accounting14, 15.
Key Takeaways
- The accrual effect describes the tendency for high-accrual firms to underperform low-accrual firms in terms of future stock returns.
- It is rooted in the idea that investors may misinterpret the quality and persistence of earnings components.
- The effect suggests that cash flow, being more reliable, is often a better predictor of future earnings than accruals.
- The accrual effect is considered a market anomaly within financial economics.
- Understanding accruals can provide deeper insight into a company's earnings quality.
Formula and Calculation
The accrual component of earnings can be calculated as the difference between reported net income and operating cash flow. This is often referred to as "total accruals."
Alternatively, total accruals can be derived from changes in balance sheet accounts:
Where:
- (\Delta \text{Current Assets}) = Change in Current Assets
- (\Delta \text{Cash}) = Change in Cash and Cash Equivalents
- (\Delta \text{Current Liabilities}) = Change in Current Liabilities
- (\Delta \text{Debt in Current Liabilities}) = Change in Debt included in Current Liabilities (e.g., short-term debt)
- (\text{Depreciation and Amortization}) = Non-cash expenses for asset usage
This formula separates the accrual component from the cash component of earnings, providing a more detailed look at the financial reporting. Analyzing this relationship helps in assessing a company's financial health.
Interpreting the Accrual Effect
Interpreting the accrual effect involves understanding that not all earnings are created equal. Accruals, such as accounts receivable or inventory changes, represent non-cash adjustments to revenue and expenses. While essential for matching revenues with expenses under accrual accounting principles, they can sometimes be less persistent than cash flows. A high level of positive accruals might indicate aggressive revenue recognition, while high negative accruals could suggest conservative accounting practices.
When the accrual effect is observed, it implies that the market is initially overvaluing companies with high positive accruals because investors are not fully discounting the temporary nature of these non-cash earnings. Conversely, companies with low or negative accruals, which often correlate with stronger cash generation, may be undervalued. Investors can use this insight to potentially identify mispriced securities by examining the composition of a company's earnings beyond just the reported net income. This type of analysis is crucial for informed investment decisions.
Hypothetical Example
Consider two hypothetical companies, Company A and Company B, both reporting a net income of $10 million for the year.
Company A:
- Net Income: $10 million
- Operating Cash Flow: $2 million
- Total Accruals: $10 million - $2 million = $8 million
Company B:
- Net Income: $10 million
- Operating Cash Flow: $9 million
- Total Accruals: $10 million - $9 million = $1 million
Although both companies have the same reported net income, Company A has significantly higher accruals ($8 million) compared to Company B ($1 million). This suggests that a larger portion of Company A's earnings are non-cash, potentially due to factors like increased accounts receivable or a buildup of inventory. According to the accrual effect, the market might initially view both companies equally based on their reported net income. However, in subsequent periods, Company A, with its higher accruals, might experience lower future earnings persistence and thus lower stock returns compared to Company B, which generated a larger share of its earnings from actual cash flows. An investor aware of the accrual effect might favor Company B, as its earnings are supported by stronger cash flow generation.
Practical Applications
The accrual effect has practical implications for fundamental analysis and investment strategy. Investors can use this insight to refine their assessment of a company's earnings quality. For instance, a firm reporting high earnings but low cash flow (indicating high accruals) might be viewed with more skepticism regarding the sustainability of its profits. This is particularly relevant in the context of revenue recognition practices, where the U.S. Securities and Exchange Commission (SEC) has provided guidance through Staff Accounting Bulletins (SABs) to ensure consistent application of generally accepted accounting principles (GAAP) to revenue recognition, especially with complex arrangements9, 10, 11, 12, 13.
Moreover, the accrual effect forms the basis for certain quantitative investment strategies that aim to capitalize on this market anomaly. These strategies often involve shorting high-accrual stocks and going long on low-accrual stocks, seeking to profit from the presumed mispricing. It encourages investors to look beyond reported earnings per share and delve into the underlying components, specifically distinguishing between the accrual and cash flow elements. This can be a key part of developing a robust portfolio management approach.
Limitations and Criticisms
While the accrual effect has been empirically documented, it faces limitations and criticisms. One significant challenge is that the anomaly's profitability can be diminished by transaction costs and liquidity constraints, particularly for smaller, less-traded stocks where the effect is often more pronounced8. Furthermore, some researchers argue that the accrual anomaly might not solely be due to investor irrationality or "earnings fixation." Alternative explanations suggest that accruals can convey valuable information about a firm's future prospects, and that the observed underperformance of high-accrual firms might reflect rational pricing of higher business risk or lower earnings persistence7.
The effectiveness of exploiting the accrual effect has also been a subject of debate. Some studies suggest that the anomaly may have weakened or even disappeared over time as sophisticated investors become aware of and arbitrage such discrepancies6. Additionally, the accrual calculation itself can be subject to various accounting choices and estimates, making it complex to precisely determine the "true" accrual component. It is important to remember that past observed effects do not guarantee future returns, and any investment strategy based on such anomalies carries inherent market risk.
Accrual Effect vs. Accrual Accounting
The accrual effect is an observed market phenomenon or anomaly where high-accrual firms tend to underperform low-accrual firms in the stock market. It speaks to how investors may misinterpret or underreact to the information conveyed by the accrual component of earnings. This is a concept related to market efficiency and investor behavior.
In contrast, accrual accounting is a fundamental accounting method. It dictates that revenues and expenses are recognized when they are earned or incurred, regardless of when cash actually changes hands. This method provides a more accurate picture of a company's financial performance over a given period by matching revenues with the expenses incurred to generate them. For example, revenue is recorded when a sale occurs, even if payment is received later (creating an accrual like accounts receivable). Similarly, expenses are recorded when they are incurred, even if paid later (creating an accrual like accounts payable). Accrual accounting is mandated by GAAP and IFRS and is widely used for financial reporting. While the accrual effect discusses the market's reaction to accruals, accrual accounting is the system by which those accruals are created and reported.
FAQs
What causes the accrual effect?
The primary theory for the accrual effect is the "earnings fixation hypothesis," which suggests investors may focus too heavily on reported net income and fail to adequately distinguish between the more persistent cash flow component and the less persistent accrual component of earnings4, 5. This can lead to an initial overvaluation of companies with high accruals.
Is the accrual effect still relevant today?
The persistence of the accrual effect is a subject of ongoing academic and practitioner debate. While some studies suggest it has diminished due to increased market efficiency and arbitrage activities, others contend that it continues to exist, particularly in certain market segments or under specific conditions2, 3. It remains an area of interest in quantitative finance.
How can investors use the accrual effect?
Investors aware of the accrual effect may choose to analyze a company's accruals in addition to its reported earnings. They might favor companies with low or negative accruals and strong cash flows, as these tend to be associated with higher earnings quality and potentially better future stock performance. This can inform decisions related to stock selection.
Is the accrual effect the same as the accrual anomaly?
Yes, "accrual effect" and "accrual anomaly" are often used interchangeably to refer to the same phenomenon: the empirical observation that firms with higher accruals tend to have lower subsequent stock returns compared to firms with lower accruals1. Both terms highlight a deviation from what might be expected in a perfectly efficient market.
How does the accrual effect relate to value investing?
The accrual effect can align with certain principles of value investing. Value investors seek to identify undervalued companies. If the market systematically overprices high-accrual firms and underprices low-accrual firms due to a misinterpretation of earnings quality, then a strategy that exploits the accrual effect could lead to identifying undervalued cash-generative businesses. This emphasizes the importance of looking for intrinsic value beyond reported profits.