Skip to main content
SpringerLink
Log in

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

  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

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.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5

Similar content being viewed by others

Notes

  1. 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.

  2. 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.

  3. 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.

  4. 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).

  5. 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).

  6. 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.

  7. 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.

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

  9. 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.

  10. 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.

  11. 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.

  12. 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.

  13. 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.

  14. 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.

  15. 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.

  16. 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.

  17. 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.

  18. 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).

References

  • Ball, R., & Shivakumar, L. (2005). The role of accruals in asymmetrically timely gain and loss recognition. Working paper, University of Chicago and London Business School.

  • Barber, B., Lehavy, R., McNichols, M., & Trueman, B. (2001). Can investors profit from the prophets? Security analyst recommendations and stock returns. Journal of Finance, 56(2), 531–563.

    Article  Google Scholar 

  • Beaver, W. (1968). The information content of annual earnings announcements. Journal of Accounting Research, 6, 67–92.

    Article  Google Scholar 

  • Bowen, R. M., Davis, A. K., & Matsumoto, D. A. (2005). “Emphasis on pro forma versus GAAP earnings in quarterly press releases: Determinants, SEC intervention, and market reactions. The Accounting Review (forthcoming).

  • Bradshaw, M. T., Richardson, S. A., & Sloan, R. G. (2001). Do analysts and auditors use information in accruals? Journal of Accounting Research, 39(1), 45–75.

    Article  Google Scholar 

  • Bradshaw, M. T., Richardson, S. A., & Sloan, R. G. (2003). Pump and dump: An empirical analysis of the relation between corporate financing activities and sell-side analyst research. Working paper, University of Michigan.

  • Bradshaw, M. T., & Sloan, R. G. (2002). GAAP versus the street: An empirical assessment of two alternative definitions of earnings. Journal of Accounting Research, 40(1), 41–65.

    Article  Google Scholar 

  • Burgstahler, D., Jiambalvo, J., & Shevlin, T. (2002). Do stock prices fully reflect the implications of special items for future earnings? Journal of Accounting Research, 40(3), 585–612.

    Article  Google Scholar 

  • Chan, K., Chan, L. K. C., Jegadeesh, N., & Lakonishok, J. (2006). Earnings quality and stock returns. Journal of Business (forthcoming).

  • Core, J. E. (2005). Discussion of an analysis of the theories and explanations offered for the mis-pricing of accruals and accruals components. Working paper, University of Pennsylvania.

  • De Bondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact? Journal of Finance, 40(3), 793–805.

    Article  Google Scholar 

  • Dechow, P. M., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(Supplement), 35–59.

    Google Scholar 

  • Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18(1), 3–42.

    Article  Google Scholar 

  • Desai, H., Rajgopal, S., & Venkatachalam, M. (2004). Value-glamour and accruals mispricng: One anomaly or two? The Accounting Review, 79(2), 355–385.

    Google Scholar 

  • Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? Journal of Finance, 53(3), 1131–1147.

    Article  Google Scholar 

  • Doyle, J. T., Lundholm, R. J., & Soliman, M. T. (2003). The predictive value of expenses excluded from pro forma earnings. Review of Accounting Studies, 8(2/3), 143–391.

    Article  Google Scholar 

  • Elliott, J. A., & Hanna, J. D. (1996). Repeated accounting write-offs and the information content of earnings. Journal of Accounting Research, 34(Supplement), 135–155.

    Article  Google Scholar 

  • Fairfield, P. M., Sweeney, R. J., & Yohn, T. L. (1996). Accounting classification and the predictive content of earnings. The Accounting Review, 71(3), 337–355.

    Google Scholar 

  • Fairfield, P. M., Whisenant J. S., & Yohn, T. L. (2003a). Accrued earnings and growth: Implications for future profitability and market mispricing. The Accounting Review, 78, 353–371.

    Google Scholar 

  • Fairfield, P. M., Whisenant, J. S., & Yohn, T. L. (2003b). The differential persistence of accruals and cash flows for future operating income versus future profitability. Review of Accounting Studies, 8(2/3), 221–243.

    Article  Google Scholar 

  • Francis, J., Hanna, J. D., & Vincent, L. (1996). Causes and effects of discretionary asset write-offs. Journal of Accounting Research, 34(Supplement), 117–134.

    Article  Google Scholar 

  • Hanlon, M., & Shevlin, T. (2002). Accounting for tax benefits of employee stock options and implications for research. Accounting Horizons, 16, 1–16.

    Google Scholar 

  • Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics, 20(2), 125–153.

    Article  Google Scholar 

  • Hribar, P., & Collins, D. W. (2002). Errors in estimating accruals: Implications for empirical research. Journal of Accounting Research, 40, 105–134.

    Article  Google Scholar 

  • Kahneman, D., & Tversky A. (1982). Intuitive prediction: Biases and corrective procedures. In Kahneman, D., Slovic, P., & Tversky, A. (Eds.), Judgment under uncertainty: Heuristics and biases. London: Cambridge University Press.

  • Karpoff, J. M. (1986). A Theory of Trading Volume. Journal of Finance, 41(5), 1069–1087.

    Article  Google Scholar 

  • Khan, M. (2005). Are accruals really mispriced? Evidence from tests of an intertemporal capital asset pricing model. Working paper, MIT.

  • Kim O., & Verrecchia, R. E. (1991). Trading volume and price reactions to public announcements. Journal of Accounting Research, 29, 302–321.

    Article  Google Scholar 

  • Kraft, G. A., Leone, A. J., & Wasley, C. E. (2005). Research design issues and related inference problems underlying tests of the market pricing of accounting information. Working paper, London Business School.

  • Lakonishok, J., Shleifer, A., & Vishny, R. W. (1994). Contrarian investment, extrapolation, and risk. Journal of Finance, 49(5),1541–1578.

    Article  Google Scholar 

  • Lee, M. C. C., & Swaminathan, B. (2000). Price momentum and trading volume. Journal of Finance, 55(5), 2017–2069.

    Article  Google Scholar 

  • Lehavy, R., & Sloan, R. G. (2004). Investor recognition, accruals and stock returns. Working paper, University of Michigan.

  • Lougee, B. A., & Marquardt, C. A. (2004). Earnings informativeness and strategic disclosure: An empirical examination of “pro forma” earnings. The Accounting Review, 79(3), 769–795.

    Google Scholar 

  • McVay, S. (2006). Earnings management using classification shifting: An examination of core earnings and special Items. The Accounting Review (forthcoming).

  • Mishkin, F. S. (1983). A rational expectations approach to macroeconometrics: Testing policy effectiveness and efficient markets models. Chicago, IL: University of Chicago Press for the National Bureau of Economic Research.

    Google Scholar 

  • Mohanram, P. S. (2005). Separating winners from losers among low book-to-market stocks using financial statement analysis. Review of Accounting Studies, 10(2/3), 133–170.

    Article  Google Scholar 

  • Piotroski, J. (2000). Value investing: The use of historical financial statement information to separate winners from losers. Journal of Accounting Research, 38(Supplement), 1–41.

    Article  Google Scholar 

  • Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, A. I. (2005). Accrual reliability, earnings persistence and stock prices. Journal of Accounting and Economics, 39, 437–485.

    Article  Google Scholar 

  • Schipper, K., & Vincent, L. (2003). Earnings quality. Accounting Horizons, 17(Supplement), 97–110.

    Google Scholar 

  • Shumway, T. (2001). Forecasting bankruptcy more accurately: A simple hazard model. The Journal of Business, 74(1), 101–124.

    Article  Google Scholar 

  • Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289–315.

    Google Scholar 

  • Teoh, S. H., & Zhang, Y. (2005). Loss firms, asset pricing controls, and accounting anomalies. Working paper, Ohio State University.

  • Thomas, J. K., & Zhang, H. (2002). Inventory changes and future returns. Review of Accounting Studies, 7(2–3), 163–187.

    Article  Google Scholar 

  • Watts, R. L. (2003). Conservatism in accounting part 1: Explanations and implications. Accounting Horizons, 17(3), 207–221.

    Google Scholar 

Download references

Acknowledgements

This paper shared First Prize for Best Paper at the 2005 Review of Accounting Studies Conference. We have benefited from the comments of Patricia Fairfield, Charles Lee, Reuven Lehavy, James Ohlson, Stephen Penman, Scott Richardson, Richard Sloan, Irem Tuna, and an anonymous referee. We thank seminar participants at Barclays Global Investors, University of California, Berkeley, Carnegie Mellon Conference 2005, and the Review of Accounting Studies 2005 Conference, for their comments. We also thank the Harry H. Jones Endowment Fund for Research on Earnings Quality for financial support. This paper was previously titled “Earnings, Cash Flows, Persistence, and Growth.”

Author information

Authors and Affiliations

  1. Stephen M. Ross School of Business, University of Michigan, Ann Arbor, MI, 48109, USA

    Patricia M. Dechow & Weili Ge

Authors
  1. Patricia M. Dechow
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Weili Ge
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Patricia M. Dechow.

Appendix

Appendix

Appendix A Detail examination of special items for a random selection of firms in the lowest decile of accruals (decile 1) that had special items more than 5% of assets for the years 1999–2002
Full size table

Rights and permissions

Reprints and permissions

About this article

Cite this article

Dechow, P.M., Ge, W. The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly. Rev Acc Stud 11, 253–296 (2006). https://doi.org/10.1007/s11142-006-9004-1

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11142-006-9004-1

Keywords

JEL Classification

Search

Navigation