The Predictive Value of Accruals and Consequences for Market Anomalies

Abstract

In this article, the authors revisit the role of the cash and accrual components of accounting earnings in predicting future cash flows using out-of-sample predictions and market value of equity as a proxy for all future cash flows. They find that, on average, accruals improve upon current cash flow from operations ( CFO) in predicting future cash flows. In the cross-section, accruals’ contribution is positively associated with proxies for quality of accruals and governance. Next, the authors investigate the implications of accruals’ predictive value for accrual-based market anomalies. They find that portfolios formed on stock return predictions using information from current CFO and accruals yield significantly positive returns on average, as opposed to CFO alone. They also find that Sloan’s accrual anomaly is related to our accrual contribution anomaly. Indeed, when accruals’ contribution to future cash flow prediction is the highest, the accrual anomaly vanishes. Collectively, the results suggest that the predictive value of accruals and market participants’ ability to process it are a significant driver of accrual-based anomalies.