LIUQING WANG
DO STOCK PRICE FULLY REFLECT INFORMATION IN
ACCRUALS AND CASH FLOWS ABOUT FUTURE EARNINGS
RICHARD G. SLOAN
University of Pennsyvania
The Accounting Review
Vol 71. No 3
July 1996
Pp 289-315
Oct 2013
CONTENTS
1
OVERVIEW
2
2
PERSISTENCE OF ACCRUALS AND CASH FLOWS
7
3
FIXATION ON EARNINGS
12
4
ABNORMAL RETURN
18
5
RETURN CLUSTER
22
6
CONCLUSIONS
25
7
SUMMARY
27
LIUQING WANG// PAGE 1
1
OVERVIEW
LIUQING WANG// PAGE 2
ABSTRACT
Two Components of Earnings: Accruals and Cash Flows
•
Accruals = (ΔCA – ΔCash) – (ΔCL – ΔSTD – ΔTP) – Dep
where ΔCA = change in current assets
ΔCash = change in cash/cash equivalents
ΔCL = change in current liabilities
ΔSTD = change in debt included in current liabilities
ΔTP = change in income taxes payable
Dep = depreciation and amortization expense
Questions this paper answered
•
Do the two components of earnings differ?
•
Do stock prices fully reflect the difference between the two components?
LIUQING WANG// PAGE 3
RESEARCH MOTIVATIONS
The importance of analyzing the accrual and cash flow
components of current earnings is frequently emphasized
•
Valuation theory prices stock by discounting further dividends which are generated from
future earnings related to current earnings.
•
While both components (cash flows and accruals) contribute to current earnings, current
earnings performance is less likely to persist if it is attributable to the accrual component of
earnings as opposed to the cash flow component.
•
Cash flow from operations (CFO), as a measure of performance, is less subject to distortion
than is the net income figure.
•
The accrual system, which produces the income number, relies on accruals, deferrals,
allocations and valuations, all of which involve higher degrees of subjectivity than what
enters the determination of CFO
LIUQING WANG// PAGE 4
SAMPLE & MEASUREMENT
Samples
The data analysis was conducted on stocks
•
From 1962 – 1991 (30 years)
•
40,679 firm-year observations (financial statement and stock price data)
•
Excluding banks, life insurance or property and casualty companies as the accruals are not
available for those firms
Measurement
𝐼𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠 𝐶𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 =
𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐼𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 − 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐶𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
LIUQING WANG// PAGE 5
DESCRIPTIVE STATISTICS
LIUQING WANG// PAGE 6
LOGIC
Hypothesis 1
The persistence of current earnings
performance is decreasing in the
magnitude of the accrual component of
earnings and increasing in the
magnitude of the cash flow component
of earnings
Hypothesis 2 (i)
The earnings expectations embedded
in stock prices fail to reflect fully the
higher earnings persistence attributable
to the cash component of earnings and
the lower earnings persistence
attributable to the accrual component
of earnings
Hypothesis 2 (iii)
The abnormal stock returns predicted
in H2 (ii) are clustered around future
earnings announced dates
Hypothesis 2 (ii)
A trading strategy taking a long position
in the stock of firms reporting relatively
low levels of accruals and a short
position in the stock of firms reporting
relatively high levels of accruals
generates positive abnormal stock
returns
LIUQING WANG// PAGE 7
2
PERSISTENCE OF ACCRUALS
AND CASH FLOWS
LIUQING WANG// PAGE 8
TEST OF H1
Earning performance attributable to the accrual components of
earnings is less persistent than earnings performance
attributable to the cash flow component of earnings
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡+1 = 𝛼0 + 𝛼1 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡 + 𝜈𝑡+1
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡+1 = 𝛾0 + 𝛾1 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠𝑡 + 𝛾2 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤𝑠𝑡 + 𝜈𝑡+1
LIUQING WANG// PAGE 9
TEST OF H1
Results from Ordinary Least Squares Regressions of
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕+𝟏 = 𝜶𝟎 + 𝜶𝟏 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕 + 𝝂𝒕+𝟏
LIUQING WANG// PAGE 10
TEST OF H1
Results from Ordinary Least Squares Regressions of
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕+𝟏 = 𝜸𝟎 + 𝜸𝟏 𝑨𝒄𝒄𝒓𝒖𝒂𝒍𝒔𝒕 + 𝜸𝟐 𝑪𝒂𝒔𝒉𝑭𝒍𝒐𝒘𝒔𝒕 + 𝝂𝒕+𝟏
LIUQING WANG// PAGE 11
TEST OF H1
Results from Ordinary Least Squares Regressions of
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔𝒕+𝟏 = 𝜸𝟎 + 𝜸𝟏 𝑨𝒄𝒄𝒓𝒖𝒂𝒍𝒔𝒕 + 𝜸𝟐 𝑪𝒂𝒔𝒉𝑭𝒍𝒐𝒘𝒔𝒕 + 𝝂𝒕+𝟏
From the results, we can see that there is significant difference between accruals and cash
flows.
LIUQING WANG// PAGE 12
3
FIXATION ON EARNINGS
LIUQING WANG// PAGE 13
TEST OF H2 (I)
Whether stock prices reflect the different properties of the
accrual and cash flow components of earnings
Rational expectations test developed by Mishkin (1983)
LIUQING WANG// PAGE 14
TEST OF H2 (I)
Whether stock prices reflect the different properties of the
accrual and cash flow components of earnings
Market efficiency imposes the constraint that
𝛼1 = 𝛼1∗
∗
∗
Market efficiency imposes the dual constraint that 𝛾1 = 𝛾1 𝑎𝑛𝑑 𝛾2 = 𝛾2
LIUQING WANG// PAGE 15
TEST OF H2 (I)
Whether stock prices reflect the different properties of the
accrual and cash flow components of earnings
Market efficiency imposes the constraint that
𝛼1 = 𝛼1∗
∗
∗
Market efficiency imposes the dual constraint that 𝛾1 = 𝛾1 𝑎𝑛𝑑 𝛾2 = 𝛾2
LIUQING WANG// PAGE 16
TEST OF H2 (I)
Results from Nonlinear Generalized Least Squares Estimation of
the Stock Price Reaction to Information in Current Earnings about
Future Earnings
Actual Values
Decile Rankings
LIUQING WANG// PAGE 17
TEST OF H2 (I)
Results from Nonlinear Generalized Least Squares Estimation of
the Stock Price Reaction to Information in the Accruals and Cash
Flows Components of Current Earnings about Future Earnings
Actual Values
Decile Rankings
From the results, we can see that investors fail to distinguish the difference between accruals
and cash flows
LIUQING WANG// PAGE 18
4
ABNORMAL RETURN
LIUQING WANG// PAGE 19
TEST OF H2(II)
Abnormal stock returns can be earned by exploiting investors’
inability to distinguish correctly between the accrual and cash
flow components of earnings
LIUQING WANG// PAGE 20
TEST OF H2(II)
Abnormal stock returns can be earned by exploiting investors’
inability to distinguish correctly between the accrual and cash
flow components of earnings
LIUQING WANG// PAGE 21
TEST OF H2(II)
Abnormal stock returns can be earned by exploiting investors’
inability to distinguish correctly between the accrual and cash
flow components of earnings
From the results, we can see that there is a robust negative relation between the accrual
component of earnings and future stock returns.
LIUQING WANG// PAGE 22
5
RETURN CLUSTER
LIUQING WANG// PAGE 23
TEST OF H2(III)
The abnormal stock returns documented in H2(ii) are clustered
around the subsequent year’s earnings announcements.
Announcement period & non-announcement period
two days
announcement
date
Announcement
period
Announcement
period
Announcement
period
Announcement
period
One Year
LIUQING WANG// PAGE 24
TEST OF H2(III)
The abnormal stock returns documented in H2(ii) are clustered
around the subsequent year’s earnings announcements.
Announcement period returns v.s. non-announcement period returns
LIUQING WANG// PAGE 25
6
CONCLUSIONS
LIUQING WANG// PAGE 26
CONCLUSIONS
Conclusions & Explanation
•
The persistence of earnings performance is shown to depend on the relative magnitudes of
the cash flow and accrual components of earnings.
•
Stock prices act as if investors fail to identify correctly the difference properties of these two
components of earnings.
•
This does not necessarily imply investor irrationality:
̶
The information acquisition costs and processing costs associated with implementing
the strategy outlined in this paper in real time are non-trivial.
̶
Returns to exploiting the strategy are potentially limited by price pressure effect.
Additional issues for future research
•
Lower persistence of earnings performance attributable to the accrual component of
earnings is due to earning management
•
Whether earnings management is made with the intent to temporarily manipulating stock
prices and the motivations for any such stock price manipulations
LIUQING WANG// PAGE 27
7
SUMMARY
LIUQING WANG// PAGE 28
SUMMARY
Lights this paper throws
•
This paper let us rethink about investors’ rationality. More specifically, classic economic
theory assumes that investors all think rationally, but “rationally” can be different for different
people due to each investor’s knowledge limitations and information cost.
•
We may get different conclusions about market efficiency from different perspectives. In this
paper, market is efficient on earnings level but it is not efficient if we divided earnings into
accruals and cash flows.
•
It is always important to combining quantitative analysis with industrial knowledge.
Questions
•
This paper doesn’t explain why the market is efficient on total earning level, despite that the
market is not efficient when consider accruals and cash flows separately. In other words,
although investors fail to interpret the information about future earnings hidden in current
earnings due to inability to distinguish the different properties of accruals and cash flows,
their expectations of future earnings are not affected.
LIUQING WANG// PAGE 29