Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? ---Richard G. Sloan

Zhengying (Vivien) Fan

Topics in Quantitative Finance

Washington University in St. Louis

Sep 16, 2015

Outline

Introduction

Development of Hypotheses

Sample Formation and Variable Measurement

Empirical Analysis

Conclusions

Introduction

This paper contributes in three key respects:

Employs a model that relies on characteristics of the underlying accounting process that are documented in texts on financial statement analysis

Uses a less restrictive model that assumes investors might not fully discriminate between different components of earnings

Assesses the extent to which the magnitude of the predictable stock returns is consistent with the predictions of the naïve earnings expectations model

Development of Hypotheses

H1: 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.

H2(i): The earnings expectations embedded in stock prices fail to reflect

fully the higher persistence attributable to the cash flow component of

earnings and the lower earnings persistence attributable to the accrual

component of earnings.

Development of Hypotheses

H2(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.

H2(iii): The abnormal stock returns predicted in H2(ii) are clustered

around future earnings announcement dates.

Sample Formation and Variable Measurement

40679 firm-year observations from 1962 to 1991

Empirical Analysis: Test of H1

(1)

Empirical Analysis: Test of H1

(2)

Empirical Analysis: Test of H1

High Earnings Portfolio

Low Earnings Portfolio

High Accrual Portfolio

Low Accrual Portfolio

High Cash Flow Portfolio

Low Cash Flow Portfolio

Time series properties of Earnings, Accruals and Cash Flows. Year 0 is the year in which firms are ranked and assigned in equal numbers to ten portfolios based on each of three respective variables.

Empirical Analysis: Test of H2(i)

Basic implication of market efficiency:

A model that satisfies the efficient-markets condition:

(3)

(4)

(2)

(6)

(1)

(5)

Empirical Analysis: Test of H2(i)

(5)

Empirical Analysis: Test of H2(i)

(6)

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(ii)

Returns of Hedge Portfolio

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(iii)

Conclusion

The persistence of earnings performance is shown to depend on relative magnitudes of the cash and accrual components of earnings.

Stock prices act as if investors fail to identify correctly the different properties of these two components of earnings.

Additional issues for further research

Comments

This paper considered only current accruals – those arise mostly due to timing of payments and expenses.

Sloan published a follow-up study “Accrual Reliability, Earnings Persistence and Stock Prices”. It looked at all accruals, but not just current ones.