Changes in the Profitability-Growth Relation and the Implications for the Accrual Anomaly

Abstract

Changes in the Profitability-Growth Relation and the Implications for the Accrual Anomaly Meng Li Valuation research establishes growth in net operating assets (∆NOA) as a primary predictor of future profitability. The negative relation between ∆NOA and future profitability, after controlling for current profitability, is researched extensively in the context of earnings quality, capital investment, accounting conservatism, earnings management, and the accrual anomaly. However, this study shows that while ∆NOA is negatively related to future profitability from 1967 to 1995, it is positively related to future profitability from 1996 to 2010. The negative effects of ∆NOA on future profitability (e.g., diminishing returns on investment, accruals overstatement, and excess capitalization) continue to exist, although they are now dominated by the positive implications of ∆NOA for future profitability. The positive relation between ∆NOA and future profitability grows stronger over time for reasons including increasing intangible intensity, increased volatility of economic activities, increased accounting conservatism, accounting principles shifting toward a balance sheet/fair value approach, changing characteristics of public firms, and the increasing importance of real options. The change in the future profitability-∆NOA relation has important implications, particularly for the accrual anomaly. The prevailing explanation for the anomaly is that an increase (decrease) in NOA predicts a decrease (increase) in profitability and investors fail to fully appreciate this negative relation. However, if this hypothesis is true, the anomaly should no longer exist. I examine the anomaly over an extended time period, including more recent years, and provide evidence that the anomaly is still present. To explain the persistence of the anomaly over time, I conjecture and show that the market reaction to ∆NOA and the future profitability implications of ∆NOA diverge throughout the sample period. Specifically, investors are always over optimistic about the future profitability implications of the growth, i.e., in the first half of the sample (1967-1988), investors do not fully react to the negative effects of growth on profitability, and in the second half (1989-2010), they appear to over-emphasize the positive implications of ∆NOA for future profitability. The anomaly weakens during periods when investors’ reaction to ∆NOA aligns with the profitability implications of ∆NOA.