Discussion of “The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Profitability”

Abstract

Fairfield et al. (2003a, this issue) suggests that the accrual effect in Sloan (1996) is at least partly due to the fact that accruals signify an increase in (less-productive) net operating assets. Thus, the paper is a useful and thought-provoking reminder that accruals have both earnings and balance sheet effects. However, the impact of the empirical results is diminished by the lack of a convincing story that ties and grounds these results to other knowledge in the area. Sloan (1996) is an influential study, which documents a simple but important relation: the accrual portion of earnings is less persistent than the cash portion of earnings. In addition, Sloan finds that investors do not seem to fully appreciate the implications of accruals for future earnings, so that firms with high current accruals earn lower future stock returns. This study prompted a flurry of subsequent research which investigates the specific causes and explanations for this phenomenon. For example, Xie (2001) finds that the lower persistence of accruals is primarily due to the role of discretionary accruals, while Desai et al. (2002) argue that the accrual effect for stock returns is a variation on the ''value/glamor'' anomaly. Fairfield et al. (2003a, this issue), hereafter FWY, is another follow-up on Sloan (1996), which observes that the documented effects in accruals and cash flows concern variables scaled by some measure of investment (e.g., total assets). Thus, the documented lower persistence of scaled accruals could be due to one of two effects. First, it could be due to the lower persistence of unscaled accruals (a numerator effect), which is the commonly accepted explanation. Alternatively, FWY suggests that the lower persistence of scaled accruals could be due to the relation between accruals and growth in the investment base (a denominator effect). As the author points out, this alternative explanation seems promising because the concept of accruals is closely related to the concept of growth in assets. In fact, the commonly used balance sheet-based derivation of accruals reveals that the two concepts are at least somewhat mechanically related.