Do Accruals Drive Stock Returns? A Variance Decomposition Analysis

Abstract

This paper extends the variance decomposition framework of Campbell (1991), Campbell and Ammer (1993) and Vuolteenhao (2002) to address the relative value relevance of accruals news, cash flow news and expected return news in driving firm-level equity returns. The extension is based on the Feltham-Ohlson (1995, 1996) clean surplus relations. Accruals news is found to significantly dominate expected-return news in driving firm-level stock returns. Operating income news is also found to significantly dominate both expected-return news and free cash flow news in driving firm-level stock returns. Furthermore, after splitting net income into cash flow and accrual earnings components in the Vuolteenhao (2000) model, accrual earnings news is found to significantly dominate both expected-return news and cash flow earnings news in driving firm-level stock returns. Overall, these three results indicate that changes in expected future accruals are the primary driver of current stock returns rather than changes in expected future cash flows or future discount rates.