Earnings Quality and Short Sellers

Abstract

SYNOPSIS: A key measure of earnings quality is the deviation of net income from operating cash flows. Sloan (1996) finds that firms with high accruals (or a large gap between net income and operating cash flow) experience a decline in earnings performance not anticipated by investors, resulting in predictable future returns. In this paper, I examine whether investors short sell securities with high accruals. Such a strategy is able to directly profit from the predictable lower future returns. Using a sample of U.S. traded firms from 1990-1 998, I do not find evidence that short sellers trade on the basis of information contained in accruals. Keywords: accruals; earnings quality; returns; short sellers. Data Availability: Data are available from sources identified in the text. INTRODUCTION Earnings quality is often defined in terms of persistence and sustainability. Revsine et al. (1999, 224-225) state that earnings are considered to be of high quality when they are sustainable. Bodie et al. (2002,628) speak of the quality of earnings in terms of the extent to which we might expect the reported level of earnings to be sustained. In this paper, earnings that are more persistent are viewed as higher quality. Examples of low-quality earnings include insufficient allowance for doubtful accounts, insufficient provisions for obsolete inventory, and aggressive revenue recognition practices that bring future revenues into the current period. Common to these examples of low earnings quality is the fact that current earnings are temporarily inflated due to accounting choices, but cash flows are unaffected. The lower persistence of earnings resulting from high levels of accruals does not have to be a direct result of earnings management activity. The nature of accrual accounting is to accrue and defer past, current, and anticipated future cash receipts and disbursements. The accrual process involves a significant amount of estimation of future cash receipts and payments, and a subjective allocation of past cash receipts and payments. In doing so, the accrual process creates accounts of varying reliability. For example, recording the net realizable value of receivables involves estimation of default risk across a portfolio of debtors. Other examples include estimating recoverable amounts of inventories, depreciating and amortizing long-lived assets, and estimating post-retirement benefit obligations. Estimation errors for the various asset, liability, and associated revenue and expense accounts (either intentional or unintentional) will all lead to lower persistence in earnings. Collectively, these estimations ma nifest themselves in the magnitude of reported accruals. Sloan (1996) documents that firms with reported income greater than operating cash flows (i.e., high accruals) experience a decline in earnings performance in the following year. In addition, stock prices fail to impound the implications of current accruals for future earnings, leading to predictable return patterns for firms with high levels of accruals. Furthermore, firms reporting earnings with large accruals are more likely to be subject to SEC enforcement actions (Dechow et al. 1996; Bradshaw et al. 2001) and earnings restatements (Richardson, Tuna, and Wu 2002). Collectively, this suggests that the magnitude of accruals is a good indicator of earnings quality. In this paper, I examine whether short sellers are able to identify and trade on earnings quality information embedded in accruals. Short sellers have particularly strong incentives to utilize measures of earnings quality because they can directly profit from the lower future performance of high-accrual firms. Previous research finds that short sellers are an informed subset of investors who are able to identify over-priced securities (see e.g., Figlewski 1981; Dechow et. al. 2001; Desai et. al. 2002). Short sellers have the ability and the financial incentive to trade on the basis of accrual information. …