Have existing theories explained the accrual anomaly? An evaluation based on the decomposition method

Abstract

Using the decomposition method proposed by Hou and Loh (2016), we evaluate whether the existing theories have explained the negative correlation between accruals and the cross-section returns (the accrual anomaly). The results show that cash-based operating profitability best explains the anomaly, with an explanatory power of about 94 percent. Among the three explanation groups, explanations about investment and cash flows explain efficiently, whereas the contributions of arbitrage costs and information asymmetry are quite limited. Together, our findings suggest that the existing theories, especially explanations about investment and cash flows, have explained most of the anomaly and the unexplained fraction is negligible.