How do Investors and Analysts React to Accruals? Evidence from a Quarterly Analysis

Abstract

Prior research finds that annual accruals are negatively associated with abnormal returns subsequent to release of annual financial statements, but are not significantly associated if annual cash flows are considered. In this study, I analyze the relation of quarterly accruals and cash flows to abnormal returns subsequent to release of quarterly financial statements and to errors in financial analysts' forecasts of upcoming earnings. After controlling for the effect of cash flows, quarterly accruals are found to be significantly positively associated with both subsequent abnormal returns and analysts' forecast errors. These findings are inconsistent with the prior conclusion that investors and analysts are overoptimistic about firms reporting high accruals and as a result, overprice accruals. Instead, because this positive association can be interpreted as an underreaction, the findings suggest that investors and analysts may consistently underprice both accruals and cash flows. Furthermore, the findings also suggest that the accrual anomaly is unlikely to be merely the value-glamour anomaly in disguise.