The Persistence of Earnings and Cash Flows and the Role of Special Items: Implications for the Accrual Anomaly

Abstract

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by balance sheet adjustments relating to special items. We then show that low accrual firms with special items have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have performed poorly, are financially distressed, and have declines in investor recognition (analysts coverage and institutional holdings). We find that special items continue to explain future returns after controlling for these factors. Our results suggest that investors underestimate the probability that special item-low accrual firms will successfully turn themselves around.