The accrual anomaly in Europe: The role of accounting distortions

Numerous studies claim that the accrual anomaly in the U.S. stock market is due mostly to temporary accounting distortions arising from accrual accounting. We examine the validity of this explanation in an international setting. Across the 15 developed European equity markets we examine, accounting distortions contribute to the negative relation between accruals and future earnings performance in 14 equity markets. Further, we show that the negative relation between accruals and stock returns could be at least attributable to accounting distortions. In particular, accruals related to accounting distortions predict returns in 7 out of the 9 markets where the accrual anomaly occurs in Europe. Finally, we show that the impact of accounting distortions on the pricing of the accrual component of earnings is stronger in markets with a higher level of trust and a lower level of secrecy.     

Predicting Stock Market Returns with Aggregate Discretionary Accruals

We find that the positive relation between aggregate accruals and one‐year‐ahead market returns documented in Hirshleifer, Hou, and Teoh [2009] is driven by discretionary accruals but not normal accruals. The return forecasting power of aggregate discretionary accruals is robust to choices of sample periods, return measurements, estimation methods, business condition and risk premium proxies, and accrual models used to isolate discretionary accruals. Our extensive analysis shows that aggregate discretionary accruals, in sharp contrast to aggregate normal accruals, contain little information about overall business conditions or aggregate cash flows and display little co‐movement with ICAPM‐motivated risk premium proxies. Our findings imply that aggregate discretionary accruals likely reflect aggregate fluctuations in earnings management, thereby favoring the behavioral explanation that managers time aggregate equity markets to report earnings.     

Exchange Rate Exposure at the Firm and Industry Level

Previous work on the exposure of firms to exchange rate risk has primarily focused on U.S. firms and, surprisingly, found stock returns were not significantly affected by exchange‐rate fluctuations. The equity market premium for exposure to currency risk was also found to be insignificant. In this paper we examine the relation between Japanese stock returns and unanticipated exchange‐rate changes for 1,079 firms traded on the Tokyo stock exchange over the 1975–1995 period. Second, we investigate whether exchange‐rate risk is priced in the Japanese equity market using both unconditional and conditional multifactor asset pricing testing procedures. We find a significant relation between contemporaneous stock returns and unanticipated yen fluctuations. The exposure effect on multinationals and high‐exporting firms, however, is found to be greater in comparison to low‐exporting and domestic firms. Lagged‐exchange rate changes on firm value are found to be statistically insignificant implying that investors are able to assess the impact of exchange‐rate changes on firm value with no significant delay. The industry level analysis corroborates the cross‐sectional findings for Japanese firms in that they are sensitive to contemporaneous unexpected exchange‐rate fluctuations. The co‐movement between stock returns and changes in the foreign value of the yen is found to be positively associated with the degree of the firm's foreign economic involvement and inversely related to its size and debt to asset ratio. Asset pricing tests show that currency risk is priced. We find corroborating evidence in support of the view that currency exposure is time varying. Our results indicate that the foreign exchange‐rate risk premium is a significant component of Japanese stock returns. The combined evidence from the currency exposure and asset pricing analyses, suggests that currency risk is priced and, therefoe, has implications for corporate and portfolio managers.     

The association of aggregate and disaggregated earnings with annual stock returns

This study compares aggregate earnings and disaggregated earnings (cash from operations, current accruals and non-current accruals) in terms of their associations with stock returns. A cross-sectional approach is adopted using Australian data over a six-year period. This analysis is undertaken for two different models of the relation between earnings and returns: one model relating returns to the magnitude of earnings, and the other relating returns to the combination of levels of, and changes in, earnings. In each model, the disaggregated regression is generally a superior explanator of stock returns, implying that disaggregated earnings provides richer information about firm performance, in a purely statistical sense, than aggregate earnings. Thus, disaggregated earnings are more informative, even in the most simple of comparison modes, linear regression.     

Real Options,Volatility, and Stock Returns

We provide evidence that the positive relation between firm‐level stock returns and firm‐level return volatility is due to firms’ real options. Consistent with real option theory, we find that the positive volatility‐return relation is much stronger for firms with more real options and that the sensitivity of firm value to changes in volatility declines significantly after firms exercise their real options. We reconcile the evidence at the aggregate and firm levels by showing that the negative relation at the aggregate level may be due to aggregate market conditions that simultaneously affect both market returns and return volatility.     

Aggregate Earnings and Corporate Bond Markets

I examine the previously unexplored relation between aggregate earnings changes and corporate bond market returns. I find that aggregate earnings changes have a negative relation to investment‐grade corporate bond market returns and a positive relation to high‐yield corporate bond market returns. The aggregate earnings‐returns relation is lower (i.e., less positive or more negative) for bonds with higher credit ratings and longer maturities. Further, I show that the aggregate earnings‐returns relation is driven by both the expected and the news component of aggregate earnings changes. The expected component is negatively related to expected returns, and the news component is positively related to cash flow news and changes in nominal interest rates, and negatively related to changes in default premia. My results contribute to the understanding of the role of earnings in corporate bond markets as well as the macroeconomic role of accounting information.     

Conditional Equity Premium and Aggregate Corporate Investment

We document a strong negative relation between aggregate corporate investment and conditional equity premium estimated from direct stock market risk measures. Consistent with the investment-based asset pricing model, the comovement with conditional equity premium fully accounts for aggregate investment's market return predictive power. Similarly, conditional equity premium is a significant determinant of classic Tobin's q measure, although q has much weaker explanatory power for aggregate investment possibly because of its measurement errors. Moreover, the positive relation between aggregate investment and investor sentiment documented in previous studies reflects the fact that both variables correlate closely with conditional equity premium.     

Accruals,Investment, and Future Performance

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly, which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.     

Accounting Ratios and the Cross‐section of Expected Stock Returns

Under clean‐surplus accounting, the log return on a stock can be decomposed into a linear function of the contemporaneous log return on equity, the contemporaneous log dividend–price ratio (if the stock pays a dividend), and both the contemporaneous and lagged values of the log book‐to‐market equity ratio. This paper studies the implications of this decomposition for the cross‐section of conditional expected stock returns. The empirical analysis reveals that the log accounting ratios capture cross‐sectional variation in both the conditional mean and conditional variance of log stock returns, which is consistent with the decomposition. It also brings fresh insights to the relation between firm size (market equity) and conditional expected stock returns. The evidence indicates that the conditional median return increases with firm size, while the conditional return skewness decreases with firm size. Empirically, the skewness effect outweighs the median effect, leading to the well‐documented inverse relation between size and average returns. The results of out‐of‐sample tests suggest that investors could use the information provided by the observed values of the log accounting ratios to formulate more effective portfolio strategies.     

The pricing of conservative accounting and the measurement of conservatism at the firm-year level

This paper analyzes the relation between equity prices and conditional conservatism and introduces a new measure of conservatism at the firm-year level. We show that the asymmetric properties of conservative accounting, the existence of non-accounting sources of information, and the properties of GAAP related to special items combine to generate a nonlinear relation between unexpected equity returns and earnings news (the shock to expected current and future earnings). Based on this model, we construct a conservatism ratio (CR) defined as the ratio of the current earnings shock to earnings news. CR measures the proportion of the total shock to expected current and future earnings recognized in current year earnings. Ranking firms according to CR, we show empirically that higher CR firms have more leverage, increased volatility of returns, more incidence of losses, more negative accruals, and increased volatility of earnings and accruals, consistent with the literature on conservative accounting.     

Articulation-based accruals

We build an articulating financial statements model in which the beginning and ending balance sheet amounts are explicitly linked to accruals. We distinguish accruals based on the source financial statement of the accruals, either the cash flow statement, balance sheet, or statement of owners’ equity. We then examine how the accrual-generating source affects the relations between accruals and future earnings and stock returns. While prior studies document a negative association between accruals and future earnings and returns, we find accruals relating to the current operating section of the balance sheet are positively associated with future earnings. Further, accruals originating from net financial asset via the statement of owners’ equity are positively associated with future returns. We also show that equity investment and discontinued asset accruals differ from operating asset accruals in their association with future earnings.     

Predictability and the earnings–returns relation

This paper studies the effects of predictability on the earnings–returns relation for individual firms and for the aggregate. We demonstrate that prices better anticipate earnings growth at the aggregate level than at the firm level, which implies that random-walk models are inappropriate for gauging aggregate earnings expectations. Moreover, we show that the contemporaneous correlation of earnings growth and stock returns decreases with the ability to predict future earnings. Our results may therefore help explain the apparently conflicting recent evidence that the earnings–returns relation is negative at the aggregate level but positive at the firm level.     

Market Illiquidity and Conditional Equity Premium

We examine the time‐series relation between aggregate bid‐ask spreads and conditional equity premium. We document that average marketwide relative effective bid‐ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out‐of‐sample tests. These findings are important because they provide strong support for the literature's conjecture that marketwide liquidity is an important asset pricing risk factor.     

Detecting news in aggregate accounting earnings: implications for stock market valuation

How much news is there in aggregate accounting earnings? I provide evidence that earnings changes at the stock market level are correlated with new information about not only expected future cash flows but also discount rates. A comprehensive investigation of the link to discount rates reveals that aggregate earnings changes are tied to news about all components of the expected future stock market return, i.e., the real riskless rate, expected inflation, and the expected equity risk premium. Over the sample period studied, cash flow news and discount rate news in aggregate earnings changes covary positively and have offsetting impacts on stock market prices. As a result, stock market prices appear to be insensitive to aggregate earnings changes. The findings highlight the importance of separating cash flow news from discount rate news when evaluating the information content of accounting earnings at the stock market level. Overall, my study sheds new light on the informativeness and relevance of accounting earnings for valuation at the stock market level.     

Average correlation and stock market returns

If the Roll critique is important, changes in the variance of the stock market may be only weakly related to changes in aggregate risk and subsequent stock market excess returns. However, since individual stock returns share a common sensitivity to true market return shocks, higher aggregate risk can be revealed by higher correlation between stocks. In addition, a change in stock market variance that leaves aggregate risk unchanged can have a zero or even negative effect on the stock market risk premium. We show that the average correlation between daily stock returns predicts subsequent quarterly stock market excess returns. We also show that changes in stock market risk holding average correlation constant can be interpreted as changes in the average variance of individual stocks. Such changes have a negative relation with future stock market excess returns.     

Accruals,cash flows,and aggregate stock returns

This paper examines whether the firm-level accrual and cash flow effects extend to the aggregate stock market. In sharp contrast to previous firm-level findings, aggregate accruals is a strong positive time series predictor of aggregate stock returns, and cash flows is a negative predictor. In addition, innovations in accruals are negatively contemporaneously correlated with aggregate returns, and innovations in cash flows are positively correlated with returns. These findings suggest that innovations in accruals and cash flows contain information about changes in discount rates, or that firms manage earnings in response to marketwide undervaluation.     

Aggregate earnings and stock market returns: The good,the bad,and the state-dependent

Prior research documents a negative aggregate earnings-returns relation. In contrast, we posit that the sign of the relation varies, depending upon the macroeconomic and financial market conditions that exist in the earnings announcement quarter. We argue that the existing macroeconomic and financial market conditions influence market participants’ frame of reference, which in turn affects whether they interpret aggregate earnings surprises to be informative about the expected inflation component of the discount rate, the market risk premium component of the discount rate, or aggregate future cash flows. Consistent with this, we find that the sign of the aggregate earnings-returns relation changes numerous times across our sample period. We also find that market participants interpret aggregate earnings to be informative about changes in expected inflation (market risk premium) when the sign of the aggregate earnings-returns relation is negative (positive). Finally, we identify macroeconomic and financial market conditions under which the aggregate earnings-returns relation is more (less) likely to be negative (positive).     

The predictive power of investment and accruals

We test whether investment explains the accrual anomaly by splitting total accruals into investment-related and “nontransaction” accruals, items such as depreciation and asset write-downs that do not represent new investment expenditures. The two types of accruals have very different predictive power for firm performance, not just for future earnings but also for future cash flow and stock returns. Most importantly, nontransaction accruals have the strongest negative predictive slopes for earnings and stock returns, contrary to the predictions of the investment hypothesis. A long-short portfolio based on nontransaction accruals has a significant average return of 0.71 % monthly from 1972 to 2010 and remains profitable at the end of the sample when returns on other accrual strategies decline. Our results suggest that nontransaction accruals are the least reliable component of accruals and show that a significant portion of the accrual anomaly cannot be explained by investment.     

The Pricing of Relative Performance Based Incentives for Executive Compensation

Japanese firms report both parent-only and consolidated financial statements. Because of the unique business environment in Japan, there is a widely held view that parent-only data provides a better means for assessing the value of the entire firm. We find that both parent-only and subsidiary earnings are important in predicting future consolidated earnings. However, while stock prices accurately reflect the persistence of parent-only earnings, the Japanese stock market appears to underestimate the persistence of subsidiary earnings, causing a significant positive relation between changes in subsidiary earnings in year t and stock returns in year t +1. This relation between subsidiary earnings and future stock returns does not persist beyond year t 7plus;1. Taking a long (short) position in firms with large, positive (negative) changes in subsidiary earnings results in an average annual abnormal return of 7.06% with positive returns in 12 of the 13 years in the test period.     

Earnings dispersion and aggregate stock returns

This paper studies the relation between aggregate stock returns and contemporaneous and future cross-sectional earnings dispersion. We hypothesize that increases in expected earnings dispersion signal increases in uncertainty and increases in unemployment, thereby causing expected returns to rise, which in turn causes prices to decline. We find a positive relation between aggregate stock returns and contemporaneous earnings dispersion because higher earnings dispersion is associated with higher expected returns. Consequently, we also find a negative relation between aggregate stock returns and future (one-year ahead) earnings dispersion, as investors anticipate higher future earnings dispersion and higher expected returns.