The Persistence and Pricing of the Cash Component of Earnings |
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| Authors: | PATRICIA M DECHOW SCOTT A RICHARDSON RICHARD G SLOAN |
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| Institution: | 1. Haas School of Business, University of California, Berkeley;2. Barclays Global Investors. We are grateful for the comments of Todd Doersch, Wayne Guay, Abbie Smith, an anonymous referee, and workshop participants at Georgetown University, UCLA, the American Accounting Association 2005 meetings, the University of Utah Accounting Conference, and the Prudential Quantitative Research Conference 2006. We thank Seungmin Chee for research assistance. |
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| Abstract: | Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments. |
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