Financial distress and the accrual anomaly

We find that the accrual anomaly is concentrated in healthy firms and is absent in financially distressed firms. The differential persistence between accruals and cash flows is the main driver of the relationship. Prior studies propose two explanations for the accrual anomaly: (1) accounting distortions of accruals and (2) investment mispricing. Our empirical evidence supports the former and challenges the latter. Our findings also disagree with the idea that the accrual anomaly is distress risk premium in disguise.