By definition, accruals represent accountants’ estimated values meant for the alignment of costs against revenues within a given period of time. It is widely agreed that accruals could only be avoided in a case where only cash is used for payments. This condition makes it nearly impossible for those trading in the stock market to avoid accrual accounting, which represents a mismatch in the amount of cash payments made or timing against the services delivered. The resulting varying non-cash earnings give rise to accruals, which are the reason behind the discretion in the accounts of most companies trading in the stock market.
Accrual anomaly has a number of effects on the capital market. First of all, it is necessary to note that the accrual anomaly is one of the most persistent inefficiencies of the stock market in any part of the world. At the very beginning, the concept of accrual anomaly stated that the organizations with small accrual ratios perform better than those with large accruals. The founder of this anomaly was Richard Sloan. In fact, accruals are the accountants’ estimates that are brought forth with to align costs and revenues over a specific period of time. In reality, if buyers were always to pay in cash upon the delivery of goods, then there would be no need for accrual accounting. Such an accounting concept exists due to the nature of the modern commerce (Green, Hand and Soliman, 2011, pp.34-35). Therefore, there is a mismatch between the payments received and the services provided by an organization. The variations in cash and non-cash earnings thus create a need for the discretion in the accounts of a given company. Therefore, the accrual anomaly has many effects on the market prices around the world.
In general, the concept of accounting anomaly is used for the identification of the market efficiency, especially in the prediction of returns. In fact, capital market anomalies reflect the market behavior of prices – a deviation from the theory of market efficiency (Zacks, 2011, pp.56-58). To identify any form of anomaly, first of all, there must be the identification of the signal of mispricing. It would be followed by the statistical and economic reliability estimation of the mispricing (Clinch et al., 2012, pp.67-68). Price movement exploitation results in abnormal returns which are positive. It is, therefore, recommended for the investors to remain cautious concerning the risks and transaction costs when looking at the various anomalies in the market.
The Workability of the Accruals Screening
According to the founder of the anomaly, it is clear that those organizations that have lower accrual ratios perform better than those that hold huge accrual ratios. For example, assuming that the earnings of the company were $1000 while the cash flows were $750 during the same time, the difference represents the adjustments made due to depreciation or receivables changes. High accruals resulting from aggressive accounting might maximize current earnings with low long-term earnings and no growth. On the other hand, low accruals resulting from the accounting of conservative nature minimize the earnings in the initial stages but later on yield higher earnings for any organization (Baker and Nofsinger, 2010, pp.59-61).
According to Sloan (1996), the founder of the concept, accrual anomaly represents the negative relationship that exists between the accruals and stock returns. He ended up attributing the relationship to the naïve fixation of investors. Under this condition, the markets fail to acknowledge that accruals are less persistent compared to the flows of cash. Extreme accruals, on the other hand, have an implication of less persistent returns in the form of earnings (Clinch et al., 2012, pp.88-89). In most cases, the investors tend to overvalue firms with high accruals while undervaluing those that have fewer accruals. Thus, presently high accruals will mean negative returns in the future, while the reverse will be true in this particular case as well. In the study of the accruals anomaly, there is the extension that can be looked at together with the alternative approaches of other scholars who have studied the topic.
The study of accruals and their implication for the economy can be derived from the information of those who have tried to further analyze the findings of Sloan (1996). This study can help to find a better approach to the accrual anomaly measure in terms of the quality of earnings and to widen the scope of accruals definition thus improving the trading strategy (Green, Hand and Soliman, 2011, pp.99-101). To explain the actions of various investors in the market, some researchers have concentrated on their reaction to the accruals information used to widen the definition of Sloan. On the other hand, the researchers can also examine the concept of accrual anomaly all over the world to determine the existing knowledge and discover the ways of improving it.
In the quest to determine why the accruals anomalies occur, the researchers have emphasized the importance of the costs of the transaction, subsequent events, and, lastly, its components. A number of studies – like the one by Green, Hand and Soliman – have discovered that accrual anomaly is, in most cases, driven by the changes of the inventory (2011, pp.45-46), abnormal accruals, and the accruals which are less reliable. It is further illustrated that even the income increasing components of the accruals may also cause the occurrence of accrual anomaly (Clinch et al., 2012, pp.77-79).
Moreover, the effects of accruals in the market are the return anomalies which are most pervasive across all groups. The case is the same with the issues of net stocks as well as the anomalies of momentum. It is true, therefore, that the concept of accrual anomaly determines prices in the market and may result in either overpricing or underpricing. In one way or the other, this particular anomaly normally relates to other accounting and finance anomalies, such as those of the post-earning announcement drift (Strydom, Skully and Veeraraghavan, 2014, pp.65-67), analyst forecast revision (Khan, 2011, pp.72-73), and the vague glamour (Wu, Zhang and Zhang, 2010, pp.105-107).
The Quantification of Accruals and Stock Returns in the Capital Markets
Accrual anomaly is the difference that exists between the accruals and the return on stocks. This definition makes the accruals and the returns on stock the fundamental variables in the accrual anomaly determination. It means that for the accurate estimation of the prices in the future, there must be a correct interpretation of these variables. This condition has to be ensured to avoid any form of error in the capital markets (Papanastasopoulos, 2015, pp.86-87). Earlier on, accrual anomaly was viewed as a determinant or a component of earnings. In fact, it was considered as the working capital, or even as depreciation, which is non-cash in nature.
One of the explanations proposed by the researchers for this form of anomaly is illustrated through the hypothesis of earnings fixation. This notion holds that those who invest tend to remain fixated on their earnings without attending in a separate manner to how the cash and the accruals are flowing. However, when cash is flowing into the business, this business is expected to earn more in future compared to what a business earns from the accrual-related earnings. This distinction should be carefully considered. Those investors who neglect it tend to be overoptimistic when it comes to forecasting the future of their firms with high accruals while being too pessimistic in their forecasts of firms with low accruals. The result is the overvaluation of accruals-intensive firms leading to low earnings when it comes to abnormal returns, and vice versa for the firms with low accruals.
With the assumption that the balance sheet accounts are subsets of the accrual accounting, another version of accruals has been born. It is based on the net operation of the system of assets rather than the cash approach of the past. The investors should thus be cautious in the event that the cash flow earnings are lower than the accrual component (Gomariz and Sanchez, 2014, pp.53-56). Here, the anticipated earnings may not be realized and converted to cash. In the event of higher accruals compared to the cash flows, the low quality of the earnings is evident. Furthermore, if the disposable income is higher as a result of high accruals, then it is a warning that income cannot be easily converted to cash in the market (Edwards and Walker, 2009, pp.79-81). This is, indeed, an indication that the accrual anomaly affects the capital market as it determines the cash inflows within the markets.
In addition to the mentioned quantifications, total accrual modeling can help to estimate the discretionary and non-discretionary accruals. Any model of the accruals quantification is based on the assumption that the benefits of decision making can be reduced by the abnormal accruals (Arab, Gogerdchyan and Hashemi, 2015). The unexpected accruals or the residuals originating from the discretionary model are used in the management of earnings as a proxy. The normal as well as the non-discretionary accruals are linked closely to the performance of the firm or organization in the capital markets. They are dictated by the conditions under which a given firm is operating.
Alternatively, if the normal accruals are correctly modeled in a market, the distortion of the quality will be represented by the abnormal accruals. In fact, it has been evident in research that the non-discretionary accruals are not offering predictive future returns, while their discretionary form makes it easier for the future predictability of the returns in organizations (Santhosh, Wang and Yu, 2013, pp.134-137). As a result, it is true that the accrual anomaly determines the current as well as the future prices in the capital markets in terms of the returns due to organizations.
Lastly, the returns on the stock as well as the abnormal accruals represent the dependent variables in the model that examines the accruals anomaly. The computation of such abnormal returns has been complex in the sense that it causes bias in the rebalancing of portfolios. Although it seems simple from the first sight, the process becomes more complicated as it does not take all the factors into consideration in such a calculation.
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The Trading Strategy with Accruals Anomaly
The correct trading strategy is based on the magnitude of accruals as it determines the returns within the capital markets. To test the strategy, the zero-investment of the portfolio should be taken into account. Dechow, Ge and Schrand (2010, pp.44-47) point out that the accounting numbers based on the anomaly indicate the mispricing in the markets. However, this is true only in the event that returns by the zero-investment portfolio are consistently positive. The zero-investment portfolio, which in the end yields positive returns and the difference in the risk, demonstrates the variability due to the annual returns (Dopuch, Seethamraju and Xu, 2010, pp. 33-34).
In the process of quantifying accruals anomaly, the best strategy is that of forming what is called a hedge portfolio. This name comes from the reduction of the risk assumption between the different magnitudes that are caused by the accruals anomaly. According to Sloan (1996), it is the hedge portfolio that provides high returns while maintaining the single position either as long-term or short-term level of accruals. Sloan (19996) further asserts that the economic significance obtained from the accrual anomaly normally identifies the deviation that is caused by the returns under the efficient market assumption. In this case, the procedure is intertwined by the zero-investment portfolio that comes from the assets based on the accruals magnitude. It is thus important to separate the earnings components in different ways so that the power of prediction the future returns may be determined concerning.
In fact, such an analysis concerning the accrual component of earnings in the worldwide capital markets is the focus of the study conducted by Ahrens (2010, pp.56-59). There is the separation of the abnormal and gross returns in this case. To corroborate the power of prediction of the returns due to accruals, the regression should be applied to the firm in question.
Evidently, the effect of accrual anomaly on capital markets cannot be underestimated. It is evident in most of the past research studies conducted concerning the capital markets. For instance, the predictive power of the form of earnings in most cases suppresses the future returns. In addition, the accruals are associated with future earnings. Therefore, the focus on the accruals makes it possible to determine whether the accruals are based on the low or high levels of earnings. At the same time, it is also evident that the accrual anomaly affects the pricing in the capital markets. Finally, it is also clear that the current levels of cash inflows and deliveries of a given company at any point in time will determine the future decisions of the investors.