The Accrual Anomaly: Risk or Mispricing?

What is it about?

We find that stocks with high accounting adjustments, known as accruals, tend to have returns that move together, as do stocks with low (negative) adjustments, even after appropriate controls. A portfolio that buys low accrual stocks and sells high accrual stocks earns a high reward-to-risk ratio (high expected returns relative to volatility)--higher than that of the US stock market factor or some other well-known factors. According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the sensitivities of their returns to this portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor sensitivity that predicts returns. These findings suggest that investors misvalue the accrual characteristic and cast doubt on rational risk premia as an explanation.

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Why is it important?

This paper contributes to a long-running debate about whether the fact that stock returns can be predicted represents mispricing and the correction of mispricing, owing to investors psychological bias; or represents rational rewards for bearing risk. The ability of accounting adjustments to predict returns suggests that investors may be misled when firms report high profits by adjusting accounting numbers upward. Our evidence suggests that investors do indeed misinterpret financial reports, and that this affects market prices.