The Persistence of Earnings and Cash Flows and the Role of Special Items: Implications for the Accrual Anomaly

61 Pages Posted: 4 May 2005

See all articles by Patricia M. Dechow

Patricia M. Dechow

University of Southern California - Leventhal School of Accounting; University of California, Berkeley - Accounting Group

Weili Ge

University of Washington - Michael G. Foster School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: December 15, 2005

Abstract

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by balance sheet adjustments relating to special items. We then show that low accrual firms with special items have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have performed poorly, are financially distressed, and have declines in investor recognition (analysts coverage and institutional holdings). We find that special items continue to explain future returns after controlling for these factors. Our results suggest that investors underestimate the probability that special item-low accrual firms will successfully turn themselves around.

Keywords: Earnings, cash flows, special items, accruals, anomaly, future returns

JEL Classification: G10, G12, G14, M41, M43

Suggested Citation

Dechow, Patricia M. and Ge, Weili, The Persistence of Earnings and Cash Flows and the Role of Special Items: Implications for the Accrual Anomaly (December 15, 2005). Available at SSRN: https://ssrn.com/abstract=715563 or http://dx.doi.org/10.2139/ssrn.715563

Patricia M. Dechow (Contact Author)

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

University of California, Berkeley - Accounting Group ( email )

Haas School of Business
Berkeley, CA 94720
United States

Weili Ge

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

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