The Q-Theory Approach to Understanding the Accrual Anomaly

Abstract

Interpreting accruals as working capital investment, we hypothesize based on q-theory that firms optimally adjust their accruals in response to discount rate changes. A higher discount rate means less profitable investments and lower accruals, and a lower discount rate means more profitable investments and higher accruals. Our evidence supports this optimal investment hypothesis: (i) adding an investment factor into standard factor regressions substantially reduces the magnitude of the accrual anomaly, often to insignificant levels; (ii) accruals covary negatively with discount rate estimates from the dividend discounting model, and for the most part, with estimates from the residual income model; (iii) accruals with low accounting reliability covary more with capital investment than accruals with high accounting reliability; and (iv) expected returns to accruals-based trading strategies are time-varying, suggesting that the deterioration of the accrual effect in recent years might be temporary and likely to mean-revert in the near future.

Keywords: The accruals anomaly, total accruals, discretionary accruals, net operating assets, investment-based asset pricing, capital investment, time-varying expected returns

JEL Classification: G12, G14, G31, G34, M41