The Predictive Power of Investment and Accruals

Abstract

We test whether investment explains the accrual anomaly by distinguishing between accruals related to new investment and so-called ‘nontransaction’ accruals, items such as depreciation and asset write-downs that do not represent new investment expenditures. The two types of accruals have very different predictive power for firm performance, not just for future earnings but also for future cashflow and stock returns. Most importantly, nontransaction accruals have the most negative predictive slopes for earnings and stock returns, contrary to the predictions of the investment hypothesis. A long-short portfolio based on nontransaction accruals has a significant average return of 0.71% monthly from 1972–2010 and remains profitable at the end of the sample when returns on other accrual strategies decline. Our results suggest that nontransaction accruals are the least reliable component of accruals and show that a significant portion of the accrual anomaly cannot be explained by investment.

Keywords: Earnings persistence, accruals, investment, stock returns, anomalies

JEL Classification: G14, M41