The Informational Role and Value Relevance of Earnings, Cash Flows, and Accruals
43 Pages Posted: 29 Jun 2016 Last revised: 16 Sep 2016
Date Written: September 15, 2016
In this paper, we establish a theoretical relationship between earnings components and future stock returns. It shows the informational role of earnings, cash flows and accruals in predicting future stock returns and the key role played by the earnings response coefficient. It also suggests that the ‘accrual anomaly’ can be explained rationally. Accounting fundamentals jointly determine the covariance risk between uncertain future cash flows and the discount factor: accruals are encompassed as long as there exists differential persistence between cash flows and accruals after controlling for aggregate earnings. In particular, it is the deviation of (scaled) accruals from their long run mean rate that is vital in explaining the ‘accrual anomaly’. Consequently, Sloan (1996) and similar results should not be interpreted as an accrual-based anomaly, instead they document important evidence of the possible fair pricing of accruals.
Keywords: Stock Returns, Earnings Components, the Ball-Brown Analysis, Accrual Anomaly
JEL Classification: M41, G12, G14
Suggested Citation: Suggested Citation