Why Do Accruals Predict Earnings?
Posted: 11 Jan 2019
Date Written: November 27, 2018
Higher accruals are associated with lower subsequent earnings. We show this phenomenon can be explained by the way sales, profits, and working capital respond to changes in a firm's product markets. Empirically, high accruals predict high subsequent sales growth but a long-lasting drop in both profits and profitability. Accruals also predict an increase in future competition, suggesting that accruals are correlated with abnormally high — and, in equilibrium, transitory — true profitability that attracts new entrants to the industry. Overall, the predictive power of accruals is better explained by product-market effects than by measurement error in accruals or diminishing returns from investment.
Keywords: Accruals, Earnings Persistence, Measurement Error, Reversals
JEL Classification: G14, M41
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