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

Posted: 16 Sep 2006

See all articles by Patricia Dechow

Patricia Dechow

USC Marshall School of Business

Weili Ge

University of Washington - Michael G. Foster School of Business

Multiple version iconThere are 2 versions of this paper

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 special items. We then show that special item-low accrual firms 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 poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

Keywords: accrual anomaly, earnings persistence, cash flows, special items, investor recognition

JEL Classification: G10, G29, M41, M44

Suggested Citation

Dechow, Patricia and Ge, Weili, The Persistence of Earnings and Cash Flows and the Role of Special Items: Implications for the Accrual Anomaly. Review of Accounting Studies, June/September 2006. Available at SSRN: https://ssrn.com/abstract=930173

Patricia Dechow (Contact Author)

USC Marshall School of Business ( email )

Los Angeles, CA 90089-0441
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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