The Accrual Anomaly & The Company Size

Accounting Research Center, Booth School of Business, University of Chicago
An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components Author(s): Arthur Kraft, Andrew J. Leone and Charles Wasley Source: Journal of Accounting Research, Vol. 44, No. 2, Current Topics in Accounting Research (May, 2006), pp. 297-339 Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University
of Chicago
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DOI: 10.1111/j.1475-679X.2006.00202.x Journal of Accounting Research Vol. 44 No. 2 May 2006 Printedin U.S.A.
An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components
ARTHUR KRAFT,*
AND
ANDREW
J. LEONE,t
CHARLES
WASLEYS
Received26 March2004;accepted24 August2005
ABSTRACT Numerous accounting studies claim that investors fail to rationally price accrual-related information and that investors are functionally fixated. This study documents the importance of performing robustness tests when testing economic or behavioral explanations for apparent accounting-related security mispricing. We find that performing robustness tests that exclude a small number of firm-year observations (approximately 200 firm-year observations or about 1% of the entire sample) reveals an inverted U-shaped relation between buy-and-hold abnormal returns and total accruals. An inverted U-shaped relation is inconsistent with the functional fixation (earnings fixation) hypothesis. We conduct similar robustness tests for the abnormal accrual anomaly and the net operating assets anomaly proposed by other investigators, and also find an inverted U-shaped relation between buy-and-hold abnormal returns and abnormal accruals and net operating assets. These findings are inconsistent with the explanations put forth by those investigators. Such evidence leads us to conclude that the accrual-related anomalies are unlikely to
* London Business School; tPenn State University; tUniversity of Rochester. We appreci-
ate comments and suggestions by workshop participants at Connecticut, Cornell, Penn State, Rochester, and Washington University,Yale, and the 2005Journal of Accounting Research conference, and from Ray Ball, Glenn McDonald, Sanjog Misra,Jake Thomas, Ross Watts, Mike Willenborg,Joanna Wu, Tzachi Zach,Jerry Zimmerman, and an anonymous referee. We gratefully acknowledge the financial support of the London Business School and Simon Graduate
School of Business at the University of Rochester.

297 Copyright ?, University of Chicago on behalf of the Institute of Professional Accounting, 2006
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be due to investors' inabilityto processaccountinginformation,as suggested by the functionalfixationhypothesestested.
1. Introduction
A number of studies propose and test hypotheses about the market pricing of accruals and accrual components (e.g., Sloan [1996] and Xie [2001], among others). These hypotheses are rooted in the functional fixation hypothesis, which is consistent with irrational investor behavior (Watts and Zimmerman [1986, p. 160-61]). For example, Sloan [1996] posits that investors naively fixate on earnings and overweight the accrual component of current earnings when forecasting future earnings. Under this earnings fixation variant of functional fixation, investors are subsequently surprised when these accruals reverse in subsequent periods, and abnormal returns (henceforth, buy-and-hold abnormal returns [BHARs]) reflect the corresponding price adjustment to the earnings surprise (i.e., when investors recognize the prior period's extreme accruals are reversing). A fundamental aspect of this earnings fixation hypothesis is that the reversing accruals are hypothesized to causethe future abnormal returns, as opposed to simply being associated with future abnormal returns. Thus, Sloan's [1996] earnings fixation version of the traditional functional fixation hypothesis is put forth as a positive theory of investor pricing of accounting information and as an alternative to the efficient market hypothesis. Sloan [1996] conducts two primary tests of the earnings fixation hypothesis. First,using the Mishkin [1983] test, he tests whether prices reflect rational forecasts of earnings based on past accruals and cash flows. The evidence is consistent with the earnings fixation hypothesis, in which investors overweight accruals and underweight cash flows in forecasting future earnings.' Sloan's [1996] second set of tests consists of a trading strategy short (long) in firms in the highest (lowest) total accrual decile. The trading strategy is motivated by the earnings fixation hypothesis and it is designed to capture the BHAR that will be generated in the subsequent year as information about the transitory (i.e., reversing) nature of the prior year's accruals is revealed to the market. Sloan [1996] concludes that the trading strategy earns a hedge portfolio BHAR of about 10% in the year after the accruals are observed and concludes that the evidence is consistent with earnings fixation. That is, the abnormal returns are caused by the unanticipated reversal of prior year's accruals.
1The three studies that we evaluate in this paper (Sloan [1996], Xie [2001] and Hirshleifer et al. [2004]) all complement their trading strategy tests with a Mishkin [1983] test for rational pricing of accounting numbers. The Mishkin [1983] test results generally support the hypotheses tested in these three papers. While the issue we raise in this paper (robustness tests) also applies to the Mishkin [1983] test, an evaluation of specification issues associated with the Mishkin [1983] test is beyond the scope of this paper. For an analysis of specification issues related to the implementation of the Mishkin [1983] test in accounting research settings see Kraft, Leone, and Wasley [2005].
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The purpose of this study is to highlight and quantify the impact of robustness tests on causal inferences drawn from trading strategies based on
accrual-related information. When researchers test a theory, it is standard practice in empirical accounting research settings to introduce safeguards to ensure the reliability of the inferences drawn from the empirical tests. These safeguards include procedures such as tests of the robustness of the results to influential observations (e.g., the regression diagnostic procedures in Belsley, Kuh, and Welsch [1980]) and truncation rules for variables used in the empirical tests (e.g., the top and bottom 1%).2 Our reading of the accrual anomaly papers leads us to conclude that robustness tests are not typically performed.3 This research design choice appears to be based on a desire to not eliminate returns when measuring the profitability of a trading strategy.We agree that when testing the profitability of a trading strategy, assuming there are no errors in the data, researchers should include all firm-year observations that were available at the time the hypothetical trading strategy is implemented.4 In other words, when testing a trading strategy, researchers should be careful about deleting observations, because doing so can lead to biased measures of portfolio return performance and potentially incorrect inferences about market efficiency.5 On the contrary, however, when researchers propose and test a theory on the cause of an apparent accounting-related anomaly, as is virtually always the case in accrual anomaly-related research, conventional robustness tests of the results should be conducted. More precisely, unless the theory explicitly predicts otherwise, the proposed relation being tested (e.g., functional
2 Albeit in two settings different from ours, other accounting researchers also stress, as we do, the importance of robustness tests. For example, Lo and Lys [2000] examine how inferences from empirical tests of the Ohlson [1995] model are affected by observations with a stock price exceeding $1,000 per share. In addition, Cohen and Lys [2003, p. 151], in their discussion/critique of Abarbanell and Lehavy [2003] and the distribution of analyst earnings forecast errors, state, "At any rate, it seems advisable for researchers to conduct diagnostics including the impact of influential observations and to examine the sensitivity of their conclusions depending on whether parametric or non-parametric tests are used." 3 Based on our reading, none of the following accrual anomaly-related studies perform robustness tests to assess the sensitivity of their results to extreme BHAR observations: Sloan [1996], Hribar [2000], Collins and Hribar [2000], Bradshaw, Richardson, and Sloan [2001], Xie [2001], Beneish and Vargus [2002], Hribar and Collins [2002], Thomas and Zhang [2002], Collins, Gong, and Hribar [2003], Fairfield, Whisenant, and Yohn [2003], Desai, Rajgopal, and Venkatachalam [2004], and Hirshleifer et al. [2004]. The lone exception is Thomas [1999]. 4As discussed later, we find several extremely large errors in the Center for Research in Security Prices' (CRSP) computation of delisting returns. For example, the delisting return reported for Smith Corona in May 1996 was in excess of 700% when it should have been -100%. This led to a computed BHAR of 2,177% when it should have been -135%. This single error is large enough to bias the return of the low accrual decile by roughly 1% (from a correct 0.72% to an incorrect 1.8%). Since this observation meets the data requirements of prior accrual related-anomaly studies, it's quite likely it will be in the low accrual decile of all such studies. SKothari, Sabino, and Zach [2005] show how active and passive truncation rules lead to biased measures of future return performance in market efficiency studies, a result largely due to the well documented skewness in realized returns.
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fixation and the relation between future BHAR and past accruals) should not be driven by a small number of observations and should be robust to the standard approaches of assessing the effect of extreme observations. For example, since the functional fixation hypothesis should apply to most firms, tests of this hypothesis should be robust to the exclusion of influential observations. Two legitimate arguments for excluding (or winsorizing) extreme observations are that the return-generating process for such observations is different from that of the rest of the sample (e.g., unusual events unrelated to accruals cause the extreme returns) or such observations are data errors. Whether the setting is an accrual anomaly study or another empirical financial accounting research setting, the concern of researchers is (and should be) that such observations will lead to incorrect inferences from tests causalrelation between returns and the accounting variable of the hypothesized (e.g., accruals). In the context of stock return anomalies, we are not the first to advocate robustness tests. For example, in the finance literature, Knez and Ready [1997] document the importance of robustness tests for inferences about the relation between ex post returns and the market value of equity and book-to-market ratio in cross-sectional returns regressions. Knez and Ready [1997] conclude that the risk premium on the market value of equity (see, e.g., Fama and French [1992]) completely disappears when 1% of the most extreme observations is trimmed. Knez and Ready [1997] do not argue that these observations should be ignored when testing the profitability of a trading strategy,but instead that they should be the focus to gaining a better understanding of the causeof the relation being tested. That is, such observations should serve as a basis to revise theories specifying a pricing role for firm size. To motivate our robustness tests of accrual-related anomalies we adopt the perspective of Knez and Ready [1997]. Our objective is to gain a better understanding of the accrual anomaly and whether it provides consistent and compelling evidence in favor of the functional fixation hypothesis as a credible alternative theory to market efficiency. This is an important issue because the functional fixation hypothesis is the motivation underlying virtually all accrual anomaly-related studies. While our primary focus is on the total accrual anomaly documented by Sloan [1996] because of the vast amount of research it has generated, we also examine two other accrual-related anomalies. Namely, the discretionary or abnormal accrual anomaly of Xie [2001] and the net operating asset anomaly of Hirshleifer et al. [2004]. Our analysis is relevant to these studies because the motivation for their hypotheses is also rooted in a form of functional fixation.A
6 Hirshleifer et al. [2004] test a "limited attention theory,"as opposed to functional fixation. The primary difference between limited attention and functional fixation is that, under limited attention, investors rely on rules of thumb to process the large amount of information available to them because of time constraints or because of exorbitant information-processing costs. For
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Our analysis unfolds as follows. First, we test the robustness of the results in the accrual anomaly literature using the least trimmed squares (LTS) procedure used in Knez and Ready [1997]. We also consider standard robustness tests (e.g., Belsley, Kuh, and Welsch [1980]) that are commonly used in the accounting literature. These two sets of robustness tests produce similar results and this adds confidence to the inferences we draw. To implement robustness tests based on the LTSprocedure, we regress returns on indicator variables capturing firms' membership in accrual deciles. Following LTS, we then eliminate the 1% of the firm-year observations (only about 200 observations from an overall sample of 20,852 observations) with the highest squaredresidualsand then we re-estimate the model.7 We find that, while the coefficient on the high accrual decile indicator variable is significantly negative both before and after eliminating the 1% of the firm-yearobservations, the coefficient on the low accrual decile indicator variable goes from being insignificantly different from zero to significantly negative. The negative coefficient for the high accrual decile is consistent with Sloan's [1996] earnings fixation hypothesis, however, the negative coefficient for the low accrual decile is not. More specifically, for 99% of the firm-yearobservations in the sample, there is an inverted U-shaped relation between accruals and returns. An inverted U-shaped relation is inconsistent with the earnings fixation hypothesis offered by Sloan [1996], which predicts a monotonically decreasing relation between BHARs and accruals. Based on the evidence we report here, we cannot reject market efficiency in favor of functional fixation. One reason why our results may not support Sloan's [1996] earnings fixation hypothesis is that the observations excluded by our robustness tests are those cases in which investors were "fooled" the most by reported earnings (and accruals). Moreover, because these firms' accruals were extreme, this is where investors overestimated accruals' persistence the most and were subsequently surprised the most by the earnings reported in year t+l. We investigate this alternative explanation by documenting the characteristics of these firms (e.g., financial condition and past stock performance) and by performing a detailed analysis of the firm-year observations excluded by our robustness tests.
example, a "limited attention" explanation for the accrual anomaly is that investors know that accrual persistence differs from cash flow persistence, but they either do not have the time or conclude that it is not cost-effective to treat these components of earnings differently. Under functional fixation, as applied to the accrual anomaly, investors are naive in that they do not know that the persistence of accruals differs from the persistence of cash flows. Essentially,both of these theories predict that investors use a simple heuristic (earnings or some other summary accounting information) to forecast future cash flows and they only differ in the reason why. Because the empirical implications of the two theories are indistinguishable, our discussion of the implications of our findings for the functional fixation hypothesis applies equally to the limited attention hypothesis. 7 The 208 excluded observations are not randomly distributed across accrual deciles. Instead, they tend to be concentrated in the extreme accrual deciles. Later in the paper, we provide insight into these firms and the nature of their accruals.
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Several interesting findings emerge. First, most of these firms are experiencing poor performance and their extreme accruals are easily observable on the income statement, making it less likely that they would be mistaken for permanent earnings changes. For example, low accrual firms recognize asset impairments, have discontinued operations, or report other asset writedowns. Earnings fixation is less likely in these cases, in which the accruals are more salient to investors. Second, and perhaps more importantly, unlike the evidence in Sloan [1996], these firms' subsequent year (t+l) stock returns do not predominantly occur around earnings announcements. It is around subsequent earnings announcements that investors are hypothesized by Sloan [1996] to observe the reversing accruals that they did not anticipate based on the magnitude of the prior year accruals. Overall, this evidence suggests that the BHAR of the firms excluded by our robustness tests are not likely driven by accrual mispricing, but rather by a return-generating process that researchers do not fully understand and/or are unable to adequately model. While we do not refute the profitability of a trading strategy based on extreme accruals, our evidence suggests that the abnormal returns earned by such a strategy are unlikely to be caused by earnings fixation, as hypothesized by Sloan [1996]. As noted above, we also examine the discretionary accrual (DA) anomaly of Xie [2001] and the net operating assets (NOA) anomaly of Hirshleifer et al. [2004], because the motivation for the hypotheses tested in those studies is also rooted in the functional fixation hypothesis. Interestingly, the same 1% of the observations identified by our robustness tests on Sloan's [1996] total accrual anomaly are also identified for Xie's [2001] DA anomaly and Hirshleifer et al.'s [2004] NOA anomaly. Moreover,when the remaining 99% of the sample observations are analyzed, the evidence is inconsistent with the theories proposed by Xie [2001] and Hirshleifer et al. [2004] for the alleged mispricing they document. Specifically, for 99% of the sample observations, abnormal DA and NOA exhibit an inverted U-shaped relation with BHAR. Such a relation is inconsistent with the functional fixationmotivated explanations and hypotheses tested in both studies. The firm-year observations excluded by our robustness tests exhibit a number of interesting characteristics. They tend to be poorly performing firms with low stock prices and small market values. Such characteristics are consistent with the data problems inherent in market efficiency studies (see Kothari [2001, p.189-90]). Kothari [2001] points out that the high frequency oflow-priced and small-capitalization stocks (among other firm characteristics) populating samples in which market inefficiency is documented raises concerns about what is the real underlying cause of the inefficiency. While the primary motivation for our analysisis robustness tests of accrualrelated anomalies, a by-product of our analysis is that we also identify and quantify the impact of three common, but subtle, sample selection biases that introduce ex post information into a research design, and which impart bias into the BHAR used in tests of the market pricing of accounting numbers. The first sample selection bias applies to studies examining only
MISPRICING OF ACCRUALS New York Stock Exchange/American Stock Exchange (NYSE/AMEX)
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or studies focusing separately on NYSE/AMEX and NASDAQ firms.8 Selecting a sample based on a firm's current exchange listing (e.g., Compustat's
ZLIST or CRSP's header exchange code), rather than the firm's exchange introduces listing at the time a hypothetical trading strategy is implemented
a predictable bias in BHAR. The bias arises because changes in exchange listing are correlated with firm performance (and accruals reflect performance). For example, a firm currently traded on the NYSE that previously
traded on NASDAQ is likely to have changed exchanges because it was performing well. Researchers selecting a sample based on current exchange listing will incorrectly classify these firms as NYSE firms at the time a hypothetical trading strategy is implemented. A second sample selection issue is the requirement that firms report accounting information in year t+1.9 The third sample selection issue is the exclusion of firms with missing returns in one or more months during the subsequent year's BHAR accumulation period. Such firms are excluded due to a lack of trading, and their exclusion disproportionately affects poorly performing firms. We document that the exclusion of such firms imparts an upward bias in measured BHAR.'0 Using the total accrual anomaly as our focus, we quantify the impact of these sample selection biases on the measured return to accrual-related
8 The following articles focus exclusively on samples of NYSE/AMEX firms: Sloan [1996], Hribar [2000], Collins and Hribar [2000], Hribar and Collins [2002], Thomas and Zhang [2002], and Fairfield, Whisenant, and Yohn [2003]. However, only Thomas and Zhang [2001] explicitly state that they use the CRSP exchange code to avoid the selection bias. We should point out, however, that it is sometimes difficult to determine from the sample selection section of every study the exact procedure used. For example, Sloan [1996, p. 293] states "There are 71,732 NYSE and AMEX firm-year observations on the Compustat tapes from 1962 through 1991." We do not know for sure that Sloan [1996] selected his sample based on Compustat's exchange code listing or CRSP's.Therefore, our discussion relates to how the results for our sample varybased on alternative selection procedures. We also note that any attempt to exactly replicate the work of Sloan [1996] is virtuallyimpossible due to changes in historical data (e.g., CRSP has retroactively changed delisting returns). 9 Based on our reading, all of the following accrual anomaly-related studies require firms to have accounting information available in year t+l: Sloan [1996], Hribar [2000], Collins and Hribar [2000], Thomas [1999], Bradshaw,Richardson, and Sloan [2001], Xie [2001], Beneish and Vargus [2002], Thomas and Zhang [2002], Collins, Gong, and Hribar [2003], Fairfield, Whisenant, and Yohn [2003], and Desai, Rajgopal, and Venkatachalam [2004]. The rationale for this data requirement is that, in most cases, in addition to conducting tests of a trading strategy, each study also conducts a Mishkin [1983] test that requires accounting information for year t+l. The only exceptions are Hribar and Collins [2002] and Hirshleifer et al. [2004], which do not require year t+l return data. 10Based on our reading of the following articles, all of the following accrual-anomaly related studies delete firms with one or more missing returns during the return cumulation period: Hribar [2000], Collins and Hribar [2000], Xie [2001], Beniesh and Vargus [2002], Fairfield, Whisenant, and Yohn [2003], and Desai, Rajgopal, and Venkatachalam [2004]. The following articles do not describe their treatment of firm-year observations with one or more missing returns: Sloan [1996], Thomas [1999], Bradshaw,Richardson, and Sloan [2001], Thomas and Zhang [2002], Hribar and Collins [2002], Collins, Gong, and Hribar [2003], and Hirshleifer et al. [2004].
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trading strategies. After correcting for various sources of selection bias in a sample of NYSE/AMEX firms from 1987-1999, we find the low (high) accrual decile's BHAR decreases from 8.39% (-3.37%) to 1.83% (-7.85%), and that the low decile's BHAR of 1.83% is not significantly different from zero, even before deleting extreme observations. While the overall hedge portfolio BHAR does not change dramatically, the source of the BHAR impacts how the results are interpreted. The fact that low accrual firms no longer earn a nonzero BHAR casts further doubt on Sloan's [1996] earnings fixation hypothesis, because it predicts investors misprice both low and high accruals. Moreover, the earnings fixation hypothesis does not specify that investors would properly weight income-decreasing accruals (low accruals), but overweight income increasing accruals (high accruals).,a In summary, our study provides guidance to researchers attempting to exanomalies. Given and other source of accrual the accounting-related plain researchers that it in is of research this the large volume area, important hypothesizing a causal economic or behavioral explanation for alleged mispricing report the results of robustness tests (as is done in almost all other accounting capital market studies). An important aspect of our results is that they illustrate that, in the absence of robustness tests, it is easy for researchers to generate "false positives" for hypotheses related to market mispricing. While we only study the impact of performing robustness tests on accrual-related anomalies, our study has implications for other studies testing theories about the relation between accounting information and stock returns. It seems clear that such studies should report the results of robustness tests, and if a small number of observations are driving the results, analyze them to better understand the source of the apparent anomaly. The rest of the paper is organized as follows. Section 2 describes issues related to testing hypotheses about the mispricing of accounting numbers, section 3 outlines data and sample section procedures, and section 4 identifies sources of sample selection bias. Section 5 reports our main results, and section 6 provides a summary of our conclusions.
2. Issues Related to TestingHypothesesAbout the Mispricing
of AccountingNumbers
VERSUSTESTINGA THEORY 2.1 TESTINGTRADINGSTRATEGIES ANOMALY TO EXPLAINTHE CAUSEOF AN APPARENT
It is well documented that returns are right-skewed. As a result, it is likely that tests of the relation between long-run returns and accounting data will
11These results use the cash flow statement approach to calculating total accruals (Hribar and Collins [2002]). When we use the traditional balance sheet approach, we can examine a longer sample period (1972-1999) and one that more closely parallels Sloan's [1996] sample period. In this setting, the BHAR for the low (high) accrual decile is 5.55% (-5.03%) before correcting for various sample selection biases and 2.25% (-7.44%) after correction. Moreover, after correcting for the Smith Corona error described in footnote 2, the BHARof the low accrual decile drops to 1.8% (from 2.25%) and is insignificantly different from zero.
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be sensitive to the active or passive exclusion of observations (see Kothari, Sabino, and Zach [2005]). Active deletion is defined as intentional deletion or truncation of observations by the researcher while passive deletion is when observations do not survive the post-event horizon. Kothari, Sabino, and Zach [2005] document that it is important for researchers to avoid passive data truncation (i.e., sample selection biases) and to make well-reasoned arguments for or against any active truncation (e.g., winsorization or deletion). In this section, we discuss the issues and trade-offs that are relevant in determining when and when not to truncate in the context of accrualrelated anomalies. Before discussing these issues, we briefly characterize each of these accrual-related anomalies. 2.1.1. Sloan's[1996] EarningsFixation Hypothesis.Sloan [ 1996] argues that a simple trading strategy can exploit mispricing arising from earnings fixation. Under earnings fixation, investors fixate on earnings and overweight the accrual component. As a result, they are positively (negatively) surprised by subsequent earnings announcements for past low (high) accrual firms. Sloan [1996] predicts that low accrual firms will subsequently earn positive abnormal returns and high accrual firms will earn negative abnormal returns and tests this earnings fixation hypothesis by forming a trading strategy long in low accrual firms (bottom decile) and short in high accrual firms (top decile). He finds that low accrual firms earn abnormal returns of about 5% and high accrual firms earn abnormal returns of about -5%, yielding a hedge portfolio return of about 10%. 2.1.2. Xie's [2001] EarningsFixationExplanation for theMispricingofDiscreAccruals. Xie is interested in whether the source of the mis[2001] tionary in Sloan is attributable to abnormal [1996] pricing (discretionary) accruals or normal (nondiscretionary) accruals. Abnormal accruals are defined as the residual from the modified Jones [1991] model and normal accruals are the difference between total and abnormal accruals. Xie's [2001] analysis can be viewed as a special case of Sloan's [1996] earnings fixation story in which investors do not recognize the transitory nature of discretionary accruals. Xie [2001] predicts that low discretionary accrual firms will earn positive abnormal returns in year t+ 1 and high discretionary accrual firms will earn negative abnormal returns in year t+l. Using trading strategy tests similar to Sloan [1996], Xie [2001] concludes that investors misprice discretionary accruals and that discretionary accruals in year t cause the abnormal returns in year t+1. 2.1.3. Hirshleifer et al.'s [2004] LimitedAttentionHypothesis and the Pricing Assets. Hirshleifer et al. [2004] propose a theory of limited of Net Operating attention to explain investors' pricing of accruals-related information. The theory posits that investors weight information more heavily if it is salient or requires less cognitive processing. Hirshleifer et al. [2004] argue that NOA represent cumulative accounting value added over time minus cumulative cash value added. They conjecture that when NOA become large, it
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is hard for the firm to sustain growth, and firms with relatively high NOA are overvalued because, due to limited attention, investors do not take into account the implications of high NOA when forecasting future earnings. Consequently, the subsequent returns of high NOA firms are negative while those of low NOA firms are positive.
THE THREE EMPIRICAL MODELCAPTURING 2.2 A SIMPLE ANOMALIES ACCRUAL-RELATED
Each of the studies above tests a hypothesis that predicts that a trading strategy that is long in firms in the lowest decile of accruals, DA, or NOA and short in the highest decile will generate future abnormal returns. For ease of exposition, we recast their trading strategies in a regression framework:
BHARit+I = al +
1
Lowit + /2Decile2it + f3DecileSit + /4Decile4it
+ + ~s5Decile7it (1) + +f + 6Decile8it f7Decile9it 8High sit BHAR is the firm's buy-and-hold abnormal return for year t+l, Lowitis set to one if the firm is in the lowest decile and zero otherwise. Highit is set to one if the firm is in the highest decile and zero otherwise and Decile2it, Decile3it,Decile4it,Decile7it,Decile8it,and Decile9itare set to one if the firm is in the corresponding decile and zero otherwise. Deciles are formed based on accruals, DA, or NOA, depending on the accrual-related anomaly being examined. In (1) a is interpreted as the average BHAR for firms in the middle quintile (deciles 5 and 6) and /1 (s8) is the difference between the mean BHAR of firms in the low (high) decile and the middle quintile. The hypothesis from each of the three studies above can be captured in the above regression in that ,8 is expected to be positive, /38 is expected to be negative, and ,8 - /s is expected to be positive. Since the independent variables are indicator variables, the regression methodology allows us to compare the mean BHAR of the extreme accrual deciles. This captures the essence of the accrual-related anomaly studies discussed above because they compare the mean BHAR across deciles. Our regression formulation of the trading strategy tests also enables us to perform standard robustness tests (described below). In addition, since the robustness tests indicate that some extreme observations should be excluded, the regression approach provides a more meaningful comparison of the decile BHAR relative to the average firm (middle quintile) rather than to zero.
OF A GIVENTRADINGSTRATEGY 2.3 TESTSOF THE PROFITABILITY
If a researcher is solelyinterested in the profitability of a given trading strategy (e.g., there's no theory being tested), and assuming there are no errors in the data, then the call for robustness tests is not as compelling as it is in a setting in which a hypothesis generated from a theory of investor pricing is being tested (e.g., functional fixation). In the case of a trading strategyper se, the only question is whether an investor can earn abnormal returns by selecting portfolios on the basis of some variable (e.g., accruals) regardless
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of whether that variable captures the effect of another priced factor (i.e., is simply correlated with a priced factor), or whether it is itself a priced factor. More precisely, testing an accruals trading strategy, per se, is not a test of whether accruals cause abnormal returns. That said, one circumstance in which it is sensible to consider the robustness of trading strategy results to data truncation, even if the purpose of the test is only to determine the profitability of a trading strategy, is when the data may contain errors and the errors are not random. For stock returns, one area where data errors are a potential problem is in the computation of delisting returns (Shumway
[1997]).12
To illustrate the impact that just one delisting return error can have, consider the case of Smith Corona, which filed for bankruptcy in 1996 and delisted in May of 1996 when the stock closed at $0.375. In February of 1997, the firm emerged from bankruptcy, and as part of the reorganization, the common stock at the time of the bankruptcy was canceled and shareholders of record received one warrant to purchase shares in the new company for every 20 shares previously held. The warrants had an estimated value of $0.10 or one halfa cent per original share.'" When the new shares began trading in February 1997, CRSP used the new trading price of $3.12 as the firm's delisting price. As a result, the calculated delisting return on CRSP is over 700%, when it actually should be closer to -100%. More importantly, using CRSP's delisting return produces a BHAR of 2,177% when it should be -135%. This one observation changes the BHAR return of the low accrual decile for the period 1987-1999 by 1.11% (from 0.72% to 1.83%). Since this observation meets the data requirements of prior accrual anomaly-related studies, it's quite likely it will be in the low accrual decile of all such studies.14
2.4 TESTS OF A HYPOTHESIS FOR THE CAUSE OF ACCRUAL-RELATED MISPRICING
A notable feature of accrual anomaly-related studies is that they do not conduct robustness tests to assess the sensitivity of their results to extreme performing firms. An important feature of such studies is that their partitioning variable (accruals, DA, or NOA) is hypothesized to cause the abnormal returns in the subsequent year. For example, in the case of total accruals (Sloan [1996]), the BHARs are hypothesized to be caused by investors' failure to account for the more transitory nature of accruals when forecasting
12 If researchers suspect that the frequency of delisting is correlated with their partitioning variable (e.g., accruals/performance) then it is worthwhile to report the sensitivity of reported results to extreme performing firms. If the results are robust, then it is simple to rule out data errors as the source of the significant results. On the other hand, if the results change, the researcher can investigate the affected observations to verify whether there are errors in the returns calculation. Any errors can then either be corrected or deleted and the analysis re-estimated. 13We thank MartyButler for providing us with this calculation (see Butler [2004]). 14" In correspondence with CRSP,they agreed that the error was theirs and plan to correct it.
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subsequent earnings. This cause-and-effect relation is a basic tenet of the earnings fixation hypothesis tested in Sloan [1996]. If the theory (e.g., functional fixation) specifying a relation between a partitioning variable like accruals and BHAR is a robust explanation for investor pricing of securities, it should not be sensitive to conventional robustness tests and it should not be driven by a small number of observations. In other words, inferences about a hypothesized theory of investor mispricing should stand up to the traditional robustness tests that accounting researchers typically use in other research settings to ensure the validity of their inferences about a theory. Finding that the results are not robust would not cast doubt on the profitability of the trading strategy,per se, but it would cast considerable doubt on the validity of the theory hypothesized to cause the anomaly. The results of our analysis, reported below, suggest that, if researchers pose a hypothesis or theory about causality, they should report the results of robustness tests. If the results are similar, then inferences about the applicability of their theory or hypothesis would seem well founded. On the other hand, if the results appear to be driven by only a small number of observations, then the researcher should perform additional tests to ascertain whether the BHARs are in fact attributable to the partitioning variable (e.g. accruals) or to other factors or data errors. If the results appear to be driven by other factors (e.g., an unusual event) then the profitability of a trading strategy should not be attributed to the partitioning variable but, instead, to an unobservable factor that is correlated with the partitioning variable.
TESTS 2.5 ROBUSTNESS
We perform two types of robustness tests. In both cases, we estimate equation (1) on deciles of accruals, abnormal accruals, and NOA. Following Knez and Ready [1997], we drop the 1% of the observations with the largest squaredresidualand re-estimate model (1) with the remaining 99% of the sample. We also use the Belsley, Kuh, and Welsch [1980] regression diagnostic procedures to identify influential observations.'5 Both procedures yield similar results and this adds confidence to the inferences we draw. We also approach our study of the economic explanations offered for accrual-based anomalies by investigating the source of accruals and abnormal returns earned by those firms identified by our robustness tests (see appendix A).
3. Data and SampleSelection

MEASUREMENT 3.1 VARIABLE
Our analysis requires BHARs, accruals, DA, and NOA. The studies we re-examine (Sloan [1996], Xie [2001], and Hirshleifer et al. [2004]) use
15An example of an influential study using Belsley, Kuh, and Welsch [1980] regression diagnostic procedures to identify influential observations (i.e., studentized residuals) is Brown, Lo, and Lys [1999].
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samples that differ in terms of time period, exchange listing, etc. Rather than constructing separate samples to exactly match each of these studies, we use a common sample selection procedure for the tests we conduct.'16 We use Compustat data to compute accruals based on the statement of cash flows (Hribar and Collins [2002]). This measure, Accruals c, mitigates the impact that acquisitions accounted for using the purchase method has on accruals. We calculate Accrualsciby subtracting operating cash flow (Compustat #308) from net income (Compustat #172).17 AccrualscF are scaled by average total
assets. 18
We estimate DA by taking the residual from a regression of Accrualsc, on the change in revenue and net property, plant, and equipment, with all variables scaled by total assets for each industry and year. This is the cross-sectional version of the Jones [1991] model.19 NOA are calculated as in Hirshleifer et al. [2004] and are operating assets (total assets - cash) (operating liabilities), scaled by beginning total assets."2 Returns are obtained from the CRSP monthly raw and size portfolio adjusted returns files. As in Sloan [1996], raw buy-and-hold returns are computed beginning four months after the fiscal year-end through the fourth month of the subsequent year (e.g., May 1, 2000 through April 30, 2001 for a firm reporting December 31, 1999). BHAR is computed by subtracting a
16 Our inferences are unchanged if we begin with sample selection procedures similar to those described in each of the three studies, and these results are available upon request. 17 Alternatively,we could compute cash flow accruals as income from operations on the cash flow statement (Compustat #123) minus cash from operations, excluding adjustments for discontinued operations, extraordinary items, and the cumulative effect of changes in accounting methods (Compustat #308 - Compustat #124). We use the approach discussed in the text to capture all of the accrual effects. While there are some measurement issues associated with using the cash flow approach to calculate total accruals, in most contexts (including ours), they do not lead to any bias. For example, if a firm reports cash flows from discontinued operations in a separate section of the cash flow statement, and it includes cash from the sale of the discontinued operation, these cash flows are included in cash from operations (even though proceeds from the sale should be considered an investing activity). In these cases, cash from operations will generally be overstated and accruals will be understated. As an example, see the 1999 10-K of Matec Corporation (http://www.sec.gov/Archives/edgar/data/85608/000008560800-000003-index.html). 18A potential concern with scaling by average assets is that beginning total assets are increasing in past accruals, past accruals are negatively correlated with current accruals, and ending total assets are increasing in current accruals. These relations may impart a bias in scaling by average assets. We repeat our analysis after scaling by market value of equity rather than average assets and obtain qualitatively similar results. The limitation of scaling by market value of equity is that, as Sloan [1996] points out, market value has been shown to be associated with future returns and scaling by market value may induce the association being tested (Fama and French [1992]). 19 Recent studies highlight specification problems associated with the Jones [1991] model (e.g., Ball and Shivakumar [2005], Kothari, Leone, and Wasley [2005]), but we use it here for comparability with the study of Xie [2001]. 20The exact computation using Compustat data items is (#6 - #1 - (#6 - #9 - #34 - #38 #130 - #60)) /#6.
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firm's size-matched portfolio BHAR from its raw BHAR.21 To mitigate selection bias (discussed in more detail below), a firm's return is set to zero for any month it is missing (a missing return is defined as the WRDS code ".B" in the return field). If a firm is not assigned to a size decile by CRSP,we use the value-weighted market return in place of a size-matched portfolio return. Consistent with prior research, when a firm delists we use the delisting return in the delisting month and assume a return equal to the firm's size-matched portfolio for the remainder of the year (i.e., the BHAR for the remainder of the year is zero). If a firm's delisting is due to liquidation or a forced delisting by either the exchange or the Securities and Exchange Commission (SEC) and the delisting return is missing, the delisting return is set to -100%.
SELECTION 3.2 SAMPLE
We use the 2003 merged Compustat/CRSP database on the WRDSsystem (WRDSdataset name: crsp.cstann) to construct a dataset spanning the 19871999 time period. As in prior research, we exclude financial institutions. We merge these observations with the CRSPmonthly return file using the crossto the historical "permnumber" reference file linking Compustat's "GVKEY' on CRSP (NPERMNO). To facilitate comparison with prior research, most of our analysis focuses on NYSE/AMEX firms. We determine NYSE/AMEX membership using CRSP's exchange code reported in the event file. The final sample of NYSE/AMEX firm-year observations is 20,852 for tests of the total accrual anomaly. The sample size is somewhat different for tests of the DA anomaly (20,799) and for the NOA anomaly (18,953) because of additional data requirements. Most of the analyses we conduct and report in the paper are based on AccrualscFand cover the 1987-1999 time period. To facilitate comparison with prior research, we also report some results, in tables 1 and 2, for a longer time period (1972-1999). Since statement of cash flow data are not available prior to 1987, we use the balance sheet approach to measure total accruals for this alternative sample period. Using the traditional balance sheet as the change in noncash current assets approach, we calculate AccrualsBs (Compustat #4 - #1) minus the change in current liabilities (Compustat #5) less the current portion of short-term debt (Compustat #34) and taxes payable (Compustat #71) minus depreciation expense (Compustat #14). Our main sample covers the period 1987-1999, while that of Sloan [1996] spans 1962-1991. To facilitate a more direct comparison with the results of Sloan [1996], we expand our sample to cover 1972-1999 (our sample size increases from about 21,000 to over 50,000 observations). When we use this expanded sample and the balance sheet measure of accruals, we still obtain the same inverted-U pattern using the LTS procedure and the Belsley, Kuh,
21 CRSP size portfolio returns are based on beginning of the year market values. The exact files used are from the Wharton Research Data Service (WRDS) and are crsp.ermport2 for NYSE/AMEX firms and crsp.ermport3 for NASDAQ firms.
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and Welsch [1980] regression diagnostics. More precisely, our inferences are unaffected when we use this longer sample period (1972-1999) to replicate
the results reported below in tables 3-6 (these results are available upon
request).
4. Sources Bias of SampleSelection

When testing a trading strategy, it is imperative that researchers select their sample based only on information available at the time a hypothetical trade is made. In this section, we discuss three sources of selection bias that likely impacted prior accrual anomaly-related studies to some degree. These are: how researchers define a firm's exchange listing at the time a hypothetical trading strategy is implemented, the requirement in some accrual anomaly studies that firms report accounting information in year t+ 1, and how researchers handle firms with missing returns during the subsequent year's BHAR accumulation period.22 The primary motivation for this analysis of these sample selection issues is to clearly describe how we handle the sample selection and data availability issues that implicitly and explicitly must be addressed by all accrual anomalyrelated studies. Identifying and quantifying these sample selection issues also provides a clearer mapping between the samples used in prior research and the sample we use in our tests in section 5. An important aspect of this analysis is that it allows us to identify a sample free of the various sample selection biases we identify. Thus, it is an appropriate sample to use in our robustness tests related to the accrual anomaly.23
22Since the work of Sloan [1996], there have been a number of studies that replicate his results for different time periods, different stock exchanges, and using different measures of accruals. While all of these studies report hedge portfolio returns in the neighborhood of 10% per annum, the source of the hedge returns varies from study to study. For example, in a sample of NYSE/AMEX firms from 1961 to 1992 and using the balance sheet approach to measure total accruals, Sloan [1996] reports a BHAR in the low decile of about 5% and a BHAR in the high decile of roughly -5%. Using a sample of NYSE/AMEX firms, Zach [2004] reports size-adjusted returns of approximately 7% and -5% for the low and high deciles, respectively. Finally,based on a sample of NYSE/AMEX and NASDAQ firms, Desai, Rajgopal, and Venkatachalam [2004] report a BHAR in the low decile of 1.3% and a BHAR in the high decile of -8.5%. Desai, Rajgopal, and Venkatachalam [2004] attribute the near zero returns (1.3%) in the low decile, which are much lower than those ofSloan [1996] or Zach [2004], to the inclusion of NASDAQ firms. In this section, we demonstrate how several sources of selection bias are the most likely causes of the differences in these past results. 23Additional motivation for the analysis in this section is drawn from Kothari, Sabino, and Zach [2005], who explore how passive and active truncation strategies introduce biases into long-horizon (one year or more) tests of market efficiency. Our analysis in this section can be viewed as further evidence and documentation of the biases that are introduced into tests of market efficiency by passive data truncation from sample selection procedures. By doing so, we extend the analysis of Kothari, Sabino, and Sloan [2005] to tests of market efficiency with respect to accruals-related information. Kothari, Sabino, and Sloan [2005] focus on tests of market efficiency with respect to financial analysts' forecasts.
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A. KRAFT, A.J. LEONE, AND C. WASLEY
4.1 THE DEFINITION OF EXCHANGE LISTING AT THE TIME OF THE TRADING STRATEGY
Historically, most researchers limit their analyses to NYSE/AMEX firms (see footnote 7) and, depending on the procedure used to identify a firm's exchange listing, a selection bias is introduced. Researchers have three primary ways to identify exchange listing: The ZLIST code on Compustat, the header exchange code on CRSP (HEXCD), and the exchange code in the CRSP event file (EXCHCD). Only EXCHCD provides the identity of the exchange a firm is traded on at the time returns are calculated. Both ZLIST and HEXCD report a firm's exchange listing at the time the particular version (i.e., year) of the database was constructed. For example, ZLIST on a July 2005 version of the Compustat database will reflect the exchange of the firm at that point in time. In accrual anomaly studies, researchers are generally silent regarding how they determine a firm's exchange listing. This subtle, but ubiquitous, research design choice has important implications for the measured BHARs to a trading strategy based on accruals. Using a current exchange listing (say ZLIST) is likely to impart an upward bias in BHAR for two reasons. First, firms previously traded on the NYSE/AMEX, but now on NASDAQ, are excluded from the sample. To the extent that those firms switched exchanges because they were performing poorly means this hindsight bias excludes poorly performing firms from the sample. This will occur, for example, if a firm trading on the NYSE no longer meets the NYSE exchange requirements and moves to another less restrictive exchange. Indeed, as reported in panel A of table 1, in our 1972-1999 sample of 109,496 firm-yearobservations, 9,532 observations are classified by Compustat's ZLISTas trading on NASDAQwhen they were actually traded on the NYSE/AMEX at the time of the return-accumulation period. These observations earn a mean (median) annual BHAR of-10.8% (-16.9%), and 1,142 firm-year observations would have been classified in the low accrual portfolio and earn a mean (median) annual BHAR of-6.9% (-25.1%). The high accrual portfolio would contain 866 firm-year observations earning a mean (median) annual BHAR of -19.0% (-27.7%). Using AccrualscFproduces similar results for the 1987-1999 period. For example, referring to the first row of panel B reveals 3,502 firm-year observations for which, based on CRSP'sEXHCD at the start of the BHAR accumulation period, the firm was traded on the NYSEor AMEX, but according to Compustat's ZLIST,it was trading on NASDAQ. The mean (median) annual BHAR for these observations is -16.2% (-27.5%). Of the total, 521 observations have accruals placing them in the lowest total accrual decile and they earn a mean (median) annual BHAR of -10.9% (-40.4%). At the other extreme, 358 observations have accruals placing them in the highest total accrual decile and these firms earn a mean (median) annual BHAR of -24.1% (-38.1%). These findings clearly document that researchers using ZLISTto identify a firm's exchange listing will omit these firms and overstate portfolio returns
TABLE 1 Sources Bias and Effects on Measured Return of Selection Performanc Buy-and-Hold
The sample in panel A (B) contains firm-year observations for the 1972-1999 (1987-1999) period. Th by subtracting the buy-and-hold size-matched portfolio return from the firm's raw buy-and-hold return after the fiscal year-end and continues for 12 months (e.g., May 1, 2000 to April 30, 2001 for a firm with change in noncash current assets (Compustat #4 - #1) minus the change in current liabilities (Com debt (Compustat #34) and taxes payable (Compustat #71) minus depreciation expense (Compustat #14 minus net income (Compustat #172). Both measures are scaled by average total assets (Compustat #6) All Observations N Mean Median N 1,142 442 Mean -6.9%*
Low Deci
Panel A: Annual BHAR during 1972-1999 for partitions based on Accruals5s Firms traded on NYSE/AMEXbut 9,532 -16.9%*** -10.8%.** classified by ZLISTas NASDAQ Firmstraded on NASDAQbut 6,275 10.7%*** -1.1%*** classified by ZLISTas NYSE/AMEX Firmsmissing t+1 12.6%*** 2,516 9.4%*** earnings/accruals Firmshaving one or more months 748 -.16.9%*** -13.5%*** with no trading activity
21.4%***
323 140
-4.7% -7.5%
Panel B: Annual BHAR during 1987-1999 for partitions based on AccrualscF Firmstraded on NYSE/AMEXbut 521 -10.9% 3,502 -16.2%*** -27.5%*** classified by ZLISTas NASDAQ Firmstraded on NASDAQ but 154 11.2%*** -3.2% 2,568 29.6%** classified by ZLISTas NYSE/AMEX Firmsmissing t+l 136 5.8%*** 1,159 6.3%*** -25.9%**. earnings/accruals Firmshaving one or more months 80 -47.8%*** 18 -39.4% -41.6%*** with no tradine activity indicatesignificanceat the 10%,5%,and 1%levels,respectively, and arebasedon t-tests for meansa *, **,and ***
Abbreviation: NYSE/AMEX, New York Stock Exchange/American Stock Exchange.
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in the process. Because more of the observations fall in the lowest accrual decile (i.e., 15% = 521/3,502 in the low accrual decile and 10% = 358/3,502 in the high accrual decile), this selection bias is more severe for the low accrual decile. An additional selection bias related to exchange listing is firms previously listed on NASDAQ later switching to the NYSE/AMEX. Using ZLIST,these firms will be classified as NYSE/AMEX even though they were trading on the NASDAQat the start of the BHAR accumulation period. It is likely that firms moving from the NASDAQ to the NYSE/AMEX are good performers, and including them in a sample ofNYSE/AMEX firms will impart an upward bias in measured BHAR. Indeed, during the 1987-1999 sample period (panel B), there are 2,568 firm-yearobservations traded on NASDAQ at the start of their BHAR accumulation period according to EXCHCD that are classified by Compustat's ZLISTas NYSE/AMEX. These firms earn a mean (median) annual BHAR of 11.2% (-3.2%) (refer to the second row of panel B). The mean (median) annual BHAR of the 210 observations in the highest total accrual decile is 6.9% (-8.6%), and for the 154 observations in the low total accrual decile, it is 29.6% (4.4%) (refer to the second row of panel B). If we focus on the longer 1972-1999 sample period reported in panel A, the magnitudes of the BHARs are quite similar. Overall, the evidence indicates an upward bias in BHAR for samples selected based on ZLIST.
OBSERVATIONS WITH MISSING VALUES 4.2 EXCLUDINGFIRM-YEAR OR ACCRUALS FOR t+1 EARNINGS
Another selection bias inherent to studies of the accrual anomaly is the exclusion of firms not reporting earnings or accruals information in year t+1l (see footnote 9). Studies often require t+l accounting information in order to conduct tests of various earnings forecasting models (e.g., Sloan [1996], Thomas and Zhang [2002]). A drawback of this procedure is that it induces a hindsight bias because an investor would not know in year t which firms will not report accounting numbers in the following year. Since these firms are either delisted or acquired, tests of subsequent return performance will be biased. As reported in the third row of panel A of table 1, there are 2,516 such firm-year observations during the 1972-1999 sample and these firms earn a mean (median) annual BHAR of 12.6% (9.4%). The 323 (164) firms in the low (high) accrual decile earn a mean annual BHAR of -4.7% (4.0%). However, the mean BHARs are insignificantly different from zero. The third row of panel B summarizes the impact of this selection bias during the 19871999 period. There are 1,159 observations for which t+1 earnings or accrual data are unavailable. The mean (median) annual BHAR for these firms is 5.8% (6.3%). Interestingly, the 136 observations in the low total accrual decile have a mean (median) BHAR of -25.9% (-26.8%), and while there are only 73 firms in the high total accrual decile, they perform better than other firms in the high total accrual decile based on a mean (median) BHAR of -0.8% (6.7%).
MISPRICING OFACCRUALS 315 FIRM-YEAR 4.3 EXCLUDING OBSERVATIONS WITH MISSING RETURNS THEBHAR DURING ACCUMULATION PERIOD Another selection bias is firms having stock price and return data in the first month of the return accumulation period, but missing a return in one or more of the subsequent 11 months. A researcher's choice here is to exclude these observations or assume the subsequent return is a two-month return and adjust the BHAR accordingly. Prior research typically excludes them (see footnote 9). Such firms are unlikely to be a random sample, and are likely to be troubled firms. While the last row in panel B shows that there are only 80 such observations in the 1987-1999 sample period, they exhibit extremely poor performance. Their mean (median) annual BHAR is -41.6% (-47.8%), and these mean and median BHARs are reasonably similar regardless of whether the observation places the firm in the low or high total accrual decile. In panel A, where the sample period is longer (1972-1999) and the sample is larger (N = 748), the behavior of the mean and median BHAR is similar,just somewhat smaller in magnitude. 4.4 THECOMBINED IMPACT OFSELECTION BIASES ON MEASURED BHAR To more precisely measure the impact the selection biases have on measured BHAR, we construct five samples in both the 1972-1999 and 19871999 periods. The construction of the samples is designed to capture different combinations of the selection biases discussed above. Panel A (B) of table 2 reports the mean annual BHAR for 1972-1999 (1987-1999) for each of the five samples. As we move from sample 1 to sample 5, we are mitigating the effects of the individual selection biases. For example, sample 1 reflects all of the biases discussed above, while sample 5 contains none of them. While sample 1 exhibits the most positive bias, it is unlikely that researchers construct samples in this way. If a researcher uses Compustat's ZLIST to select NYSE/AMEX firms and then uses the NYSE/AMEX sample as defined in the current version of CRSP, the combined effect of these sample selection procedures will yield a sample like sample 2. Consistent with the results of Sloan [1996], and based on his description of his sample selection procedure, sample 2 exhibits a large fairly balanced t+1 BHAR in the low and high accrual deciles (about 5% in each, see panel A). Two key features of table 2's results are as follows. First, the BHAR for the low accrual decile approaches zero as the different selection biases are eliminated. For example, in sample 5, during the 1972-1999 period, the BHAR is only 2.25%. The corresponding BHAR for these samples in the period 1987-1999 is only 1.83%. This result is striking, as the BHAR of the low accrual decile is reduced by about 72% (88%) as we move from sample 1 to sample 5 during the period 1972-1999 (1987-1999). Second, as the different selection biases are relaxed (i.e., as we move from sample 1 to sample 2 and to sample 3, and so on) the BHAR for the high accrual decile gets more and more negative. For example, in sample 5, during the
TABLE 2 Bias and Impacton Measu Combined Effectsof AlternativeSourcesof Selection Panel A (B) covers the 1972-1999 (1987-1999) period and measures accruals as AccrualsBs (Accrual (Compustat #4 - #1) minus the change in current liabilities (Compustat #5) excluding the current is cash from opera payable (Compustat # 71), minus depreciation expense (Compustat #14). Accrualshcr #172). Both measures are scaled by average total assets (Compustat #6). The buy-and-hold-abnormal re and-hold size-matched portfolio return from the firm's raw buy-and-hold return. The return accumula and continues for 12 months. Sample 1 contains all firm-year observations identified by Compustat a in year t+1 and no missing returns data during the retu Stock Exchange (NYSE/AMEX) with AccrualsBs 1 except the firm must be identified by both Compustat and the Center for Research in Security Pr identical to sample 1 except the NYSE/AMEX exchange listing is determined from CRSP. Sample 4 where missing monthly returns are set to zero. As in samples 1-3, firm-yearsare excluded if Accrualss in firms with missing AccrualsBsin t+1 are included. Sample Selection Description NYSE/AMEX Firms with missing returns within the return interval. Firms with missing values for earnings or accruals in t+ 1. Sample 1 Identified by Compustat Excluded Excluded Sample 2 Identified by Compustat and CRSP Excluded Excluded Sample 3 Identified by CRSP Excluded Excluded
Panel A: Annual BHAR during 1972-1999 based on AccrualsBs Sample 1 Sample 2 Decile (44,950) (38,790) Low (decile 1) 7.94%*** 5.55%*** (3,879) (4,495) Mid (deciles 5 and 6) 2.22%*** 1.22%*** (7,793) (9,016) High (decile 10) -2.75%*** -5.03%*** (4,498) (3,881) Panel B: Annual BHAR during 1987-1999 based on AccrualscF Sample 1 Sample 2 Decile (18,840) (16,300) Low (decile 1) Mid (deciles 5 and 6) High (decile 10)
*, **, and
Sample 3 (47,780) 3.03%** (4,778) -0.03% (9,585) -7.81%*** (4,782)
Sample 3 (19,560)
10.29%*** (1,884) 1.36%** (3,781) -2.35% (1,884)
8.39%*** (1,630) 0.80% (3,275) -3.37%** (1,630)
4.22%* (1,956) -1.14%* (3,926) -7.93%*** (1,956)
***indicate significance at the 10%, 5%, and 1% levels, respectively, and are based on t-tests for means.
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A. KRAFT, A.J. LEONE,AND C. WASLEY
1972-1999 period, the BHAR is -7.44%. The corresponding BHAR for this sample in the 1987-1999 period is -7.85%. This result is also striking as the BHAR of the high accrual decile is more negative by a factor of about 2.7 (3.3) times as we move from sample 1 to sample 5 during the 1972-1999 (1987-1999) period. More importantly, however, when compared with results for the existing "accrualanomaly,"where more of the return anomaly tends to be observed in the low accrual decile, table 2's results reveal that, after correcting for various selection biases inherent in prior studies, most of the BHARs are realized in the upper accrual decile (i.e., the short side of the trading strategy). A key aspect of the findings in table 2 is that they are helpful in reconciling the results of Sloan [1996] to those of Desai, Rajgopal, and Venkatachalam [2004] and others (see, e.g., Houge and Loughran [2000], Chan et al. [2001], and Beneish and Vargus [2002]). Desai, Rajgopal, and Venkatachalam [2004] analyze NYSE/AMEX and NASDAQ securities, so their study is not subject to the NYSE/AMEX selection bias described above, and given the nature of their tests, they do not require accounting data for year t+1. As a result, they report BHARs of 1.3% and -8.5% for the low and high accrual deciles, respectively, which are similar to the results we report in panel A for sample 5. The salient feature of table 2's results is that they indicate that the difference between the results of Sloan [1996] and those of Desai, Rajgopal, and Venkatachalam [2004] are not a result of the inclusion of NASDAQ firms, as Desai, Rajgopal, and Venkatachalam [2004] conclude, but rather because of the fact that they avoid two of the sample selection biases we describe above. In summary, the results in table 2, as we move from sample 1 to sample 5, quantify how much sample selection bias can influence the returns to the various accrual portfolios, and how such biases also impact inferences about the underlying cause of the accrual anomaly (e.g., the earnings fixation story). The main conclusion we draw from table 2 is that sample 5 is the only sample free of the sample selection biases we describe above. As a result, this sample is used below in our robustness tests related to the accrual anomaly.
Tests Resultsof Robustness 5. Empirical Anomalies24 ofAccrual-Related

ANOMALY TESTSOF THE TOTALACCRUAL 5.1 ROBUSTNESS
Before reporting our regression results, we first provide details about the distribution of the BHARs for portfolios made up of firms in the low decile, middle quintile, and high decile of accruals. Figure 1 provides a histogram
24The results reported in this section and in the remainder of the paper are based on the 1987-1999 sample period. As noted earlier in the text, our inferences are unaffected when we use a longer sample period (1972-1999) to replicate the results reported in tables 3-6 based on the period 1987-1999. Results for the period 1972-1999 are available upon request.
MISPRICING OF ACCRUALS Histograms of the BHAR for the Low Accrual Decile, Middle Accrual Quintile, and High Accrual Decile 9.0% 8.0% o7.0%E6.0%
319
5.0% 4.0% 3.0% 2.0%1.0%

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Summary Statistics of the BHAR Distributions
Low Including all observations Mean Standard deviation Median Percent negative 1.83% 109.89% -11.95% 60.56%
Middle -0.12% 42.77% -3.01% 54.97% 17 -1.40% 37.45%
High -7.85% 65.18% -17.81% 66.33% 22 -11.68% 49.98%
Excluding observations with BHAR exceeding 200% Number of observations excluded 54 Mean -10.13% Standard deviation 54.79%
FIG.1.--The histogram portrays the annual buy-and-hold abnormal returns (BHARs) for the low accrual decile, middle accrual quintile, and high accrual decile. The underlying sample is sample 5 from panel B of table 2 and includes 20,852 firm-yearobservations from the 1987-1999 period in which firms are identified by the Center for Research in Security Prices (CRSP)'s exchange code as trading on the New York Stock Exchange or American Stock Exchange. Observations with a BHAR exceeding 200% are excluded. If, during the return accumulation period, a monthly return is missing because there is no price information on CRSP,the return is set to zero. Firms with missing accounting data in t+1 are included. The BHAR for each firm is computed by subtracting the buy-and-hold size-matched portfolio return from the firm's raw buy-and-hold return. The return accumulation period begins four months after the fiscal year-end and continues for 12 months.
of the BHARs of the low accrual decile, middle accrual quintile, and high accrual decile. To initially capture the impact of extreme performance, the histograms truncate observations with a BHAR exceeding 200% (54, 17, and 22 firm-year observations from the low, middle, and high portfolios, respectively). Several aspects of the histograms are worth noting. First, there is clearly separation between the high and low accrual portfolios, as the high accrual portfolio is to the left of the low accrual portfolio. However, both the high
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and low accrual BHAR distributions are quite far to the left of the middle accrual quintile portfolio. In addition, a much higher percentage of firms in the low and high accrual deciles (60.56% and 66.33%, respectively) exhibit negative BHARswhen compared with the middle accrual quintile (54.97%). When we exclude firm-year observations with a BHAR exceeding 200%, the mean return for the low accrual decile (-10.13%) and high accrual decile (-11.68%) portfolios are very similar, but both are much lower than the middle accrual quintile (-1.4%). The key aspect of these patterns to appreciate is that they are fundamentally different from what one would expect under the earnings fixation hypothesis. Under the earnings fixation hypothesis, the distribution of returns for the low accrual decile should be strictly to the right of the middle accrual quintile. Turning to the regression results, column 1 of table 3 reports results of estimating equation (1) where the decile partitions are based on AccrualscF. The intercept is not significantly different from zero, suggesting that the The cofirms in the middle accrual quintile do not earn a significant BHIAR. efficient on Lowis not significantly different from zero, which is inconsistent with the earnings fixation hypothesis of Sloan [1996], but consistent with findings in recent research (Desai, Rajgopal, and Venkatachalam [2004]) that the abnormal returns to portfolios formed on the basis of accruals are driven more by the high accrual decile than the low accrual decile. Based on the analysis above, the positive returns in the low accrual decile reported in past research (e.g., Sloan, [1996]) are likely due to sample selection bias (see section 4 above). Turning to the coefficient on High, consistent with Sloan's [1996] earnings fixation hypothesis, the coefficient of -0.077 is significantly negative (p < 0.01). Interestingly, Decile2is positive and significant (p < 0.01), with an implied portfolio return that is 0.051 higher than the middle accrual quintile. We next perform a robustness test based on LTS (see Knez and Ready [1997]), in which we exclude the 1% of the sample with the largest squared As noted by Knez and Ready [1997, p. 1360], while least squares residuals.25 has desirable features, its undesirable features include being sensitive to outliers (y observations or y-direction observations, i.e., returns) and leverage points (x observations or x-direction observations, i.e., accruals). They go on to note that these undesirable features of least squares are "particularly problematic when there is some chance the data contain errors (p. 1360)."26 Under the LTS robust estimation procedure, Knez and Ready [1997] advocate excluding the influential observations and then fitting least squares to the remaining observations.27
25There is by no means a requirement that the same number of observations be trimmed from both the upper and lower tails of the residuals. 26As noted in footnote 4, we identified several data errors that we confirmed with CRSP and which CRSP plans to correct in the next version of the tape. All of these errors stem from the calculation of delisting returns of firms that enter bankruptcy and later emerge from bankruptcy with new common stock. 27For a discussion of the detection of influential observations and robust regression methods, see Hampel et al. [1986] and Rousseeuw and LeRoy [1987].
MISPRICING OF ACCRUALS TABLE 3 Returnsand TotalAccruals Analysis of theRelationbetween Buy-and-Hold with and withoutTruncation
321
+ f4Decile4it f2Decile2it + fl3Decile3it + ,sDecile7it + t6Decile8it + f7Decile9it + fasHigh+ eit The results reported in the table are based on a sample of 20,852 firm-year observations from the 1987-1999 period (sample 5 from panel B, table 2). The sample includes all firms identified by the Center for Research in Security Prices' (CRSP) exchange code as trading on the New YorkStock Exchange or American Stock Exchange. If, during the return accumulation period, a return is missing because there is no price information on CRSP (which is coded as ".B"in the SAS CRSPdatasets on the Wharton Research Data Service), the return is set to zero. Firms with missing accounting data in t+l are included. Accrualsct is cash from operations (Compustat #308) minus net income (Compustat #172). Both are scaled by average total assets (Compustat #6). The buy-and-hold-abnormal return (BHAR) is computed by subtracting the mean buyand-hold size-matched portfolio return from the firm's raw buy-and-hold return. The return accumulation period begins four months after the fiscal year-end and continues for 12 months. The indicator variable Lowit is set to one if the firm is in the lowest accrual decile and zero otherwise. The indicator variable Highit is set to one if the firm is in the highest accrual decile and zero otherwise. Decile2,Decile3,Decile4,Decile7, Decile8, and Decile9 are indicator variables set to one if the firm is in the corresponding accrual decile. The intercept reflects the mean BHAR for firms in the middle accrual quintile (deciles 5 and 6). BHARit+I
= al + fl Lowit All Least Trimmed Belsley, Kuh, and Welsch
Model:
Description Intercept (middle quintile) Low Decile2 Decile3 Decile4 Decile7 Decile8 Decile9 High Adj. R2 No. of obs.
Observations -0.001 (-0.13) 0.020 (1.17) 0.051"**
Squares (1%) -0.014** (-2.17) -0.088*** (-7.54) -0.004
[1980] -0.018** (-3.09) -0.102*** (-9.75) -0.016
(3.08)
-0.003 (-0.19) 0.006 (0.34) -0.007 (-0.43) -0.021 (-1.27) --0.043** (-2.57) -0.077*** (-4.63) 0.002 20,842
(-0.38)
-0.005 (-0.45) -0.004 (-0.32) -0.012 (-1.08) --0.038*** (-3.31) --0.052*** (-4.53) --0.107*** (-9.25) 0.007 20,634
(-1.57)
--0.019* (-1.82) --0.020** (-1.99) -0.021"* (-2.05) --0.055*** (-5.38) --0.074*** (-7.23) -0.142** (-13.72) 0.013 20,152
*, **, and ***denote significance at the 10%, 5%, and 1% levels, respectively (one-tailed test).
When we implement the LTS procedure, 208 firm-year observations are dropped from the original regression results reported in column 1 of table 3. The revised results are reported in column 2 of table 3 and differ dramatically from the earlier results. Most importantly, the coefficient on Low is significantly negative (-0.088, p < 0.01). If we use the regression diagnostic procedures advocated by Belsley, Kuh, and Welsch [1980], we
322
observe similar results, although more observations are removed (690 vs. 208). These latter results are reported in column 3 of table 3, and Low is again significantly negative (-0.102, p < 0.01).28 The striking feature of these findings is that they place a very different interpretation on the accrual anomaly. Namely, based on the results from the LTSrobust estimation procedure, where only 208 observations are removed from the sample, the empirical evidence is inconsistent with the earnings fixation hypothesis in Sloan [1996]. More precisely, based on 99% of the firm-yearobservations in the sample, there is an inverted U-shaped relation between accruals and BHARs. An inverted U-shaped relation is consistent with investors underreacting to negative accruals but overreacting to positive accruals. Such an effect is not what is predicted under the earnings fixation hypothesis, and, as a result, these findings suggest the relation between accruals and stock returns observed in prior studies is not driven by functional fixation or accrual mispricing. Alternatively, the results suggest that some (unspecified) firm characteristics are correlated with extreme accruals. We provide some empirical evidence on this latter point in the next section of the paper.29
ON THE RELATION BETWEEN TOTALACCRUALS EVIDENCE 5.2 GRAPHICAL AND BHAR
To provide some visual perspective on the relation between BHAR and total accruals, figure 2 plots the regression function of BHAR for period t+ 1 on total accruals from period t. Two regression functions are plotted. The first, the dotted line, is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude of accruals. This regression function is estimated using the entire sample of 20,842 firm-year observations. The solid line in the figure is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude accruals after removing 1% of the firm-year observations based on the LTS robust estimation procedure. This regression function is estimated using a sample of 20,634 firm-year observations (i.e., the full sample of 20,842 minus the 208 observations identified by the LTS procedure). Note that the independent variable in both regressions is the magnitude of the firm's total accrual, not its accrual decile membership indicator variable.
28All of the coefficients in columns 2 and 3 are negative because more observations with positive BHARs are deleted by our robustness tests than observations with negative BHARs. As a result, the average BHAR of the remaining firms is less than zero due to the positive skewness in returns. In addition, the results of other robustness tests, such as using ranked regressions and logged BHAR, yield inferences similar to those here based on LTS. This holds for the results reported in the remainder of the paper as well. 29This observation is consistent with Kothari's [2001] point that the high frequency of lowpriced and small capitalization stocks (among other firm characteristics) populating samples in which market inefficiency is documented raises concerns about what is the real underlying cause of the inefficiency.
323
The RegressionFunctionof BHAR on the Magnitudeof Total Accruals: Full Sampleand RobustEstimationSample
10.00% 8.00% 6.00% 4.00% 2.00% .
0.00o%
-2.000%
,Robust
' " ",
,- ,- ,-
. ,. ,-Estimation
o ,, All Firm . .----
Years
-4.00% -6.00% -8.00% -10.00% Accruals
FIG.2.-The dotted line in the figure is the fitted regression function from an ordinary least squares regression of buy-and-hold abnormal return (BHAR) for period t+1 on the magnitude of firm-specific total accruals from period t. This regression function is estimated using the entire sample of20,842 firm-yearobservations. The solid line in the figure is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude of firm-specific total accruals after removing 1% of the firm-year observations based on the least trimmed squares (LTS) procedure. This regression function is estimated using a sample of 20,634 firmyear observations (i.e., the full sample of 20,842 minus the 208 observations identified by the LTS procedure). The independent variable in both regressions is the magnitude of the firm's total accrual, not its accrual decile membership indicator variable.
The information provided in the plots is quite telling. When the full sample is used to estimate the regression, the resulting function produces a (nicely) downward sloping line that is consistent with the earnings fixation hypothesis. Low (high) total accruals in period t are followed by high (low) BHARs in period t1-. However, when 1% of the firm-year observations identified by the LTS robustness estimation procedure are removed and the regression is re-estimated, the resulting regression function is virtually flat. In other words, there is no evidence of any relation between BHAR and the magnitude of total accruals. One thing missing from figure 2 is that it doesn't capture the U-shaped (i.e., nonlinear) relation between BHAR and total accruals documented above. This is because the regression functions plotted in figure 2 do not include an independent variable (such as the square of total accruals) attempting to capture this U-shaped relation. Figure 3 addresses this by plotting regression functions in which a squared term has been added to capture the nonlinearity. The dotted line in figure 3 is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude of
324
A. KRAFT, A.J. LEONE, ANDC. WASLEY TheRegression Function of BHAR ontheMagnitude of TotalAccruals andTotalAccruals FullSample andRobust Estimation Squared: Sample
5.00%
0.00%
0)
LO 3N-C') 0 ) C') C' C') C'J C'J '--00000000 LO ','? 00 O0~0 -
00006666
t0 0 00'-r ,)
-)
N. ?
1) C'J CV ,
-5.00%
-10.00%
----All Firm Years
-Robust Estimation
-15.00%
-20.00%
-25.00%
Accruals FIG.3.--This figure captures the nonlinear (i.e., U-shaped) relation reported in the paper by plotting regression functions in which a squared term has been added to capture the nonlinearity. The dotted line in the figure is the fitted regression function from an ordinary least squares regression of buy-and-hold abnormal return (BHAR) for period t+1 on the magnitude of firm-specific total accruals and the square of the magnitude of firm-specific total accruals from period t. This regression function is estimated using the entire sample of 20,842 firm-year observations. The solid line in the figure is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude of firm-specific total accruals and the square of the magnitude of firm-specific total accruals, after removing 1% of the firm-yearobservations based on the least trimmed squares (LTS) procedure. This regression function is estimated using a sample of 20,634 firm-year observations (i.e., the full sample of 20,842 minus the 208 observations identified by the LTSprocedure). The independent variable in both regressions is the magnitude of the firm's total accrual, not its accrual decile membership indicator variable.
firm-specific total accruals and the square of the magnitude of firm-specific total accruals in which the regression is estimated using the entire sample of 20,842 firm-year observations. The solid line in the figure is the fitted regression function from an ordinary least squares regression of BHAR on the magnitude of firm-specific total accruals and the square of the magnitude of firm-specific total accruals, after removing 1% of the firm-year observations based on the LTS procedure. This regression function is estimated using a sample of 20,634 firm-year observations (i.e., the full sample of20,842 minus the 208 observations identified by the LTSprocedure). As in figure 2, the total accrual variable is the magnitude of the firm's total accrual, not its accrual decile membership indicator variable. In figure 3, the U-shaped relation between BHAR and total accruals is very apparent in the robust estimation sample in which 1% of the firm-year observations identified by the LTSrobustness estimation procedure have been
OF ACCRUALS MISPRICING
325
removed. As noted above, this U-shaped relation for 99% of the sample is inconsistent with the pricing mechanism imbedded in the functional fixation hypothesis underlying the explanations for accrual-related anomalies.
OF EXTREME 5.3 A CLOSERLOOKAT THE CHARACTERISTICS FIRMS PERFORMING
Since removing only 208 observations based on the LTSrobust estimation procedure has a dramatic impact on the results, a natural question to ask is what types offirm-year observations are these and what underlying economic factors give rise to their extreme BHARs?Zellner [1981, p. 9] writes "Inview of the potential importance of unusual and surprising data, it is troubling to see how often outlying observations are discarded without thought or averaged with usual observations ...." In this spirit, we provide some analysis of the deleted firm-year observations. Of the 208 (1% of the overall sample) observations dropped using LTS, 55, 18, and 27 are in the low accrual decile, middle accrual quintile, and high accrual decile, respectively. Moreover, roughly 26% are in the low accrual decile when only 10% would be expected by chance. Appendix A provides a detailed analysis of 29 of the 55 firm-year observations in the low accrual decile and 17 of the 27 firm-year observations in the high accrual decile. These observations consist of all firm-year observations in the low or high accrual decile from the period 1995-1999. We limit our analysis to observations for this time period because we can easily obtain firms' financial statement information from the EDGAR database of SEC filings. The evidence reported in the appendix reveals that most of the low accrual firms recorded large write-downs and/or disposed of significant assets. This is consistent with poor economic performance leading to large negative accruals (Butler, Leone, and Willenborg [2004]). In the case of high accrual firms, many of the firms experienced high accruals from growth in inventory and accounts receivable (e.g., Shaw Group and Advanced Photonix). However, in the remaining cases the causes were idiosyncratic. For example, Media-bay Inc. had an initial public offering in 1997 and used much of the proceeds to acquire inventory and other noncash working capital, and Commodore Applied Tech. Inc. recorded a gain on early retirement of debt and a gain from the sale of assets, both of which caused the large income-increasing accruals. Additional descriptive statistics for the firm-year observations in the low accrual decile, middle accrual quintile, and high accrual decile are provided in panel A of table 4. To focus the following discussion, we just examine the low and high accrual deciles and use the middle accrual quintile as a benchmark for normal accruals. Examination of the descriptive statistics in panel A provides some insight into the performance characteristics of these firm-year observations. The middle accrual quintile is characterized by profits close to zero as evidenced by a mean (median) ratio of net income to assets of -1.0% (2.0%). Operating cash flow for this group is positive with a mean (median) of 4.0%
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TABLE 4 Characteristics FirmsExcludedBasedon theLeast Trimmed EstimationProcedure of Extreme Performing Squares The table presents descriptive statistics for 100 of the 208 firm-year observations excluded based on the least trimmed squares procedure. Panel A reports mean and median values for various measures of financial performance for the firm-year observations falling into the low accrual decile, middle accrual quintile, and high accrual decile. AccrualscF is cash from operations (Compustat #308) minus net income (Compustat #172). Net Income is Compustat #172. Operating cash flow is cash from operations (Compustat #308). Both are scaled by average total assets (Compustat #6). Net operating assets is total [(assets - cash) - (total assets - short-term debt - long-term debt - minority interest - preferred stock - common equity)]/beginning total assets [Compustat (#6 - #1 - (#6 - #34 - #9 - #38 - #130 - #60))/#6]. Market value of equity is fiscal year-end share price times shares outstanding (Compustat #199 * #25). Stock price is from CRSP and is the firm's share price on the first day of the return accumulation period. Sales growth is the percentage change in annual sales (Compustat #12) and the return (BHAR) is computed by subtracting the mean buy-and-hold buy-and-hold-abnormal size-matched portfolio return from the firm's raw buy-and-hold return. The return accumulation period begins four months after the fiscal year-end and continues for 12 months. Panel B reports the portion of the period t + 1 BHAR occurring on earnings announcement and announcement days. non-earnings Panel A: Descriptive statistics Low Accrual Decile (N = 55) Variable Total accruals Operating cash flows Net income Current year BHAR Stock price Market value of equity Annual sales growth BHAR Mean -0.38 -0.04 -0.42 -34.5% 7.65 628.01 -0.11 445.8% Median -0.24 0.06 -0.22 -54.9% 1.75 20.49 -0.04 319.7% Std. Dev. 0.41 0.56 0.81 84.6% 20.25 3050.56 0.46 383.1% Middle Accrual Quartile (N = 18) Mean -0.05 0.04 -0.01 -1.4% 7.35 68.26 -0.11 High Accrual Decile (N = 27) Median Std. Dev. 0.09 0.09 -0.04 0.23 0.06 -7.5% 8.88 40.22 0.18 0.21 85.9% 13.81 1145.26 0.45 190.3%
Median Std. Dev. Mean -0.05 0.01 0.11 0.06 0.14 -0.10 0.02 -7.2% 3.88 44.06 0.01 0.14 57.4% 8.02 67.88 0.76 0.01 23.3% 12.40 396.57 0.23
305.9% 269.8%
93.5% 321.0% 244.7%
Panel B: Earnings announcement returns vs. non-earnings announcement returns Earnings Announcement Non-Earnings Announcement Period Returns Period Returns
Accrual Portfolio N Mean % of Total BHAR N Mean % of Total BHAR
All Low accrual decile High accrual decile
203 51 27
26.3% 26.2% 28.8%
7.44% 6.43% 8.98%
203 51 27
326.9% 382.2% 292.2%
92.56% 93.57% 91.02%
(6.0%), while sales growth is fairly weak, as reflected in modest sales growth rates of -11% (mean) and 0.01% (median). The mean (median) BHAR for the current year is -1.4% (-7.2%) for the middle quintile. Turning to the low accrual decile, these firm-yearobservations have lower mean cash flows (-4.0%) but similar median cash flows (6.0%), compared with the middle quintile. They also have much lower income (mean of -42.0% and median of -22.0%) and these firms are experiencing declining sales based on mean (median) sales growth of -11% (-4%). Their weak
327
and declining performance is also evidenced by their current year BHAR (mean of -34.5% and median of -54.9%). Their relatively low mean and median stock prices ($7.65 and $1.75, respectively) also suggest poor past performance. Focusing on the high accrual decile reveals that their income is slightly better than that of the middle group (mean of 1.0% and median of 6%), but that their operating cash flows are much weaker (mean of- 10.0% and median of -4.0%). Further, their sales growth is higher (mean of 23% and median of 18%) and they exhibit strong current BHAR performance (mean of 23.3% and median of -7.5%) when compared with the middle accrual quintile and low accrual decile. Finally, and not surprisingly, the BHARs in t+1 for the three samples (i.e., low decile, middle quintile, and high decile) are extremely high with a mean (median) BHAR ranging from 305.9% to 445.8% (244.7% to 319.7%). The standard deviations of the BHARs are quite large, ranging from 190.0% for the high accrual decile to 383.1.0% for the low accrual decile. In all cases, the mean, median, and standard deviation of the BHARs are largest in the lowest accrual decile.
5.4 ARE THE EXCLUDED FIRM-YEAROBSERVATIONS WHERE THE EARNINGS FIXATION HYPOTHESIS APPLIES THE MOST?
An argument against excluding any BHAR firm-year observations is that important information is being thrown away, and perhaps it is in this set of firm-year observations firms where the earnings fixation hypothesis applies the most. Moreover, these firm-yearobservations have extreme returns because they had extreme accruals in year t, which "fooled" investors, and the subsequent reversal reflects the revelation of new information at the time of later earnings announcements. If this is the case, we would expect a large portion of their BHARs to occur on subsequent earnings announcement dates. The motivation for this prediction is drawn directly from Sloan [1996]. Sloan [1996, p. 309] states "The final prediction of H2 (iii) is that the abnormal returns documented in H2 (ii) are clustered around the subsequent year's earnings announcement dates." Sloan [1996] reports, on average, that about 40% of firms' BHARs are earned in subsequent earnings announcement periods. This percentage is quite large given that the number of trading days with an earnings announcement is only about 5% of the total number of trading days in a year (12/252).3o Sloan [1996, p. 312] concludes "These results therefore are consistent with a delayed response to information in accruals and cash flows about future earnings." Following Sloan's [1996] logic, if we find that most of the BHARs for the extreme performing firms we identify occur on non-earnings announcement days, then it is much less likely that earnings fixation is what explains the firms' BHAR of these firm-yearobservations. If so, we have even greater
30While it is true that announcement day returns are computed over only about 5% of the total trading days, earnings announcements are known to be significant "information"events, so it is hard to say whether or not 40% is a large percentage of total returns.
328
justification to exclude such firm-year observations from our analysis in order to test the earnings fixation explanation for the BHARs documented in prior accrual anomaly studies. As in Sloan [1996], we perform tests of announcement versus nonannouncement date returns. For each quarterly earnings announcement occurring during the BHAR accumulation period, we cumulate daily abnormal returns beginning two days before the earnings announcement through the earnings announcement day. The sum of the cumulative returns over the quarterly earnings announcement dates reflects the earnings news reported during the BHAR accumulation period.31 The total annual BHAR minus the cumulative earnings announcement period BHAR is a measure of the non-announcement date BHAR. To perform this analysis, we obtain quarterly earnings announcement dates from the merged Compustat Quarterly database (WRDS dataset cstqtr) and daily returns from the CRSP.Of the 208 firm-year observations excluded by the LTS procedure, 203 have quarterly announcement dates available. Panel B of table 4 reports the earnings announcement and non-earnings announcement date returns for these firm-year observations. Given that these firm-yearobservations exhibit large BHARs (see panel A), it is not surprising that the mean announcement cumulative abnormal returns are large and positive (26.3% for all 203 firms). Perhaps more interesting, however, is that the announcement period returns are similar for both the low and high accrual deciles (26.2% and 26.8%, respectively). If, under the earnings fixation hypothesis, earnings-related information leads investors to reinterpret the information in prior period accruals, then the announcement period returns for the low accrual decile should be higher than those of the high accrual decile. Another important feature of panel B is that roughly 93% of the BHARs occurs during non-earnings announcement periods, and this percentage is similar for the low and high accrual deciles. Such return behavior is inconsistent with accruals leading to mispricing, but instead suggests factors other than earnings (accrual) surprises are influencing these firms' t+l BHAR.
ANOMALY ACCRUALS 5.5 ABNORMAL
Xie's [2001] hypothesis related to discretionary accruals is a simple extension of the work of Sloan [1996] in that Xie [2001] hypothesizes that, while investors fixate on earnings, it is the reversing nature of abnormal (discretionary) accruals that "fools"them. As a result, it is the discretionary portion
31In some cases there are more than four quarterly earnings announcements. This can occur, for example, if a firm has a fiscal year-end of December 31, 1995, with a BHAR accumulation period from May 1, 1996 to April 30, 1997, and it reports earnings for the first quarter ended March 31, 1996, on May 2, 1996 and then reports earnings for the first quarter ended March 31, 1997 on April 28, 1997 (five quarterly announcements between May 1, 1996 and April 30, 1997). We include returns surrounding all five quarters as earnings announcement returns; however, our results are not sensitive to this choice.
MISPRICING OF ACCRUALS TABLE 5 Accruals Returns and Abnormal (Discretionary) Buy-and-Hold Analysisof theRelationbetween withand withoutTruncation
Model: BHARit+S = a1 + j1 Lowit + f2Decile2it + BsDecile3it + /4Decile4it + fsDecile7it + f6Decile8it + f37Decile9it+ FsHigh + eit
329
The results reported in the table are based on a sample of 20,799 firm-yearobservations for the 1987-1999 period and consist of sample 5 from panel B, table 2, less 53 observations without sufficient data to compute discretionary accruals. The sample includes all firms identified by the Center for Research in Security Pricing's (CRSP) exchange code as trading on the New YorkStock Exchange or American Stock Exchange. If, during the return accumulation period, a return is missing because there is no price information on CRSP (which is coded as ".B"in the SAS CRSPdatasets on the Wharton Research Data Service), the return is set to zero. Firms with missing accounting data in t+1 are included. AccrualscFis cash from operations (Compustat #308) minus net income (Compustat #172) scaled by average total assets (Compustat #6). Abnormal accruals are the residuals from the cross-sectionalJones [1991] model estimated for each industry and year.The buy-and-hold-abnormal return (BHAR) is computed by subtracting the mean buy-and-hold size-matched portfolio return from the firm's raw buy-and-hold return. The return accumulation period begins four months after the fiscal year-end and continues for 12 months. The indicator variable Lowit is set to one if the firm is in the lowest discretionary decile and zero otherwise. The indicator variable Highit is set to one if the firm is in the highest discretionary accrual decile and zero otherwise. Decile2,Decile3,Decile4,Decile7,Decile8, and Decile9 are indicator variables set to one if the firm is in the corresponding discretionary accrual decile. The intercept reflects the mean BHAR for firms in the middle discretionary accrual quintile (deciles 5 and 6). All Observations 0.000 (0.02) 0.013 (0.76) -0.002 (-0.13) 0.020 (1.21) -0.003 (-0.2) 0.000 (-0.02) -0.005 (-0.29) -0.029* (-1.71) --0.085*** (-5.1) Least Trimmed Squares (1%) -0.020*** (-3.06) -0.075*** (-6.46) --0.019* (-1.65) 0.008 (0.72) -0.010 (-0.9) -0.004 (-0.38) -0.010 (-0.88) -0.043*** (-3.74) -0.098*** (-8.49) Belsley,Kuh, and Welsch [1980] -0.025*** (-4.16) --0.091*** (-8.73) -0.030*** (-2.88) -0.003 (-0.32) -0.023** (-2.21) -0.015 (-1.45) -0.032*** (-3.09) -0.062*** (-6.01) --0.133*** (-12.85)
Description Intercept (middle quintile) Low Decile2 Decile3 Decile4 Decile7 Decile8 Decile9 High
0.006 0.011 0.002 Adj. R2 No. of obs. 20,799 20,591 20,118 denote significance at the 10%,5%,and 1%levels,respectively (one-tailed test). *, **,and ***
of totals accruals that is driving Sloan's [1996] accrual anomaly. Thus, Xie's [2001] hypothesis is also rooted in functional fixation. Table 5 reports the results of tests similar to those in table 3 except that portfolios are constructed on the basis of abnormal (discretionary) accruals.
330
When all observations are included (see column 1), the coefficient on Low is not significantly different from zero, while the coefficient on High is significantly negative (-0.085, p < 0.01). These results are very similar to those estimated using total accruals (see table 3) in that virtually all of the significant BHARs are earned in the High accrual decile. However, as is the case in table 3, applying the LTS robust estimation methodology and eliminating 1% of the sample again yields very different results. The coefficient on Low becomes significantly negative, -0.075 (p < 0.01), while the coefficient on High remains significantly negative (-0.098) (p < 0.01). Applying the Belsley, Kuh, and Welsch [1980] regression diagnostic procedures yields similar results, as both Lowand High are significantly negative (-0.091 and -0.133, respectively, see column 3). This U-shaped relation, as that observed for total accruals in table 3, is inconsistent with the earnings fixation hypothesis proposed by Xie [2001].
5.6 NET OPERATING ANOMALY
Based on a "limited attention hypothesis," Hirshleifer et al. [2004] predict the sign on Low should be positive and the sign on High should be negative when these deciles are formed on the basis of NOA. As for the total accrual and abnormal (discretionary) accrual anomaly above, we also perform tests of robustness on the NOA anomaly. Table 6 reports the results of estimating model (1), where the partitioning variable is NOA. When we analyze all observations (see column 1, the coefficient on Lowis positive, but not significantly different from zero while the coefficient on High is significantly negative (-0.075, p < 0.01). When we re-estimate the model under the LTS robust estimation procedure (see column 2), the coefficients on Low and High are both significant and negative. Similar results are observed when we use the Belsley, Kuh, and Welsch [1980] procedure. Collectively, the results in table 6 indicate that, for 99% of the firms in the sample, there is an inverted U-shaped relation between BHAR and NOA. This is inconsistent with the limited attention theory proposed by Hirshleifer et al. [2004], which predicts that the low NOA decile should earn positive abnormal returns.
6. Summary
A number of studies propose and test theories about the market pricing of accruals and components of accruals (e.g., Sloan [1996], Xie [2001], and Hirshleifer et al. [2004]). Sloan [1996] posits that investors naively fixate on earnings and overweight the accrual component of current earnings when forecasting future earnings. Under this earnings fixation version of the traditional functional fixation hypothesis, investors are surprised when these accruals reverse in subsequent periods and abnormal returns reflect the corresponding price adjustment. Xie [2001] follows a similar structure to that of Sloan [1996] except that total accruals are broken down into discretionary and nondiscretionary components.
MISPRICING OF ACCRUALS TABLE 6
331
Returnsand Net Operating Assets Analysisof theRelationbetween Buy-and-Hold with and withoutTruncation = cal+ l Lowit + f2Decile2it+ fsDecile3it + /4Decile4it Model: BHARit+I + ,sDecile7it + f6Decile8it + fl7Decile9it + fsHigh + eit The results reported in the table are based on a sample of 18,953 firm-yearobservations for the 1987-1999 period. This consists of sample 5 from panel B, table 2, minus 1,899 observations that did not have sufficient data to compute Net Operating Assets (NOA). The sample includes all firms identified by the Center for Research in Security Pricing's (CRSP) exchange code as trading on the New York Stock Exchange or American Stock Exchange. If, during the return accumulation period, a return is missing because there is no price information on CRSP (which is coded as ".B"in the SAS CRSP datasets on the Wharton Research Data Service), the return is set to zero. Firms with missing accounting data in t+1 are included. NOA is [(total assets cash) - (total assets - short-term debt - long-term debt - minority interest - preferred stock common equity)] /beginning total assets [Compustat (#6 - #1 - (#6 - #9 - #34 - #38 - #130 #60)) /#6]. The buy-and-hold-abnormal return (BHAR) is computed by subtracting the mean buy-and-hold size-matched portfolio return from the firm's raw buy-and-hold return. The return accumulation period begins four months after the fiscal year-end and continues for 12 months. The indicator variable Lowitis set to one if the firm is in the lowest NOA decile and zero otherwise. The indicator variable Highitis set to one if the firm is in the highest NOA decile and zero otherwise. Decile2,Decile3,Decile4,Decile7, Decile8, and Decile9 are indicator variables set to one if the firm is in the corresponding NOA decile. The intercept reflects the mean BHAR for firms in the middle NOA quintile (deciles 5 and 6). All Observations -0.006 (-0.56) 0.025 (1.38) 0.029 (1.6) 0.019 (1.08) 0.032* (1.78) 0.009 (0.52) -0.023 (-1.27) --0.037** (- 2.09) -0.075*** (-4.17) 0.002 18,953 Least Trimmed Squares (1%) -0.028*** (-3.95) -0.057*** (-4.64) -0.019 (-1.57) 0.007 (0.56) 0.030** (2.43) -0.005 (-0.43) -0.013 (-1.09) --0.044*** (- 3.55) -0.075*** (-6.14) 0.004 18,764 Belsley, Kuh, and Welsch [1980] -0.034*** (-5.44) --0.078*** (-6.96) --0.033*** (-2.96) -0.009 (-0.79) 0.005 (0.49) -0.014 (-1.26) -0.025** (-2.32) --0.055*** (-4.99) --0.097*** (-8.77) 0.007 18,361
Description Intercept (middle Quintile) Low Decile2 Decile3 Decile4 Decile7 Decile8 Decile9 High Adj. R2 No. of obs.
*, **, and ***denote significance at the 10%, 5%, and 1% levels, respectively (one-tailed test).
Our study highlights the importance of robustness tests to studies of the mispricing of accruals. Researchers hypothesizing a causal economic or behavioral explanation for mispricing should report the sensitivity of their results to standard robustness tests (as do almost all other accounting capital
332
market studies). While we only study the impact of robustness tests on tests of accrual-related anomalies, our study has implications for other studies testing a theory about the relation between accounting information and stock returns. It is advisable for such studies to perform robustness tests to see if a small number of firm-year observations are driving the results. We find that performing robustness tests that exclude a small number of firm-year observations (approximately 200 firm-year observations or about 1% of the entire sample) reveals an inverted U-shaped relation between BHAR and total accruals. An inverted U-shaped relation is inconsistent with the functional fixation (earnings fixation) hypothesis underlying Sloan's [1996] results and the results of other accrual anomaly-related studies as well. Interestingly, the same firm-year observations that the robustness tests identify as driving the total accrual anomaly of Sloan [1996] also serve to explain the abnormal accrual anomaly of Xie [2001] and the NOA anomaly of Hirshleifer et al. [2004]. Moreover, the exclusion of these firm-year observations reveals an inverted U-shaped relation between BHAR and abnormal accruals and between BHAR and NOA. Such evidence leads us to conclude the accrual-related anomalies documented in these three studies are unlikely due to investors' inability to process accounting information, as suggested by the functional fixation hypotheses tested in these papers. An important aspect of our results is that they illustrate how easy it is for researchers to generate "false positives" for hypotheses related to market mispricing when they are not sensitive to issues related to robustness tests and selection biases. On this dimension, our findings are consistent with a common concern about evidence on market inefficiency, namely the notion of arbitrage profits versus paper profits. While our primary focus is the importance of performing robustness tests when researchers hypothesize a causal economic or behavioral explanation for mispricing (e.g., functional fixation), we also identified and quantified the impact of three sample selection decisions that introduce ex post information, and, in the process, impart bias into the BHAR used in tests of the market pricing of accounting numbers.
APPENDIX Detailed Characteristics ReturnPerformance Ending Up in theLow or Hig ofFirmswithExtreme
Of the 55 (27) extreme firm-year observations ending in the low (high) accrual decile, 29 (17) occur bet analysis of these 44 firm-year observations because financial statement data are easily obtainable from
Citp
Accrual Decile 1 1 1 1
Company Name Britesmile Inc. Tyler Technologies Inc. America Online Inc. Learning Company Inc.
Compustat "GVKEY' 21673 10789 25056 7345
Year 1997 1996 1997 1996
Major Source of Accruals Primarily due to asset impairment charge. Big charges for impairment and discontinued operations. Write-off of deferred subscriber acquisition costs (60% of total accruals). Company had a large merger-related charge that showed up as amortization. Unlikely to be amortization because it almost exceeds total assets. Large goodwill write-off. Company emerged in 1997 as the result of a number of mergers under pooling of interest. No company information in 1996 is available. Accruals mainly from reductions in working capital (decrease in inventory and increase in A/P). Had been funding operations from 1996 IPO. Poor performance and a large write-down. Odd charge, "capital expenditures," charged to income. Discovered new oil reserves in t+1. Large asset write-down, $328,630.
Market Value of Equity (Millions) 42.9 54.6 4,729.2 574.8
1 I
Unilab Corp. VSI Holdings Inc.
14652 2028
1996 1996
96.5 0.0
Pacific Research and Engineering Corp.
63073
1998
7.8
1 1 1
Storage Computer Corp. Goodrich Petroleum Corp. Triton Energy Ltd.
31591 8387 10743
1998 1998 1998
67.7 44.4 1,064.5
A P P E N D IX -
Continued
Accrual Decile 1 1 1 1 1
Company Name Franklin Electronic Publish Signal Technology Corp. Hanover Direct Inc. Cypress Semiconductor Corp. Arch Coal Inc.
Compustat Major Source of Accruals "GVKEY"' Year 1998 Big inventory write-down and other charge 12472 in funds other. 1998 Big drop in inventory, sales, and income. 28337 5711 12215 14793 1996 1998 1999 Company implemented a turnaround program and started earning profits. Big restructuring charge.
Market Value of Equity (Millions) 91.8 37.2 145.3 736.1 678.6
(S
A -
Best Buy Co Inc.
2184
1 1
KCS Energy Inc. Smith Corona Corp.
14633 15761
Chesapeake Energy Corp.
27786
Large impairment charge, which went to funds other. The big news for the company wasjust the coal market. 1997 Very good performance. Large increase in A/P was the source of cash (income-decreasing accrual $239,285), which was coupled with a decline in inventory. Good working-capital management. It appears 1997 results were restated. 1999 Depreciation was the big charge. Firm had large write-down in the previous year. 1995 Emerged from bankruptcy and going concern lifted in 1997. Error in the calculation of BHAR. 1995 A/P and depreciation were big items. (Based on 1996 filing.)
403.1
88.3 139.9
41.5
Tele-touch Communications Inc. Musiciand Stores Corp.
31234
1998
Big items were depreciation and a noncash interest expense. Company had large impairment charge and restructuring charge for store closings. Company in financial distress (going concern opinion, debt covenant waivers). Large decline in accounts receivable and inventory. Inventory decline due to lack of cash to buy inventory and fill new orders. This also impacted A/R. Decreasing accruals also arose from loss on disposal of division. This is a premerger period and data are unavailable. Development State Company, and in financial distress (going concern opinion). Acquired R&D firm and wrote off in-process R&D acquired in the acquisition. Primarily from disposal of assets. Disposal of unit was above the line. Largely from loss in unconsolidated subsidiary. Based on 1996 financial statements. Large impairment charge, $139,805. No individual item. Fairly large declines in inventory and A/R. Loss on disposal of asset (which was reversed in 1996). The firm did not have a going concern opinion, but the auditor warned the firm needed to sell an operation in order to make an upcominfg sinking fund payment.
19.9
13031
1996
144.1
Stevens Intl. Inc. - Ser A Comn
13699
1996
14.1
1 1
America Online Sheffield Pharmaceuticals, Inc.
25056 26747
1998 1997
5,318.1 16.47
1 1
Intertan Inc. Converse Inc.
13067 31636
1998 1995
42.2 198.3
1 1 1
Davita Inc. NTN Communications Inc. Waxman Industries
61483 21232 11318
1999 1998 1995
2,369.2 22.7 24.8
A P P E N D IX -
Continued
Accrual Decile 10 10 10 10 10
Company Name Dataram Corp. Keithley Instr Inc. Skechers USA Inc. Shaw Group Inc. Media-bay Inc.
10 10 10 10 10 10
BARR Laboratories RJ Reynolds Tobacco Holdings Applera Corp. Applied Biosystems Titan Pharmaceuticals Inc. Advanced Photonix Inc. Sonic Foundry Inc.
Compustat "GVKEY' Year Major Source of Accruals 3785 1998 Essentially from increase in A/R. 6370 1999 Gain on sale of business which caused a big accrual. Big sales increase in t+1. 1999 Large growth and increase in A/R and 121142 inventory. 1998 Big increase in A/R from increased sales. 29353 1997 Company had an IPO this year (October 65670 23, 1997). Proceeds used for working capital (inventory). 13365 1999 Large drop in income taxes payable and accounts payable. 1999 Due to income/gain from discontinued 120877 operations 8488 1999 Discontinued operations treated wrong by Compustat. 61836 1998 No revenue, losing money and burning cash. 1998 A/R and inventory growth. 23616 109186 1998 Losing money and an increase in inventory.
Market Value of Equity (Millions) 35.3 39.5 0.0 251.5 0.0
A (S
900.57 1,912.22 3,019.8 73.1 12.9 0.0
10
Commodore Applied Tech. Inc.
63188
1998
10 10
VICON Industries ICN Pharmaceuticals Inc. Westmoreland Coal Co.
9340
1996
10
11440
1999
10 10
1999 A tracking stock (part of Circuit City) so 101.7 details are unavailable. Abbreviations: A/P, accounts payable; A/R, accounts receivable; IPO, initial public offering; R&D, research and d
Centennial Technologies Inc. Car-max
30031 64410
1995
Most came from gain on early retirement of debt and gain on sale of assets. A going concern opinion was lifted the following year, but from a new (smaller) auditor. Large build up in finished goods inventory. Huge A/R increase. Issues related to foreign currency exposure discussed in audit opinion. Company received a cash distribution from independent power projects which were added to income to get to cash from operations (not a real accrual). InventoryandA/R80% of assets.
65.5
589.5
26.6
11.6
338

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Accounting Research Center, Booth School of Business, University of Chicago

Stable URL: http://www.jstor.org/stable/3542443 . Accessed: 10/01/2014 05:20

Received26 March2004;accepted24 August2005

School of Business at the University of Rochester.

A. KRAFT, A.J. LEONE, ANDC. WASLEY

be due to investors' inabilityto processaccountinginformation,as suggested by the functionalfixationhypothesestested.

A. KRAFT, A. J. LEONE, AND C. WASLEY

A. KRAFT, A. J. LEONE,AND C. WASLEY

MISPRICING OF ACCRUALS New York Stock Exchange/American Stock Exchange (NYSE/AMEX)

A. KRAFT, A. J. LEONE,AND C. WASLEY

2. Issues Related to TestingHypothesesAbout the Mispricing

A. KRAFTI, A. J. LEONE,AND C. WASLEY

Lowit + /2Decile2it + f3DecileSit + /4Decile4it

A. KRAFT, A. J. LEONE,AND C. WASLEY

3. Data and SampleSelection

A. KRAFT, A. J. LEONE,AND C. WASLEY

4. Sources Bias of SampleSelection

A. KRAFT, A.J. LEONE, AND C. WASLEY

A. KRAFT, A. J. LEONE,AND C. WASLEY

Sample 3 (47,780) 3.03%** (4,778) -0.03% (9,585) -7.81%*** (4,782)

10.29%*** (1,884) 1.36%** (3,781) -2.35% (1,884)

8.39%*** (1,630) 0.80% (3,275) -3.37%** (1,630)

4.22%* (1,956) -1.14%* (3,926) -7.93%*** (1,956)

A. KRAFT, A.J. LEONE,AND C. WASLEY

Tests Resultsof Robustness 5. Empirical Anomalies24 ofAccrual-Related

5.0% 4.0% 3.0% 2.0%1.0%

Summary Statistics of the BHAR Distributions

Middle -0.12% 42.77% -3.01% 54.97% 17 -1.40% 37.45%

High -7.85% 65.18% -17.81% 66.33% 22 -11.68% 49.98%

A. KRAFT, A. J. LEONE, AND C. WASLEY

Observations -0.001 (-0.13) 0.020 (1.17) 0.051"**

Squares (1%) -0.014** (-2.17) -0.088*** (-7.54) -0.004

[1980] -0.018** (-3.09) -0.102*** (-9.75) -0.016

A. KRAFT, A. J. LEONE,AND C. WASLEY

-4.00% -6.00% -8.00% -10.00% Accruals

----All Firm Years

A. KRAFT, A. J. LEONE, AND C. WASLEY

93.5% 321.0% 244.7%

All Low accrual decile High accrual decile

26.3% 26.2% 28.8%

7.44% 6.43% 8.98%

326.9% 382.2% 292.2%

92.56% 93.57% 91.02%

A. KRAFT, A. J. LEONE,AND C. WASLEY

A. KRAFT, A. J. LEONE, AND C. WASLEY

MISPRICING OF ACCRUALS TABLE 6

A. KRAFT, A. J. LEONE,AND C. WASLEY

APPENDIX Detailed Characteristics ReturnPerformance Ending Up in theLow or Hig ofFirmswithExtreme

Compustat "GVKEY' 21673 10789 25056 7345

Year 1997 1996 1997 1996

Market Value of Equity (Millions) 42.9 54.6 4,729.2 574.8

Unilab Corp. VSI Holdings Inc.

Pacific Research and Engineering Corp.

Storage Computer Corp. Goodrich Petroleum Corp. Triton Energy Ltd.

31591 8387 10743

1998 1998 1998

67.7 44.4 1,064.5

Market Value of Equity (Millions) 91.8 37.2 145.3 736.1 678.6

Best Buy Co Inc.

KCS Energy Inc. Smith Corona Corp.

Chesapeake Energy Corp.

Tele-touch Communications Inc. Musiciand Stores Corp.

Stevens Intl. Inc. - Ser A Comn

America Online Sheffield Pharmaceuticals, Inc.

The Accrual Anomaly & The Company Size

The Accrual Anomaly & The Company Size

Sample 3 (47,780) 3.03% (4,778) -0.03% (9,585) -7.81%* (4,782)

10.29%* (1,884) 1.36% (3,781) -2.35% (1,884)

8.39%* (1,630) 0.80% (3,275) -3.37% (1,630)

Squares (1%) -0.014 (-2.17) -0.088* (-7.54) -0.004

[1980] -0.018 (-3.09) -0.102* (-9.75) -0.016