Decomposing Accruals: A More Granular Approach to the Anomaly
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Introduction: Beyond the Aggregate Number
Previous articles have established the accrual anomaly as a robust and persistent feature of financial markets, driven by the differential persistence of cash flows and accruals. However, treating accruals as a single, monolithic number can obscure important details. The aggregate accrual figure is a composite of many individual accounting adjustments, each with its own characteristics and implications for future earnings. By decomposing total accruals into their constituent parts, we can gain a more granular and nuanced understanding of the anomaly.
This article will explore the benefits of disaggregating accruals, focusing on the two primary components: working capital accruals and long-term accruals. We will examine the different economic drivers of these components and discuss how their individual persistence and mispricing contribute to the overall accrual anomaly. This deeper level of analysis can lead to more refined trading strategies and a more sophisticated understanding of earnings quality.
The Balance Sheet Approach to Decomposition
One of the most common methods for decomposing accruals is the balance sheet approach, which separates accruals into those related to changes in working capital and those related to long-term assets and liabilities. The formulas for this decomposition are as follows:
Working Capital Accruals = ΔAR + ΔINV - ΔAP - ΔTP
Working Capital Accruals = ΔAR + ΔINV - ΔAP - ΔTP
Long-Term Accruals = Total Accruals - Working Capital Accruals
Long-Term Accruals = Total Accruals - Working Capital Accruals
Where:
- ΔAR = Change in Accounts Receivable
- ΔINV = Change in Inventory
- ΔAP = Change in Accounts Payable
- ΔTP = Change in Taxes Payable
Working capital accruals are generally considered to be more transient and more susceptible to managerial manipulation than long-term accruals. This is because they are more closely tied to the day-to-day operations of the business and are subject to a greater degree of estimation and judgment. Long-term accruals, on the other hand, are often related to major investment and financing decisions and are therefore more likely to be driven by long-term economic fundamentals.
The Differential Persistence of Accrual Components
Just as cash flows are more persistent than aggregate accruals, the components of accruals themselves exhibit differential persistence. A number of studies have shown that working capital accruals are significantly less persistent than long-term accruals. This is because working capital accruals are more likely to be self-reversing. For example, a large increase in inventory in one period is likely to be followed by a period of slower inventory growth or even a decline as the inventory is sold.
The table below presents a hypothetical regression analysis that examines the persistence of working capital accruals and long-term accruals. The results are consistent with the findings of numerous academic studies.
| Variable | Coefficient (β) | Standard Error | t-statistic | p-value |
|---|---|---|---|---|
| Model: Decomposed Accruals | ||||
| Intercept (α) | 0.01 | 0.007 | 1.43 | 0.153 |
| CFO_t | 0.89 | 0.04 | 22.25 | <0.001 |
| Working Capital Accruals_t | 0.55 | 0.06 | 9.17 | <0.001 |
| Long-Term Accruals_t | 0.72 | 0.05 | 14.40 | <0.001 |
As the table shows, the persistence of working capital accruals (0.55) is significantly lower than the persistence of long-term accruals (0.72). This suggests that the market's mispricing of accruals may be driven more by the working capital component than the long-term component. Investors who are able to distinguish between these two components can gain a significant analytical edge.
Actionable Example for Traders
A trader can use the decomposition of accruals to refine the basic accrual anomaly trading strategy. Instead of simply ranking firms based on total accruals, the trader can rank them based on working capital accruals. This is likely to be a more effective signal of future returns, as it isolates the most transient and mispriced component of earnings.
The steps for this refined strategy are as follows:
- Define the Universe: Start with a broad universe of stocks.
- Calculate Accrual Components: For each company, calculate working capital accruals and long-term accruals using the balance sheet method.
- Rank and Decile: Rank all the companies based on their scaled working capital accruals.
- Construct the Portfolio: Go long on the stocks in the bottom decile (lowest working capital accruals) and short the stocks in the top decile (highest working capital accruals).
- Rebalance: Rebalance the portfolio annually.
This strategy is likely to generate higher risk-adjusted returns than a strategy based on total accruals, as it is more precisely targeting the source of the mispricing.
Conclusion
Decomposing accruals into their working capital and long-term components provides a more granular and effective way to analyze earnings quality and to exploit the accrual anomaly. Working capital accruals are less persistent and more susceptible to manipulation than long-term accruals, and as a result, they are a stronger predictor of future returns. By focusing on this more transient component of earnings, traders can develop more refined and profitable trading strategies. The decomposition of accruals is a effective reminder that in the world of financial analysis, the devil is often in the details.
References
[1] Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, I. (2005). Accrual Reliability, Earnings Persistence and Stock Prices. Journal of Accounting and Economics, 39(3), 437–485. https://doi.org/10.1016/j.jacceco.2005.04.001 [2] Lewellen, J., & Resutek, R. J. (2019). Why Do Financial Markets Reward Accruals? Journal of Accounting and Economics, 67(2-3), 426-446. https://doi.org/10.1016/j.jacceco.2018.12.003