The Genesis of the Accrual Anomaly: Sloan's 1996 Study
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Introduction: The Dichotomy of Earnings
In the world of financial statement analysis, a firm's reported earnings number is often the headline figure, the primary measure of performance. However, not all earnings are created equal. The distinction between the two core components of earnings—the cash flow component and the accrual component—is a foundational concept in modern finance. This distinction lies at the heart of one of the most persistent and widely studied market anomalies: the accrual anomaly. The seminal 1996 paper by Richard G. Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?", ignited a decades-long conversation among academics and practitioners about whether investors systematically misprice the information contained within accruals.
At its core, the difference between net income and cash flow from operations stems from the principles of accrual accounting. Unlike cash basis accounting, which recognizes revenues and expenses only when cash is exchanged, accrual accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of the timing of the associated cash flows. This process necessitates the use of accruals, which are accounting adjustments for revenues and expenses that have been recognized but for which cash has not yet been received or paid. While accrual accounting provides a more accurate picture of a company's economic performance over a period, it also introduces a level of subjectivity and estimation that can be exploited or misunderstood.
Sloan's Groundbreaking Discovery
Sloan's 1996 study was groundbreaking in its systematic documentation of the market's apparent inability to distinguish the persistence of the cash flow component of earnings from the accrual component. The central thesis of his research was that earnings generated from the cash flow component are more persistent than earnings generated from the accrual component. In other words, a dollar of earnings backed by a dollar of cash is more likely to recur in the future than a dollar of earnings generated through accounting adjustments.
Sloan hypothesized that if investors were rational and efficient, they would recognize this differential persistence and price stocks accordingly. However, his empirical evidence suggested otherwise. He found that companies with a high proportion of accruals in their earnings tended to have their stock prices bid up, as if investors were naively extrapolating the accrual-heavy earnings into the future. Conversely, companies with a low proportion of accruals (and thus a higher proportion of cash flow) in their earnings saw their stock prices languish. The subsequent reality, however, was a stark reversal. The high-accrual firms experienced lower future returns as their less-persistent earnings failed to meet the market's lofty expectations. The low-accrual firms, on the other hand, generated superior returns as their more-persistent cash-flow-driven earnings surprised to the upside.
This systematic mispricing gave rise to a simple yet effective trading strategy: go long on firms with low accruals and short on firms with high accruals. Sloan's research showed that this strategy generated significant abnormal returns, a finding that has been subjected to intense scrutiny and has largely held up across different time periods and international markets.
Calculating the Accrual Component
To implement a strategy based on the accrual anomaly, one must first calculate the accrual component of earnings. Sloan proposed a straightforward method using data readily available from a company's balance sheet. The formula is as follows:
Total Accruals = (ΔCA - ΔCash) - (ΔCL - ΔSTD - ΔTP) - Dep
Total Accruals = (ΔCA - ΔCash) - (ΔCL - ΔSTD - ΔTP) - Dep
Where:
- ΔCA = Change in Current Assets
- ΔCash = Change in Cash and Cash Equivalents
- ΔCL = Change in Current Liabilities
- ΔSTD = Change in Short-Term Debt included in Current Liabilities
- ΔTP = Change in Taxes Payable included in Current Liabilities
- Dep = Depreciation and Amortization Expense
This formula essentially captures the change in non-cash working capital, which is the primary source of short-term accruals. A positive value for Total Accruals indicates that earnings are higher than cash flow from operations, while a negative value indicates that earnings are lower than cash flow from operations.
A Tale of Two Companies: A Hypothetical Example
To illustrate the concept, let's consider two hypothetical companies, "CashFlow Corp." and "Accrual Inc." Both companies report the same net income of $1 million for the year. However, a closer look at their financial statements reveals a very different story.
| Metric | CashFlow Corp. | Accrual Inc. |
|---|---|---|
| Net Income | $1,000,000 | $1,000,000 |
| Cash Flow from Operations | $900,000 | $200,000 |
| Total Accruals | $100,000 | $800,000 |
| Accruals as % of Net Income | 10% | 80% |
In this simplified example, CashFlow Corp. generates the vast majority of its earnings from its core operations, with only a small portion coming from accruals. Accrual Inc., on the other hand, relies heavily on accounting adjustments to generate its reported earnings. According to the accrual anomaly, an investor should favor CashFlow Corp. over Accrual Inc., as the former's earnings are of a "higher quality" and are more likely to persist into the future.
Actionable Example for Traders
A professional trader could implement a strategy based on the accrual anomaly by following these steps:
- Define the Universe: Start with a broad universe of stocks, such as the S&P 500 or the Russell 3000.
- Calculate Accruals: For each company in the universe, calculate Total Accruals using the balance sheet method described above. To make the measure comparable across firms of different sizes, it is common to scale Total Accruals by average total assets.
- Rank and Decile: Rank all the companies in the universe based on their scaled Total Accruals, from lowest to highest. Divide the ranked list into deciles.
- Construct the Portfolio: Go long on the stocks in the bottom decile (the 10% of companies with the lowest accruals) and short the stocks in the top decile (the 10% of companies with the highest accruals).
- Rebalance: Rebalance the portfolio on a periodic basis, typically annually, to capture the latest financial data.
This long-short strategy aims to profit from the systematic mispricing of accruals. The long portfolio is expected to generate positive abnormal returns as the market eventually recognizes the persistence of their cash-flow-driven earnings. The short portfolio is expected to generate negative returns (and thus a profit for the short-seller) as the market is disappointed by the low persistence of their accrual-heavy earnings.
Conclusion
Sloan's 1996 study was a watershed moment in the history of quantitative finance. It provided compelling evidence that investors, on average, fail to fully appreciate the information contained in the accrual component of earnings. This "earnings fixation" leads to a predictable pattern of over-and under-reaction, creating a fertile ground for systematic trading strategies. While the anomaly has evolved over time and has been the subject of much debate, its core insight remains as relevant as ever: not all earnings are created equal, and the distinction between cash and accruals is a important one for any serious financial analyst or trader.
References
[1] Sloan, R. (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? The Accounting Review, 71(3), 289–315. http://www.jstor.org/stable/248290