The Long and Short of the Accrual Anomaly

Abstract

The paper provides evidence that the relation between accruals and future returns is not symmetric. We find that firms with low accruals generate insignificant abnormal returns in asset pricing regressions that control for either earnings quality or operating volatility. In contrast, we find that accrual hedge returns are driven by firms with large positive accruals and firms with high probabilities of earnings overstatement. This asymmetry is consistent with our view that upwards rather than downwards earnings management is an important contributor to accrual mispricing. We also find that firms with high accruals are smaller and have higher arbitrage risk (residual return volatility), suggesting that short sellers are unlikely to arbitrage away these negative abnormal returns. We conclude that an omitted risk factor explains results for low accruals and that transaction costs/limits to arbitrage explain the persistence of mispricing for high accruals.

Keywords: Accrual Mispricing, Asymmetry, Risk, Earnings Management, Asset pricing

JEL Classification: G12, G14, M41, M43, G11