The accrual anomaly: Why investors should care about accruals & earnings quality

Saturday, Dec 31 2011 by
The accrual anomaly Why investors should care about accruals  earnings quality

One of the most widely studied and persistent stock market inefficiencies ever identified is the "accrual anomaly". It was first documented by Richard Sloan of the University of Michigan in 1996 whose ground-breaking paper found that shares in companies with small or negative accrual ratios vastly outperform (+10% annually) those of companies with large ones

Sloan was apparently involved with auditing speculative mining companies before going into academia, which may have inspired him. In order to test out the longstanding view that investors fixate too heavily on corporate earnings and not on cash generation, he decided to rank companies based on their "accrual ratio" for last year's results, i.e the size of non-cash earnings relative to total assets. He then measured how their shares performed in the year after the results were announced, effectively "going long" the top decile of stocks with the lowest accrual ratio and "going short" the bottom decile with the highest accrual ratio. 

What are Accruals anyway? 

Accruals are estimates made by accountants to align revenues and costs in a specific period. Theoretically, if all buyers and suppliers paid in cash when the services were provided, there would be no need for accrual accounting, but the reality of modern commerce is that, often, there is a mismatch between the timing / amounts of cash payments versus the delivery of services. As a result, a pound of company earnings may be comprised by varying amounts of non-cash earnings. The existence of such items creates a high degree of discretion in company accounts.

Let's imagine that earnings for a company last year were £1000 but the increase in the corporate bank balance, i.e. cash-flow, was £750. That £250 difference derives from a lot of messy accrual adjustments, such as depreciation or changes in receivables. Unusually high accruals due to aggressive accounting will maximize current earnings but by necessity will likely result in lower earnings later (assuming no growth) whereas low accruals due to conservative accounting may minimize current earnings but will result in higher earnings later.

Does Accrual Screening Work?

As already mentioned, Sloan’s work found that companies with low accrual ratios massively outperform companies with high accrual ratios. For the 40-year period between 1962 and 2001, he found that the strategy resulted in an average annual compounded return of almost 18%, more than double the S&P 500’s 7.4% annual return over the…

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8 Comments on this Article show/hide all

nigelpm 31st Dec '11 1 of 8

I just don't get this at all.

It seems to imply that accruals are some "accounting trick".

To give a very simple example.

A business has y/e of 31/12

If a business purchases £10m worth of goods on the 28/12 but hasn't even received the invoice let alone paid for the goods.

You would not expect the results for y/e 31/12 to ignore this and include the £10m in stock without a £10m in accruals. That would clearly be misleading to the investor picking up the accounts.

Timing of accruals are likely to fluctuate wildly anyway.

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Edward Croft 31st Dec '11 2 of 8

In reply to post #63006


I think you may have misunderstood this one. Of course all companies have to accrue some earnings as a matter of daily business - thats the nature of invoicing. The point here is that companies have a fair amount of discretion in when and how they book their sales which can lead to optimistic accounting.

They can offer better credit terms to buyers or aggressively market products with favourable return policies - both are examples of booking higher sales without generating cash, thus creating longer 'accruals' in the accounts - earnings which hopefully will accrue into cash in the future, but which may have to be written off if they are found to be over optimistic.

Effectively high accruals may indicate a form of earnings massaging, and at its worst, a form of earnings manipulation. The anomaly discussed above indicates that companies with high accruals don't perform as well as companies with low accruals. So you should try to weed out high accrual companies from your portfolio unless there are extenuating circumstances.

Of course many rapidly growing companies do have high accruals as a matter of course, but management in those cases do tend to become under pressure to keep up appearances which can lead to issues later. We've seen plenty of growth companies like that in recent years on the UK market, and there are certainly a lot of Chinese companies on AIM that suffer from very high accruals.

The Beneish M Score is one meter that we've created in Stockopedia Premium which highlights earnings manipulation on a company by company basis, and is useful additional tool to the accruals screen in the investor armoury. Its best to defend oneself against bad management as much as possible in times like these!

Happy New Year!

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emptyend 31st Dec '11 3 of 8

In reply to post #63007

Very good and timely article/topic, given the macro-economic backdrop.

I might also add ( from my own first/second-hand observations  in banks) that accruals offer staff lots of opportunities to game both the accounting system and the bonus system (thus getting paid in cash for accruals that never actually turn into cash). For example:

Jett had discovered a glitch in Kidder's computer system; it would record profits on a forward reconstitution daily, even if the trades would be worthless upon settlement.

Kidder, Peabody & Co.'s system was designed to tally profits while allowing time for trades to settle. By moving his trades forward again and again, Joseph Jett was able to keep profits building while delaying the final transaction that would necessarily cause a loss equal to the false profits.


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nigelpm 31st Dec '11 4 of 8

In reply to post #63007

Thanks for the clarification Ed.

They can offer better credit terms to buyers or aggressively market products with favourable return policies - both are examples of booking higher sales without generating cash, thus creating longer 'accruals' in the accounts - earnings which hopefully will accrue into cash in the future, but which may have to be written off if they are found to be over optimistic.

I'd argue that Auditors would (or perhaps should) pick up the anomolies. Certainly when I've been involved in auditing accruals - it's not just as simple as obtaining management's number and ticking it off.

There needs to be a clearly measurable obligation.

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LongbeardRanger 31st Dec '11 5 of 8

I think this is an excellent article, and highlights an important point: earnings that are not backed up by cash flows are to be treated with suspicion. There may, of course, be perfectly good reasons for divergence between reported earnings and cash flows, but at the least one needs to understand, where this is the case, the reasons behind the divergence.

One significant strand that is not really picked up on in the article (though it may be in the supporting academic studies) but which is, I think, suggested in emptyend's post, is that certain industries and sectors give rise to much more accruals accounting (and consequently greater possibilities for manipulation) than others. Trading companies cannot be too aggressive for long periods with their accruals, but in the financial sector - notably in banking and insurance - earnings, assets and liabilities are largely accruals-based estimates. It follows that misstatements (usually overstatements ;-)) can persist for many years before coming to light.

Insurance companies, for example, generally receive a premium up front (in cash) and at the same time incur the liability to pay out an uncertain amount under that premium for a period of many years, with no certainty as to when the payout will occur (if ever). They still, however, book the profit at the end of year one - based on an estimate of likely future payouts (in practice based upon a class of business rather than on a premium by premium basis).

Clearly therefore, understatement or mis-estimation of claims payable, resulting in under reserving, will overstate current year profits and require destructive reversal in future years, as the true extent of claims comes to light. In the meantime, required regulatory capital will have been underestimated and excess capital will have been allocated to business lines that were thought more profitable than they were in reality.

For this reason it's essential to look at the history of reserves development when considering which insurance companies are investible and which aren't. Frequent or large upward revisions of reserves is a big red flag, whereas reserve releases suggest a prudent management and reserving culture.

Much of the above applies to banks as well, and I am more convinced than ever that prudent, cautious and trustworthy management is the sine qua non of investing in the financial sector. Which presents a bit of a conundrum ;-)

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emptyend 31st Dec '11 6 of 8

In reply to post #63011

I am more convinced than ever that prudent, cautious and trustworthy management is the sine qua non of investing in the financial sector. Which presents a bit of a conundrum ;-)

Well yes. However I would say that finding trustworthy management (paradoxically) isn't really a serious problem......the problem is that the charactistic of trustworthiness is completely subverted by the pyramid nature of the bonus system that inevitably also trumps prudence and caution! That was without doubt the situation at Kidder, where virtually every line manager's bonus (right to the top) depended on the fictitious "profits" being accrued by Jett's operation.

The trick with managing these things is to have the drains up in ANY fast-growing business segment before it becomes so big it subverts line management controls. If it makes real profits and produces real cash then that is great - but not as many pass that test as management would hope.

(former manager of a business area that actually did produce cash fees, but who could never get management to accord a premium valuation to its profits when comparing them to risk businesses)

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Kai Petainen 3rd Jan '12 7 of 8


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