Quarterly Cash Flows and Accruals: Implications for Future ...
Quarterly Cash Flows, Accruals and Future Returns
Joshua Livnat
Professor of Accounting
Department of Accounting
Stern School of Business Administration
New York University
311 Tisch Hall
40 W. 4th St.
New York City, NY 10012
(212) 998–0022
jlivnat@stern.nyu.edu
and
Massimo Santicchia
Director
Standard & Poor’s Investment Services
55 Water St.
NYC, NY 10041
(212) 438 3934
massimo_santicchia@
First Draft: December 2004
Current Draft: December 6, 2005
The authors gratefully acknowledge the preliminary and original Compustat quarterly data provided by Charter Oak Investment Systems Inc. and the SEC filing dates provided by Compustat. The authors also thank Chiara Szczesny for copy editing. This research project is an outcome of work done by the S&P Equity Research Group.
Quarterly Cash Flows, Accruals and Future Returns
Abstract
This study shows that the famous accruals anomaly is also present in quarterly earnings and accruals. Specifically, future quarterly earnings are more highly associated with current net operating cash flows than with accruals, because accruals have lower persistence than net operating cash flows. Consequently, firms with extremely high (low) current quarterly accruals have significant and negative (positive) abnormal returns through the subsequent four quarters. A hedge portfolio that combines short positions in firms with extremely high quarterly accruals and long positions in firms with extremely low quarterly accruals is shown to generate consistently positive and economically significant returns for the 53 quarters in the study. The study is different from prior studies in that it uses the originally reported, or un-restated, quarterly data to calculate accruals and SEC filing dates to identify the precise day on which investors first obtain information about accruals.
Quarterly Cash Flows, Accruals and Future Returns
In a rigorous study, Sloan (1996) documents that net operating cash flow is more closely associated with future income and stock returns than accruals; which is the difference between income and net operating cash flows. Sloan attributes this phenomenon to the fact that accruals reverse faster than earnings in subsequent periods and are less persistent than net operating cash flows. Investors who focus on total income and not on operating cash flows tend to overestimate the persistence of accruals and underestimate the persistence of net operating cash flows. A trading strategy that holds long positions in companies with extremely low accruals and short positions in companies with high accruals obtains significant abnormal returns over the subsequent three years. Sloan also shows that a substantial portion of the abnormal returns to the accrual strategy occurs around subsequent quarterly earnings announcement dates, consistent with an initial market mispricing of accruals that is corrected when future quarterly earnings become known. Sloan’s findings have been confirmed by many ensuing studies.
To better understand what accruals are and why they are likely to be less persistent than net operating cash flows, the appendix highlights two specific accrual cases of inventory and accounts receivable. In the first case, management is overly optimistic about future sales, building up excessive inventories that are reduced in future periods. Because the current accounting system treats inventory increases as investments in assets which are not expensed on the income statement, earnings are initially higher but lower in subsequent periods when inventories are drawn down. The first case does not assume any sinister managerial motives; it is based on the reasonable assumption that some managers may at times be too optimistic about future demand leading to excess inventories. The second case is based on channel stuffing[1], when a manager inflates current income by booking current sales that are not collected until future periods and that reduce future sales. The accounting system again records the increase in receivables as an investment, and the income statement is based on all sales whether collected during the period or not, leading to higher current income at the expense of lower future income. Of course, managers can also affect current income through mere accounting choices (unlike the channel stuffing described in the second case) such as the selection of aggressive accounting methods and estimates. For example, if bad debt expense in the current period is too low it will likely lead to higher bad debt expense in the future and lower future income.
Whether accruals are actively managed to produce a desired level of current income, or are just due to genuine but erroneous managerial expectations about the future, the current accounting system nevertheless includes accruals in current earnings, which may be less persistent into future earnings. Careful financial statement users such as financial analysts, investors and creditors should closely scrutinize the firm’s quarterly accruals for the possibility of future reversals. However, if a sufficiently large proportion of investors are fixated on earnings, ignoring information in net operating cash flows and accruals, prices may not accurately reflect the economic situation of the firm, leading to a potential mispricing and the accruals anomaly.
The purpose of this study is to investigate whether quarterly accruals exhibit the same pattern as that of annual accruals in prior studies. As the literature review in the next section illustrates, most accruals studies to date focused on annual accruals, which are shown to have lower levels of persistence than net operating cash flows. However, if extreme quarterly accruals contain valuable information about future earnings and stock return reversals, users of financial statements should focus on quarterly cash flows and accruals to obtain an early warning signal that future earnings may reverse. Financial analysts tend to revise earnings forecasts after quarterly earnings are released; therefore, their ability to improve forecasts after a careful consideration of quarterly accruals and cash flows is likely to be extremely important for them. Similarly, investment and credit managers are unlikely to wait around a whole year for the next annual earnings announcement to examine changes in accruals, rebalance their portfolios, or take actions about their outstanding credit positions, if such information is available and is useful on a quarterly basis.
Why then did most previous studies examine annual instead of quarterly accruals? There are two primary reasons for that. First, accruals typically become known to the market when firms file their 10-Q/10-K forms with the SEC, unless they disclose net operating cash flows in their preliminary earnings announcements, which only about 10% do. Unlike preliminary earnings release dates which are available in the Compustat Quarterly database, SEC filing dates are not part of computerized databases used by academics, hence quarterly accruals have not been studied by academics in earlier studies due to the massive necessary hand-collection. Instead, these studies focused on annual accruals, beginning the return accumulation period four months after fiscal year-end, when firms have already filed their 10-K forms with the SEC. The second reason for not studying quarterly accruals is that quarterly accruals and subsequent reversals may be very natural and likely in companies that are subject to seasonality in their operations. It is unclear whether quarterly accruals may exhibit the same pattern as annual accruals if most firms are affected by within-year seasonality in operations.
Our study shows that quarterly net operating cash flows are more persistent than quarterly accruals, and that future quarterly earnings are more strongly associated with current quarter’s net operating cash flows than with current accruals. Furthermore, there is a negative and statistically significant association between current accruals and subsequent abnormal stock returns through all four subsequent quarters. We also show that a hedge portfolio that holds long positions in companies with the most extreme negative accruals and short positions in companies with the most extreme positive accruals yields positive and significant abnormal returns, whether held for one, two, three or even four quarters. These results indicate that analysts, investors and credit managers need to carefully examine net operating cash flows and accruals when interpreting current quarterly earnings.
2. Literature Survey
The accruals anomaly is based on the implicit premise that accruals tend to be less persistent than net operating cash flows because of intentional or unintentional managerial errors in forecasting future demand, events, or cash flows that cause erroneous levels of current accruals. In particular, managers may use positive accruals to elevate earnings when operating cash flows are low and negative accruals that reduce high levels of earnings when operating cash flows are high. Indeed, Sloan (1996) and others document a negative association between net operating cash flows and accruals, as well as higher earnings for companies with higher levels of accruals than those with lower accruals. Xie (2001) and DeFond and Park (2001) provide evidence that the accrual anomaly is driven by the mispricing of abnormal accruals, i.e., those that are subject to managerial discretion. In contrast, Beneish and Vargus (2002) find that the accrual anomaly can mainly be attributed to mispricing of income-increasing accruals, regardless of whether total or discretionary accruals are used. Thomas and Zhang (2002) attribute the accruals anomaly to investors’ failure to correctly understand the role of inventory changes, which is just one although important component of total accruals. Richardson, Sloan, Soliman and Tuna (2004) provide evidence that the accruals anomaly can be attributed to those accounts that have low earnings quality and potentially high managerial discretion.
Several studies attempt to determine whether the accrual anomaly is unique, supplemented, or subsumed by other known anomalies. Collins and Hribar (2000) show that the accruals anomaly is separate from the post-earnings-announcement drift, and that combining both anomalies yields greater abnormal returns than each of them alone. Barth and Hutton (2003) show that the accruals anomaly can be combined with analysts’ earnings revisions to yield greater abnormal returns. Desai, Rajgopal and Venkatachalam (2004) provide evidence that the accruals anomaly is another manifestation of the value-glamour (growth) anomaly. Finally, Fairfield, Whisenant and Yohn (2003) suggest that the accrual anomaly is partially driven by mispricing the implications of growth in net operating assets for future profits and returns.
As for most anomalies, a question remains why the accruals anomaly persists and are not arbitraged away. Collins, Gong and Hribar (2003) provide evidence that firms with a greater proportion of institutional investors, who are supposed to be more sophisticated, are subject to a weaker accruals anomaly. Mashruwala, Rajgopal and Shevlin (2004) show that the annual accruals strategy does not earn positive abnormal returns in all twelve months after portfolio formation, and that it is indeed weaker for companies with lower arbitrage risk. Lev and Nissim (2004) show that firms with extreme accruals have attributes that institutional investors shun. Finally, Kraft, Leone and Wasley (2004) argue that the accruals anomaly is likely driven by relatively few extreme observations and the failure to properly use delisting returns.
Most accrual studies have followed Sloan’s (1996) use of annual cash flows and accruals, which are associated with annual buy and hold returns. There are just a few studies that examine whether the accruals anomaly is present in quarterly data. Collins and Hribar (2000) provide such evidence, but they accumulate returns from the assumed SEC filing date through the subsequent two quarters, and not from the actual date on which investors obtain access to the SEC filings. DeFond and Park (2001) examine whether investors seem to interpret quarterly earnings surprises correctly, depending on abnormal working capital accruals for a sample of observations in the years 1992-1995. They show that abnormal returns for good earnings news firms with income-decreasing accruals during the 80-day period after the preliminary earnings announcement exceed those with income-increasing accruals. However, they essentially assume that the market has the accrual information at the time of the preliminary earnings announcement.[2] Thus, there is very little research into whether quarterly accruals follow the same patterns as those observed for annual accruals. Financial analysts, investors and creditors are likely to be interested in applying the accruals strategy using quarterly data instead of waiting a whole year for the next annual earnings, if quarterly accruals exhibit similar characteristics to annual accruals.
3. Data and Sample
3.1 The Preliminary and Un-restated Compustat Quarterly Data
Data entry into the Compustat databases has been performed in a fairly structured manner over the years. When a firm releases its preliminary earnings announcement, Compustat takes as many line items as possible from the preliminary announcement and enters them into the quarterly database within 2-3 days. The preliminary data in the database are denoted by an update code of 2, until the firm files its Form 10-Q (10-K) with the SEC or releases it to the public, at which point Compustat updates all available information and uses an update code of 3. Unlike the Compustat Annual database, which is maintained as originally reported by the firm (except for restated items), the Compustat Quarterly database is further updated when a firm restates its previously reported quarterly results. For example, if a firm engages in mergers, acquisitions, or divestitures at a particular quarter and restates previously reported quarterly data to reflect these events, Compustat inserts the restated data into the database instead of the previously reported numbers. Similarly, when the annual audit is performed and the firm is required to restate its previously reported quarterly results by its auditor as part of the disclosure contained in Form 10-K, Compustat updates the quarterly database to reflect these restated data.
Charter Oak Investment Systems, Inc. (Charter Oak) has collected the weekly original CD-Rom that Compustat sent to its PC clients, which always contained updated data as of that week. From these weekly updates, Charter Oak has constructed a database that contains three numbers for each firm for each Compustat line item in each quarter. The first number is the preliminary earnings announcement that Compustat inserted into the database when it bore the update code of 2. The second number is the “As First Reported” (AFR) figure when Compustat first changed the update code to 3 for that firm-quarter. The third number is the number that exists in the current version of Compustat, which is what most investors use. The Charter Oak database allows us to use the first-reported information in the SEC filing, so that our quarterly earnings, cash flows and accruals correspond to those reported originally by the firms, which are also available to market participants at the time of the SEC filing. Using the restated Compustat Quarterly database may induce a hindsight bias into our back-tests, since we may have used restated earnings, cash flows or accruals that were not known to market participants on the SEC filing dates.
3.2 Sample Selection
The initial population for the study consists of all firm-quarters in the Compustat database between the first quarter of 1988 (the first quarter after the adoption of SFAS No. 95, which mandated the disclosure of net operating cash flow) and the most recent quarter at the time of the study. The only limitation on the initial selection of firm-quarters is that market value at quarter end is in excess of $50 million, yielding an initial population of 368,378 firm-quarters. From this initial population, we delete observations if the originally reported income before extraordinary items and discontinued operations (Compustat Quarterly item No. 8) is missing; or the originally reported quarterly net operating cash flow (Compustat Quarterly item No. 108) is missing; if market value at the end of the prior quarter is unavailable; or if total assets (Compustat Quarterly item No. 44) at the end of the prior quarter or the at the end of the current quarter are missing. This yields a reduced population of 242,292 firm-quarters.
For each firm-quarter in this reduced population, we obtain the SEC filing date of the 10-Q/K forms, which is supplied to us by Compustat for the calendar years 1991-2004. This reduces the sample to 176,864 observations with SEC filing dates. We then use the GVKEY from Compustat to match the observation to the CRSP database. We compute Buy and Hold excess Returns (BHR) from two days after the SEC filing date through the next four subsequent preliminary earnings announcements. We assume that investors get access to the SEC filings on the day after the filing date, and that after estimating accruals, they take portfolio positions on the following day. We use holding periods through one day after subsequent earnings announcements since prior studies indicate that a substantial portion of the accrual strategy returns are generated around subsequent earnings announcements, presumably when investors understand their earlier mispricing.
To reduce the survival bias, we use holding periods of 90, 180, 270, or 360 days after the SEC filing date if subsequent quarterly earnings announcements are missing. If a security is delisted from an exchange before the end of the holding period, we use the delisting return from CRSP if available, and -100% if the stock is forced to delist by the exchange or if the delisting is due to financial difficulties. After delisting, we assume the proceeds are invested in the benchmark size and B/M portfolio. This is the procedure used by Kraft, et al (2004). We first calculate the buy and hold return on the security during the holding period; then subtract the buy and hold return on a similar size and B/M benchmark portfolio for the same holding period. The benchmark returns are from Professor Kenneth French’s data library, based on classification of the population into six (two size and three B/M) portfolios.[3] To make sure that our results are not driven by observations with extreme returns, we delete all observations with buy and hold excess returns in any of the four return periods at the top or bottom 0.5% of the distribution. This reduces the sample to 155,985 firm-quarters.
Consistent with the accruals literature, we estimate accruals as earnings minus net operating cash flows, and scale by average assets during the quarter. To be consistent in our scaling, all current and subsequent quarters’ variables (i.e., earnings, net operating cash flows and accruals in quarters t, …,t+4) are scaled by average total assets in quarter t.[4] To eliminate the undue influence of extreme observations, earnings, net operating cash flows and accruals are winsorized to fall in the range [-1,+1]. This procedure keeps all observations, even when some earnings, cash flows, or earnings surprises are extreme.
Table 1 provides summary statistics about our sample. As can be seen from the table, mean (median) quarterly earnings are about -0.07% (1.03%) of average total assets, with over 75% of the firm-quarters having positive earnings. The mean (median) quarterly net operating cash flow is even higher at 1.25% (1.78%) of average total assets, but accruals have a negative mean (median) of 1.33% (1.0%) of average assets, mostly due to depreciation and amortization which is included in income but excluded from net operating cash flow. Note that in spite of the negative mean and median accruals, over 25% of the observations have positive, income-increasing accruals. Finally, the mean (median) buy and hold abnormal return from the SEC filing through the subsequent preliminary earnings announcements are all negative, indicating that the average firm in our sample has been likely to disclose unfavorable news from the SEC filing through the subsequent earnings announcement.
(Insert Table 1 about here)
To focus on firms which are more likely to have extreme accruals that will be less persistent, we further require that all observations in the bottom two deciles of accruals, i.e., the most negative accruals, have both positive income and positive net operating cash flow. Such firms have either decided to manage earnings downwards to reduce already high positive earnings and operating cash flows, or have future expectations that are too pessimistic on the average.[5] We further require that firms in the top two accrual deciles, i.e., the most positive accruals, also have positive current earnings, consistent with either income-increasing earnings management or with too optimistic forecasts on the average. These restrictions reduce the sample further to 137,012 observations for the remaining analyses.
4. Results
Table 2 shows the distribution of excess Buy and Hold Returns (BHR) from two days after the SEC filings through one day after the subsequent earnings announcements for sample observations sorted according to the level of accruals each quarter. The accruals literature provides evidence that firms with income-decreasing, or low, accruals have larger future subsequent abnormal returns than firms with income-increasing, or high, accruals. The evidence in Table 2 is consistent with those prior findings. The bottom accruals decile (decile 0) always has higher subsequent returns than the top accruals decile (decile 9). Note that this difference in BHR is 3.4% for the first quarter, rising to 6.1% through quarter t+2, 8.4% through quarter t+3, and 9.9% through quarter t+4. The latter result is comparable to Sloan’s (1996) hedge portfolio return for the subsequent year. The table also shows that the long portfolio (extreme negative accruals, decile 0) has BHR that exceeds the expected transaction costs of 2%. Thus, the strategy yields positive abnormal returns net of transaction costs, even if only the long position is used.
(Insert Table 2 about here)
The accruals literature attributes the negative association between accruals and returns to the lower persistence of accruals as compared to net operating cash flows. Table 3 examines the relationship between earnings in the subsequent four quarters and current earnings, net operating cash flows and accruals. As can be seen in the table, there is a positive and statistically significant association between current earnings, and earnings in the subsequent four quarters, where about 78-79 cents of each dollar of current quarter’s earnings is carried over to earnings in the subsequent four quarters (79, 78, 78, and 83 cents for the subsequent four quarters, respectively)[6]. The table also shows that net operating cash flow is more persistent than accruals, with 81 cents of every dollar of cash flow carried over to the subsequent four quarters (81, 81, 81 and 87 cents, respectively), whereas only about 68-74 cents of a dollar of accruals are carried over to earnings in the subsequent four quarters (74, 70, 68, and 73, respectively). Thus, consistent with findings about annual data, quarterly net operating cash flows and accruals exhibit the same pattern of a greater persistence of net operating cash flows than accruals into future earnings.[7]
(Insert Table 3 about here)
Table 4 provides direct evidence about the persistence of accruals. It shows the associations between accruals in the current quarter t and those in the subsequent four quarters. The table shows a negative and statistically significant association between current accruals and accruals at quarter t+1 (-0.025, p ................
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