Each Unhappy Firm Is Unhappy in Its Own Way

The negative relationship between the accruals component of earnings and future firm performance cannot be unilaterally explained with a risk based argument that was previously put forward in the literature.

Francesco Momentè and Francesco Reggiani (Department of Accounting), together with their coauthor Scott Richardson (London Business School), conclude this based on large scale empirical analyses. They recently published these findings in the Review of Accounting Studies, in an article entitled Accruals and Future Performance: Can it Be Attributed to Risk? (doi: 10.1007/s11142-015-9319-x).

This risk based explanation that they investigate poses that managers are more likely to invest when required returns to operations are low (low cost of capital). Subsequently future firm performance is observed to be low because returns were low, and not because the firm invested high amounts. In order to test this proposition, the authors make use of the fact that peer firms that operate in the same industry and in the same supply chain face the same risks. If the risk based theory is true, and similar firms face the same risks, we can expect that the negative relationship between accruals and future firm performance is driven by fluctuations in accruals that are shared between peer firms.

The authors test this by examining US firms that were observed monthly in the period from 1988 to 2010 resulting in a total of 766,496 observations. The key idea in the paper is that they differentiate a broad measure of accruals (change in net operating assets) into three parts. One is firm specific and thus idiosyncratic to the firm, and two parts are shared with other firms. Of these two parts, one is shared across all firms that operate in the same industry, and one is shared between firms in the same supply chain. If the risk based explanation is valid, the firm specific accruals should have the weakest relationship with performance, as this part of investment is unlikely to be made in response to the low cost of capital (that should be shared between similar firms).

To test this, the authors regress various measures of future firm performance namely return on assets and stock market returns, on these variables. Finally, they also use sell-side analyst earnings forecast revisions as a dependent variable. Contrary to what the risk-based explanation indicates, the authors find that the negative relationship between accruals and future firm performance is almost entirely attributable to the firm-specific component of accruals. Next to this, the authors also find evidence that analysts fail to incorporate the information content of these accruals into their expectations, as these analysts are more likely to have to revise their expectations negatively after an increase in accruals.

These findings mean that scholars will have to look for other explanations in order to explain the negative relationship between accruals and future firm performance. Current alternatives in the literature include diminishing returns to new investment, accounting distortions and earnings management, and transaction cost explanations. In the meantime, investors should note that analyst expectations are likely to be biased upwards in the presence of high accruals, and might want to incorporate this knowledge in their investment decisions.