Understanding the Accrual Anomaly

Interpreting accruals as working capital investment, we hypothesize that firms optimally adjust their capital investment in response to discount rate changes. Consistent with the discount-rate hypothesis, we document that (i) the predictive power of accruals for future returns increases with the correlations of accruals with past and current stock returns; (ii) controlling for investment substantially reduces the magnitude of the accrual anomaly; (iii) the ex-ante expected returns of various accrual strategies have been stable at around 5% per annum over the past 35 years; (iv) the accounting reliability of various accrual components is inversely related to their cross-correlations with investment-to-assets; and finally (v) high accrual firms have similar corporate governance and entrenchment indexes as low accrual firms, suggesting that the accrual anomaly is unlikely to be driven by investor overreaction to over-investment. Terry College of Business, University of Georgia, 443 Brooks Hall, Athens, GA 30602. Tel: (706) 542-3638, and e-mail: [email protected]. Stephen M. Ross School of Business, University of Michigan, 701 Tappan Street, ER 7605, Ann Arbor MI 48109-1234; and NBER. Tel: (734) 615-4854, fax: (734) 936-0282, and e-mail: [email protected]. Yale School of Management, 135 Prospect Street, P. O. Box 208200, New Haven, CT 06520-8200. Tel: (203) 432-7938, fax: (203) 432-6974, and e-mail: [email protected]. For helpful comments, we thank Andrew Ang, Sreedhar Bharath, Long Chen, Mozaffar Khan (discussant), Paolo Pasquariello, Amiyatosh Purnanandam, Reuven Lehavy, and seminar participants at Emory University and the 18th Annual Conference on Financial Economics and Accounting at New York University. Lu Zhang acknowledges the financial support provided by the NTT Program of Asian Finance and Economics at the Stephen M. Ross School of Business at the University of Michigan. This manuscript supersedes our working paper previously circulated as “The accrual anomaly: Exploring the optimal investment hypothesis.” All remaining errors are our own.