The Accrual Anomaly: Exploring The Optimal Investment Hypothesis

Interpreting accruals as working capital investment, we hypothesize that firms rationally adjust their investment to respond to discount rate changes. Consistent with the optimal investment hypothesis, we document that (i) the predictive power of accruals for future stock returns increases with the covariations of accruals with past and current stock returns, and (ii) adding investmentbased factors into standard factor regressions substantially reduces the magnitude of the accrual anomaly. High accrual firms also have similar corporate governance and entrenchment indexes as low accrual firms. This evidence suggests that the accrual anomaly is more likely to be driven by optimal investment than by investor overreaction to excessive growth or 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 Bus Ad, Ann Arbor MI 48109-1234; and NBER. Tel: (734) 615-4854 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 and e-mail: [email protected]. For helpful comments, we thank Sreedhar Bharath, Long Chen, Mozaffar Khan (discussant), Paolo Pasquariello, Amiyatosh Purnanandam, Reuven Lehavy, and workshop participants at Emory University and the 18 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. All remaining errors are our own.