OVERREACTION OR UNDERREACTION? A REEXAMINATION OF THE ACCRUAL ANOMALY

This study reexamines the evidence underlying the prior conclusion that investors overreact to accruals accruals are negatively associated with subsequent abnormal returns (i.e., the accrual anomaly). This study shows that the two features of the research design used to document the accrual anomaly the omission of cash flows and the use of an annual setting both bias downward the association between accruals and subsequent returns. After controlling for cash flows and using a quarterly setting, this study presents evidence that accruals are positively associated with subsequent returns, and this positive association is weaker than the positive association between cash flows and subsequent returns. These results hold for the full sample of firms on average and are even stronger for sub-samples of firms where accruals are likely to play a more important role in measuring firm performance. These results suggest that investors underreact to accruals and underreact to cash flows even more. Further, this study shows that the puzzling inconsistency between the results generated by the two approaches of testing investors reaction to accruals (i.e., the general one-equation approach and the two-equation Mishkin test) is due to the absence of controls for some common risk factors and the use of pooled regressions in the Mishkin test. Finally, this study provides evidence that financial analysts, like investors, also underreact to accruals and underreact to cash flows even more in their forecasts of future earnings.