Understanding the Accrual Anomaly

Interpreting accruals as working capital investment, we hypothesize that firms optimally adjusttheir capital investment in response to discount rate changes. Consistent with the discount-ratehypothesis, we document that (i) the predictive power of accruals for future returns increaseswith the correlations of accruals with past and current stock returns; (ii) controlling for invest-ment substantially reduces the magnitude of the accrual anomaly; (iii) the ex-ante expectedreturns of various accrual strategies have been stable at around 5% per annum over the past 35years; (iv) the accounting reliability of various accrual components is inversely related to theircross-correlations with investment-to-assets; and finally (v) high accrual firms have similar cor-porate governance and entrenchment indexes as low accrual firms, suggesting that the accrualanomaly is unlikely to be driven by investor overreaction to over-investment.