Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? ---Richard G. Sloan Zhengying (Vivien) Fan Topics in Quantitative Finance Washington University in St. Louis Sep 16, 2015

Outline Introduction Development of Hypotheses Sample Formation and Variable Measurement Empirical Analysis Conclusions

Introduction This paper contributes in three key respects: Employs a model that relies on characteristics of the underlying accounting process that are documented in texts on financial statement analysis Uses a less restrictive model that assumes investors might not fully discriminate between different components of earnings Assesses the extent to which the magnitude of the predictable stock returns is consistent with the predictions of the naïve earnings expectations model

Development of Hypotheses H1: The persistence of current earnings performance is decreasing in the magnitude of the accrual component of earnings and increasing in the magnitude of the cash flow component of earnings. H2(i): The earnings expectations embedded in stock prices fail to reflect fully the higher persistence attributable to the cash flow component of earnings and the lower earnings persistence attributable to the accrual component of earnings.

Development of Hypotheses H2(ii): A trading strategy taking a long position in the stock of firms reporting relatively low levels of accruals and a short position in the stock of firms reporting relatively high levels of accruals generates positive abnormal stock returns. H2(iii): The abnormal stock returns predicted in H2(ii) are clustered around future earnings announcement dates.

Sample Formation and Variable Measurement 40679 firm-year observations from 1962 to 1991

Empirical Analysis: Test of H1 (1)

Empirical Analysis: Test of H1 (2)

Empirical Analysis: Test of H1 Time series properties of Earnings, Accruals and Cash Flows. Year 0 is the year in which firms are ranked and assigned in equal numbers to ten portfolios based on each of three respective variables. High Earnings Portfolio Low Earnings Portfolio High Cash Flow Portfolio High Accrual Portfolio Low Accrual Portfolio Low Cash Flow Portfolio

Empirical Analysis: Test of H2(i) Basic implication of market efficiency: (3) A model that satisfies the efficient-markets condition: (4) (1) (5) (2) (6)

Empirical Analysis: Test of H2(i) (5)

Empirical Analysis: Test of H2(i) (6)

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(ii) Returns of Hedge Portfolio

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(ii)

Empirical Analysis: Test of H2(iii)

Conclusion The persistence of earnings performance is shown to depend on relative magnitudes of the cash and accrual components of earnings. Stock prices act as if investors fail to identify correctly the different properties of these two components of earnings. Additional issues for further research

Comments This paper considered only current accruals – those arise mostly due to timing of payments and expenses. Sloan published a follow-up study “Accrual Reliability, Earnings Persistence and Stock Prices”. It looked at all accruals, but not just current ones.