The Accrual Volatility Anomaly

Abstract

We find that quarterly cash flow shocks are more likely to be offset by contemporaneous accruals than to be reported as earnings. We examine the pricing implications of a consistent deviation of earnings from cash flow. Measuring the consistent deviation by accrual volatility, we find a strong and long-lasting negative association between accrual volatility and future stock returns. In decile portfolios that rank accrual volatility, a hedge portfolio that goes long in the lowest decile and short in the highest decile generates an annual, risk-adjusted return in the order of 10% from one-month to five-year horizon. These results are robust to common risk factors and return-informative variables, extend to both operating accruals and discretionary accruals, are distinct from the accrual anomaly, and are not subsumed by transaction costs and short-sale constraints. In addition, an accrual-volatility mimicking portfolio provides additional explanatory power to returns on the Fama-French 25 size/book to market portfolio. The accrual volatility effect is consistent with the information uncertainty effect where higher historical information uncertainty leads to lower future returns, and is also consistent with the earnings fixation hypothesis in that investors overprice the transitory accruals component of earnings in high accrual volatility stocks.