Accrued Earnings and Growth: Implications for Earnings Persistence and Market Mispricing

Abstract

An important goal of accounting research is to provide evidence that improves the analysis of financial statements for predicting future profitability. Research (Sloan 1996; Xie 2001) has found that (1) the persistence of earnings performance depends on the proportions of the cash and accrual components and that (2) a market inefficiency results from the failure of investors to fully appreciate the implications of cash flows and accruals for future earnings performance. In this study we investigate whether these results with respect to accruals can be generalized to another form of growth in net operating assets. We find that growth in long-term net operating assets, like accruals, has a negative association with one-year-ahead return on assets. We also find that the negative associations of both forms of growth (accruals and growth in long-term net operating assets) to one-year-ahead return on assets are attributable to the effect of growth on the denominator of return on assets. Furthermore, we find that the apparent market mispricing of accruals applies to growth in long-term net operating assets and that the severity of the mispricing does not significantly differ between the components of growth. Thus, the results suggest that the accrual anomaly documented in Sloan (1996) is a subset of a larger anomaly with respect to a general market mispricing of growth in net operating assets. Statement Analysis, Market Mispricing