Earnings Quality and Stock Returns: The Evidence from Accruals

Earnings Quality and Stock Returns: The Evidence from Accruals
Author(s): Jegadeesh, Narasimhan and Chan, Konan and Chan, Louis K.C. and Lakonishok, Josef
Year: 2001
Paper Number: GBS-FIN-2001-005
Goizueta Department: Finance

Abstract

An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flows) are reliably, negatively associated with future stock returns. Earnings increases that accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses - earnings manipulation, extrapolative biases about future growth, and under-reaction to business conditions - to explain accruals' predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, and discretionary versus nondiscretionary components of accruals.