Earnings-Based and Accrual-Based Market Anomalies: One Effect or Two?

Daniel W. Collins*
Henry B. Tippie Research Chair in Accounting

Paul Hribar
Ph.D. Student

College of Business Administration

University of Iowa
Iowa City, IA 52246-1000

May 25, 1999

Abstract: This paper investigates whether the accrual pricing anomaly documented by Sloan
(1996) for annual data holds for quarterly data and whether this form of market mispricing is
distinct from the post-earnings announcement drift anomaly. We find that the market appears to
overestimate (underestimate) the persistence of the accrual (cash flow) component of quarterly
earnings and, therefore, tends to overprice (underprice) accruals (cash flows). Moreover, the
accrual (cash flow) mispricing appears to be distinct from post-earnings announcement drift. A
hedge portfolio trading strategy that exploits both forms of market mispricing generates
abnormal returns in excess of those based on unexpected earnings, accruals, or cash flow
information alone.
Key Words: Market Efficiency, Accruals, Post-Earnings Announcement Drift
JEL Classification: G14, M41

*Corresponding Author. Phone (319) 335-0910; Fax: (319) 335-1956; e-mail: danielcollins@uiowa.edu.
We gratefully acknowledge the insightful comments and suggestions made by Kevin Den Adel,
Bruce Johnson, Mort Pincus, Shyam Sunder, Richard Tubbs, Charles Wasley, Greg Waymire
and workshop participants at the University of Utah and Carnegie Mellon University.

Earnings-based and accrual-based market anomalies: one effect or two?

1. Introduction
The efficiency of capital markets has received a great deal of attention in both the finance
and accounting literature. Research in this area most commonly examines market anomalies,
which are defined simply as predictable abnormal returns (Ball 1992). Prominent examples of
market anomalies include post-earnings announcement drift (e.g. Foster et al. 1984; Bernard and
Thomas 1989, 1990), the book-to-market anomaly (Stattman 1980), the earnings-to-price
anomaly (Basu 1977), and more recently the accrual anomaly (Sloan 1996). This study
compares two prominent earnings-based accounting anomalies -- post-earnings announcement
drift and the accrual anomaly -- to determine whether they capture the same market inefficiency
or whether they represent different anomalies that in combination reveal more extreme market
mispricing than has been documented in the literature to date.1
The literature on post-earnings announcement drift demonstrates that prices continue to
drift in the direction of the initial market response to quarterly earnings surprises (standardized
unexpected earnings or SUEs) for at least 120 trading days following the earnings
announcement, with much of the price adjustment occurring in the days surrounding the
subsequent two quarters earnings releases (e.g. Foster, Olsen, Shevlin 1984; Rendleman, Jones,
Latane 1987; Bernard and Thomas 1989; 1990; Freeman and Tse 1989). The results of this
stream of research suggest that the market fails to fully appreciate and price the future earnings

An example of related research is Greig (1992), who forms portfolios along two dimensions, using both size and
Ou and Penmans (1989) fundamental analysis statistic, and finds the size effect dominates Ou and Penmans
statistic. Similarly, Jaffe, Keim and Westerfield (1989) form portfolios on size and earnings/price (E/P), and show
that earnings/price is more robust predictor of future abnormal returns when controlling for the January effect.

implications of current earnings surprises. Essentially, the post-earning announcement drift

literature suggests that the market underreacts to earnings surprises.
The accrual anomaly documented by Sloan (1996) shows that the level of standardized
accruals is negatively related to abnormal returns over the following year. Sloans results
suggest that the market fails to appreciate that the accrual component of earnings is less
persistent than the cash flow component. Consequently, the market appears to overreact to
earnings that contain a large accruals component. This result holds for both extreme positive and
negative accruals. The over-reaction is subsequently reversed when earnings are reported in the
following year and the market learns that the earnings of the previous period are not sustainable.
The goal of this paper is to provide additional insight into the relation between the
earnings-based and accrual-based anomalies (and the closely related cash-flow anomaly). To
address this issue, three primary questions are answered. First, does the accrual anomaly hold on
a quarterly basis? That is, do portfolios formed on the basis of quarterly accruals provide
evidence that the market overreacts to earnings surprises with a large accrual component?
Second, if the accrual anomaly holds on a quarterly basis, does it represent a form of mispricing
distinct from post-earnings announcement drift? That is, can undereaction to earnings surprises
and overreaction to accruals co-exist? Finally, if post-earnings announcement drift and the
accrual anomaly represent distinctly different forms of market mispricing, can they be combined
into a joint strategy that exploits both anomalies to earn even larger abnormal returns than those
associated with the individual anomalies? For example, will the amount of post-earnings
announcement drift be less prominent or even move in the opposite direction for firms that report
extreme positive (negative) unexpected earnings due to extreme positive (negative) accruals?
Conversely, will the mispricing be greater when positive (negative) earnings surprises contain a

large negative (positive) accrual component? If so, hedge portfolios based on various
combinations of unexpected earnings and accrual rankings should generate abnormal returns that
exceed those that can be earned by exploiting any one of the anomalies in isolation. Analogous
predictions hold for combinations of unexpected earnings and cash flow strategies.
Our results provide evidence of statistically significant abnormal returns associated with
quarterly accrual and cash flow-based trading strategies as well as unexpected earnings-based
strategies. More importantly, the unexpected earnings and accrual (cash flow) strategies appear
to capture different mispricing phenomenon. Thus, combining the earnings-based SUE strategy
with either the accrual or the cash flow-based strategy significantly increases the magnitude of
abnormal returns that can be earned. Moreover, there does not appear to be significant additional
risk involved with the combined strategies in terms of magnitude or frequency of losses. In
summary, we find the unexpected earnings and accruals/cash flow anomalies, when combined,
reveal a more extreme form of market mispricing than previously documented in the literature.
This mispricing can be exploited to generate abnormal returns in excess of those based on
unexpected earnings, accruals or cash flow rankings alone.
The remainder of the paper proceeds as follows. Section two summarizes the extant
research on earnings-based and accrual-based (cash flow) anomalies and develops the
hypotheses. Section three explains sample selection procedures and provides descriptive
statistics. Section four outlines the Mishkin test (1983) and hedge portfolio tests for market
mispricing and gives the empirical results. Section five provides diagnostic tests, and Section six
gives our summary and conclusions and discusses the future research opportunities suggested by
our findings.

2. Earnings-Based and Accrual-Based Market Anomalies:

Post-earnings announcement drift -- the phenomenon where stock prices continue to drift
in the direction of the initial price response to an earnings announcement -- is one of the most
prominent and perplexing market anomalies documented in the accounting literature. More
generally, post-earnings announcement drift can be viewed as a manifestation of what Bernard,
Thomas and Whalen (1997) label the standardized unexpected earnings (SUE) effect.2 This
broader characterization refers to all market anomalies designed and tested using the SUE metric
as a proxy for unexpected earnings. Therefore, it includes the literature on post-earnings
announcement drift as well as the related work on the time series properties of SUEs (e.g.
Bernard and Thomas 1990, Ball and Bartov 1996). In the current paper, these anomalies are
referred to as earnings-based SUE anomalies.
The central puzzle underlying this group of anomalies is that stock prices act as if
investors use a simple seasonal random walk with drift expectations model in forming quarterly
earnings expectations. However, earnings forecast errors conditional on such a model exhibit
strong and predictable autocorrelation patterns. Thus, when subsequent quarterly earnings are
announced, stock prices adjust to a component of the earnings surprise that should have been
predictable given the past time series of earnings. The upshot of these findings is that stock
prices do not appear to fully impound the implications of current quarterly earnings surprises for
future earnings. While there is some skepticism that SUE-based anomalies truly reflect a
departure from market efficiency, rather than just an artifact of research design, Bernard et al.

To compute SUE, expected earnings are first computed using either a seasonal random walk, a first-order
autoregressive process, or the Brown-Rozeff model. For example, Foster et al. (1984) and Bernard and Thomas
(1989) calculate expected earnings as: E(Qi,t) = Qi,t-4 + i( Qi,t-1 - Qi,t-5 ) + i . SUEs are then computed as the
difference between actual earnings and expected earnings, scaled by the standard deviation of the past earnings
series.

(1997) argue that of six prominent anomalies, this group is the most likely to reflect market
mispricing.3
Sloans (1996) results suggest the market fails to properly price the accruals component
of earnings. He shows that the market erroneously overestimates the persistence of the accruals
component of annual earnings while underestimating the persistence of the cash flow
component. Moreover, accruals exhibit negative serial correlation or mean reversion tendencies.
Consequently, the market responds as if surprised when seemingly predictable earnings reversals
occur in the following year.
In order to exploit this overreaction to accruals, Sloan forms zero net investment hedge
portfolios that take a long position in firms with the largest negative accruals (standardized by
total assets) and an offsetting short position in firms with the largest positive accruals. This
strategy earns positive annual excess returns of 10.4% and incurs losses in only two of the thirty
years examined. Although Sloans hypotheses are stated in terms of accounting accruals, he
notes that similar predictions could be made based on investors underestimating the persistence
of cash flows (p.292, footnote 4). Thus, a trading strategy taking a long position in firms with
the highest level of operating cash flows and an offsetting short position in firms with the lowest
level of operating cash flows also appears to generate positive abnormal returns.
One complication that arises when comparing the earnings-based anomaly with an
accrual or cash flow anomaly is that the SUE-based anomaly has been examined on a quarterly
basis while Sloan documents the accrual-based anomaly only for annual data. Accordingly, to
facilitate a comparison between the unexpected earnings and accrual anomalies, we first
implement the accrual-based and related cash flow-based trading strategies on a quarterly basis

The six anomalies tested are: (1) earnings momentum (SUE), (2) returns momentum, (3) book to market ratio, (4)
E/P ratio, (5) Ou and Penman fundamental analysis, (6) Holthausen and Larcker fundamental analysis.

to determine whether the mispricing documented by Sloan generalizes to quarterly data. In a

quarterly setting, it is unclear how long it will take for any mispricing which may be associated
with quarterly accruals and cash flows to be corrected when subsequent quarters earnings are
realized. Because post-earnings announcement drift largely manifests itself in the two quarters
immediately following the earnings announcement, the primary tests will focus on the two
quarters immediately following an extreme quarterly accrual or cash flow realization.
A second objective of this study is to determine if the unexpected earnings-based
anomaly is distinct from the accrual or cash flow anomalies and whether one dominates or is
subsumed by the other. We do this by forming portfolios based on rankings along both
dimensions (unexpected earnings and either accruals or cash flows). The resultant contingency
tables allow us to examine conditional and marginal frequencies to determine the degree of
overlap between the unexpected earnings and accruals/cash flow rankings and to test predictions
about the abnormal return performance of various portfolio subgroups within the contingency
table.
If, in fact, unexpected earnings and accruals/cash flow anomalies reflect different forms
of mispricing and are largely independent of one another, we predict that a new trading strategy
which takes advantage of both forms of mispricing will yield even larger abnormal returns than
those associated with each individual anomaly. Specifically, formulating a strategy that takes a
long (short) position in firms with extreme positive (negative) unexpected earnings and extreme
negative (positive) accruals is expected to yield larger abnormal returns than a strategy that
exploits only one of the anomalies. Similarly, a strategy that takes a long (short) position in
firms with extreme positive (negative) unexpected earnings and extreme high (low) operating

cash flows is expected to dominate a strategy that exploits only the SUE or cash flow strategy
alone.

2. Sample Selection and Data.

Quarterly COMPUSTAT and daily CRSP data are collected for all NYSE/AMEX firms
on either the Primary, Supplementary and Tertiary Industrial File or the Research File over the
years 1988-1997.4 In contrast to Sloan (1996), we estimate quarterly accruals as the difference
between earnings and cash flows from operations.5 Specifically, the accruals component of
quarterly earnings is computed as follows:

Accrualst = Earningst - CFOt

(1)

where
Earningst = earnings from continuing operations (COMPUSTAT #8)
CFOt
= cash flow from operations (COMPUSTAT #108).6

This restriction is necessary in order to compute accruals as in equation (1). COMPUSTAT reports quarterly
funds flow data based on either a working capital statement, a source and use of funds statement, or a cash
statement by activity starting in 1984, but these data are often incomplete and/or incorrect with respect to the
Working capital changes Other account (Quarterly item #73). Since this item is necessary to compute cash from
operations we focus only on the post SFAS 95 period for which cash flow data are reported.
5
Sloan (1996) and most prior studies that test the pricing implications of accruals use the period-to-period change in
current asset and current liability accounts, adjusted for changes in cash and reclassifications of currently maturing
portions of long-term debt, to estimate the accrual component of earnings. Drtina and Largay (1985) and Revsine,
Collins and Johnson (1999) demonstrate this balance sheet approach to calculating accruals can lead to serious
errors, particularly when a firm has been involved in mergers, acquisitions, or divestitures. When these events
occur, the articulation between the changes in working capital balance sheet accounts and the accrual components of
earnings is destroyed. Collins and Hribar (1999) assess the implications of this measurement problem associated
with the balance sheet approach to estimating accruals for studies on earnings management and the pricing of
discretionary versus non-discretionary accruals.
6
For cash flow statement items, COMPUSTAT reports data for the cumulative interim period year-to-date.
Therefore, for the 2nd, 3rd, and 4th quarters, the differences between the reported amounts in quarter t and quarter t-1
must be computed to arrive at the correct amount of cash flow from operations for the three months ended in the
current quarter.

As in Sloan (1996), earnings, cash flows and accruals are all standardized by average total assets
to enhance cross-sectional comparability.
To provide evidence on post-earnings announcement drift and the earnings-based SUE
anomalies, expected earnings are calculated as a seasonal random walk with drift
(Bernard and Thomas 1989, 1990):
E (Qi,t) = Qi,t-4 + i

(2)

where i is the drift term estimated using a minimum of 12 quarters and a maximum of 36
quarters. The SUE for firm i in quarter t is then calculated as:
SUEi,t = (Qi,t E(Qi,t)) / [Qi,t E(Qi,t)]

(3)

where [Qi,t E(Qi,t)] is the standard deviation of the forecast error. Note that equation (2)
excludes the first-order autoregressive term used in Bernard and Thomas (1989). Foster, Olsen,
Shevlin (1984), however, report no substantive difference from using either estimation equation,
and Bernard, Thomas, Whalen (1997) use equation (2) in their analysis of the SUE-based
anomaly.7 Additionally, while the standard deviation of the forecast error is used as a scaling
variable when replicating prior studies, later empirical tests use unexpected earnings
standardized by average total assets in order to maintain a consistent scaling variable across all
variables.8 The final sample of quarterly accruals, operating cash flows and SUE realizations
contains 41,237 firm-quarters.
Tables 1a and 1b provide descriptive statistics for the final sample based on quarterly
partitions of both accruals and cash flows. In Table 1a, quarterly accruals are used as the

As a robustness check, expected earnings with a first order autoregressive term are estimated for firms with
continuous data from 1976-1987. The correlation between expected earnings calculated in this manner and expected
earnings calculated using equation (2) is 0.956. Thus, because of the additional data requirements needed to obtain
stable firm specific AR(1) estimates, the seasonal random walk with drift model in equation (2) is used instead in an
effort to increase sample size.
8
None of the results are qualitatively affected by the choice of a scaling variable.

partitioning variable. The negative correlation between accruals and cash flows is evident in the
mean cash flow realizations, which appear to be monotonically decreasing with respect to the
accrual ranking. Similarly, in Table 1b when cash flows are used as the partitioning variable,
mean accrual realizations appear to be monotonically decreasing with respect to the cash flow
ranking. This is confirmed by a strong negative Spearman rank correlation of 0.75 (p-value <
0.001) between accrual and cash flow decile classifications.
The SUE variable appears to be positively correlated with both accruals and cash flows,
although the relation is not linear. This is confirmed by Spearman rank correlations of 0.078 (pvalue < 0.001) between SUE and accrual deciles, and 0.125 (p-value < 0.001) between SUE and
cash flow deciles. It should be noted that because of the documented post-earnings
announcement drift effect, the correlation between unexpected earnings and either accruals or
cash flows might confound a trading strategy based on these latter variables. For example, a
quarterly accrual strategy predicts positive (negative) excess returns for firms in the lowest
(highest) accrual decile. The positive correlation of accruals with SUE, however, implies that
there will be a disproportionate number of firms with large negative accruals that will belong to
the lowest unexpected earnings decile, for which we predict negative excess returns. Thus,
quarterly accrual trading strategies that do not control for unexpected earnings will likely be
understated. With cash flows the relation is just the opposite. Cash flow deciles tend to be
positively correlated with unexpected earnings deciles. Thus, the highest cash flow decile will
tend to be populated by a disproportionate number of firms in the highest unexpected earnings
decile. Accordingly, the abnormal returns to a cash flow strategy that fails to control for
unexpected earnings are likely to be overstated. Our subsequent joint tests control for both SUE
decile membership and accrual/cash flow decile membership.

With respect to the risk proxies listed in Panel B of Tables 1a and 1b, the extreme accrual
and cash flow deciles on average contain smaller firms as well as firms with slightly higher
betas. Table 1a reveals that the mean betas for the first and tenth accrual deciles are 1.08 and
1.10 respectively, while the mean beta for firms in accrual deciles 2 through 9 is 1.04. Similarly,
mean betas for the first and tenth cash flow deciles are 1.12 and 1.08 respectively, while the
mean beta for firms in cash flow deciles 2 through 9 is 1.08. The average size based on market
value decile ranking for the first and tenth accrual deciles are 6.6 and 6.6 respectively, while the
average for accrual deciles 2 through 9 is 7.7. Similarly, the average market value decile ranking
for the first and tenth cash flow deciles are 6.3 and 7.3 respectively, while the average for deciles
2 through 9 is 7.7.
As noted in Sloan (1996), the symmetric relationship between firm characteristics in the
extreme accrual and cash flow deciles results in negligible exposure to either beta or size pricing
effects when offsetting long and short positions are taken in firms in these extreme deciles.
Nevertheless, to control for potential risk or size-based explanations for our results, returns will
be adjusted for both size and beta before computing excess returns
3.1 Abnormal return calculations
Previous anomaly studies typically calculate abnormal returns using a companion portfolio
approach (e.g. Foster, Olsen and Shevlin, 1984; Bernard and Thomas, 1989; Sloan 1996). Under
this approach, size-adjusted abnormal returns are computed as:
ARi,t = Ri,t - Rp,t
where

ARit
Rit
Rpt

(4)

= size-adjusted abnormal return for firm i, day t.

= the raw return for firm i, on day t.
= value weighted mean return on the NYSE/AMEX
size decile that firm i is a member of in the quarter examined.

CRSP computes size decile returns (Rp,t) by ranking firms on market capitalization at the

10

beginning of the portfolio formation year and then dividing these firms into ten equal portfolios.
The decile classifications are rebalanced annually. As indicated in Table 1, the extreme accrual
(cash flow) deciles (1 and 10) tend to be composed of smaller firms and firms with higher betas.
Moreover, the full sample has a mean beta exceeding 1, indicating that on average, the entire
sample contains somewhat riskier firms (mean beta = 1.04). While there is a known negative
relation between size and beta, basic exploratory tests for the sample show statistically positive
abnormal returns for the entire sample of approximately 1.8% over the two years following
portfolio formation when using equation (4) to compute abnormal returns. This suggests that
implicitly assuming a coefficient of one on Rp,t in equation (4) may ignore firm-specific
covariation with the an appropriately chosen benchmark (e.g. the size control portfolio).
Therefore, to control for both size and covariation as sources of risk, the following regression is
estimated over the 60 months prior to the month of the portfolio formation:

Ri ,t = + R p ,t + i ,t

(5)

where the variables are as defined above. Abnormal returns are then computed as prediction
errors using the following equation:
ARi , t = Ri ,t ( + R p ,t )

(6)

Using size portfolio average returns as the independent variable controls for the well-known
size effect (Banz, 1981 and Reinganum, 1982). Moreover, allowing the coefficient on the size
portfolio return to vary by firm helps control for firm-specific systematic risk. Using equation
(6) results in abnormal returns that are insignificantly different from zero for the entire sample
over the two years following portfolio formation, suggesting that risk and size effects have been

11

effectively controlled.9
Abnormal returns are cumulated from 18 days after the earnings announcement for quarter t
to 17 days after the earnings announcement for quarter t+2 (approximately 120 trading days).10
The hedge portfolio return is computed by subtracting the average abnormal return on the short
portfolio from the average abnormal return on the long portfolio. Thus, for example, taking the
average cumulative abnormal return of firms in the highest SUE decile and subtracting the
cumulative abnormal return of firms in the lowest SUE decile produces the SUE hedge portfolio
return.
4. Tests of Market Mispricing
Following Sloan (1996), we use the Mishkin (1983) test and hedge portfolio tests to
determine whether the market efficiently impounds accounting information (e.g., earnings
surprises (SUEs), accruals, or cash flows from operations) into the price structure.
4.1 Mishkin test
Mishkin (1983) develops a framework to test the rational expectations hypothesis in
macroeconomics. We adapt this framework to examine whether the markets valuation of
quarterly unexpected earnings, accruals or cash flows rationally anticipates the implications of
these signals for future earnings. Mispricing is indicted if the weight the market assigns to these
items in valuation is significantly larger (smaller) than the weight that these items receive in
predicting future earnings.

All primary tests are replicated using both standard size-adjusted returns (constraining the coefficient to equal 1)
as well as market model returns, with no qualitative change in the results.
10
Easton and Zmijewski (1993), using a sample of 193,283 10-Q filings, estimate that on average the 10-Q becomes
publicly available 44.7 days after the fiscal quarter-end, or 14.7 days after the earnings announcement date. To
provide a conservative estimate of when accrual and cash flow data become publicly available, 18 days after the
earnings announcement date is used as the start of the accumulation period.

12

In the present setting, an earnings forecasting equation is combined with a rational

pricing model to yield the following system of equations that are jointly estimated:11
Qt+1 = Qt-3 + (Qt Qt-4) + + t

(7)

CSARt+1 = Rt+1 - Et(Rt+1t) = [Qt+1 Qt-3 - - * (Qt Qt-4)] + t,

(8)

where t is the set of information available to the market at the end of period t.
Notice that the forecasting equation is essentially Fosters (1977) model of quarterly
earnings. Conditional on equation (7) being correctly specified, market efficiency implies that
expected size-adjusted abnormal returns (CSARt+1 ) should be zero. Therefore, market efficiency
imposes the constraint that = *. This nonlinear constraint requires that the market correctly
anticipate the implications of seasonal differences for the most recent quarter for updating
forecasts of next quarters earnings. The evidence on post-earnings announcement drift suggests
that the market systematically fails to do this and, therefore, that * < .
To test whether Sloans (1996) findings of the markets overpricing of accruals carries
over to a quarterly setting, the current quarters earnings (Qt) are decomposed into its accruals
and cash flow components and the above system of equations is rewritten as follows:
Qt+1 = Qt-3 + 1Accrualst + 2 CFOt Qt-4 + + t

(9)

CSARt+1 = [Qt+1 Qt-3 - - 1* Accrualst - 2* CFOt + *Qt-4] + t,

(10)

The benefits of this specification are two-fold. First, decomposing the current quarters
earnings into accrual and cash flow components allows the coefficients on the two components
to differ, thereby highlighting any differential persistence between the accrual and cash flow

11

For purposes of conducting the Mishkin tests, we initially limit the return accumulation period to 18 days after the
earnings announcement for quarter t to 17 days after the earnings announcement for quarter t+1 (approximately 60
days) to parallel the forecasting horizon in the forecasting equation. Extending the return accumulation period to
120 days, does not significantly alter any of the results reported here.

13

components. Second, allowing the coefficient to vary between the two equations in essence
captures the effect of post-earnings announcement drift. Thus, we are able to investigate if
accruals and/or cash flows are systematically mispriced on a quarterly basis after controlling for
post-earnings announcement drift.12 If the market appropriately prices the future earnings
implications of current accruals and cash flows, then we expect 1 = 1* and 2 = 2*. If, however,
Sloans findings that the market over-prices accruals and under-prices cash flows carries over to
a quarterly setting, then we expect 1 < 1* and 2 > 2*. Moreover, if post-earnings
announcement drift exists after allowing the coefficients on accruals and cash flows to differ, we
expect > *.
Mishkin shows that the following likelihood ratio statistic is distributed asymptotically
2(q) under the null hypothesis of market efficiency:
2*n*ln(SSRc/SSRu),
where
q = the number of constraints imposed by market efficiency,
n = the number of observations in the sample,
SSRc = the sum of squared residuals from the constrained weighted system, and
SSRu = the sum of squared residuals from the unconstrained weighted system.
Market efficiency is rejected in favor of market mispricing if the likelihood ratio statistic
is sufficiently large; i.e. if imposing the market efficiency constraint substantially increases SSRc
as compared to SSRu.
Table 2 presents the results of the Mishkin tests. Panel A provides the results of
estimating equations (7) and (8). Consistent with the evidence in Bernard and Thomas (1989,
1990) and Ball and Bartov (1996), the market appears to systematically under-react to quarterly

An equivalent specification of equation (9) is: Qt+1 = Qt-3 + 1(1Accrualst + 2 CFOt Qt-4 ) + + t, which
highlights more readily the post-earnings announcement drift parameter 1. In our equivalent specification given in
eqn. (9), 1 = 11 and 2 = 22.

12

14

earnings surprises. Specifically, the 1 coefficient in the forecasting equation equals 0.306 while
the 1* coefficient in the returns equation equals 0.093. The likelihood ratio statistic for the test
of market efficiency (1 = 1*) is 43.55, which is significant at the =0.001 level.
Table 2, Panel B presents the results of estimating equations (9) and (10) where we
decompose the current quarters (Qt) earnings into its cash flow and accruals component. This
analysis allows us to determine if the accrual or cash flow mispricing is distinct from the postearnings announcement drift effect captured by parameters 1 and 1*. Consistent with Sloans
annual results, Panel B shows in the forecasting equation that quarterly accruals (1 = 0.234) are
less persistent than quarterly cash flows (2 = 0.247) with respect to next quarters earnings.
However, the difference is less pronounced than on an annual basis. More importantly, the
market appears to systematically over-estimate the persistence of accruals (1* = 0.295), and
under-estimate the persistence of cash flows (2* = 0.134). The likelihood ratio test statistic for
market efficiency, which is a joint test of whether 1 = 1* and 2 = 2*, is 113.44 which is
significant at the 0.001 level. Finally, the unexpected earnings coefficient in the forecasting
equation (1 = 0.301) is still larger than the unexpected earnings coefficient implied in the
returns equation (1* = 0.092). This result demonstrates that post-earnings announcement drift is
still present after allowing for differential pricing implications of the accrual and cash flow
components. In summary, it appears that post-earnings announcement drift as well as accrual
and cash flow mispricing occurs on a quarterly basis. These results provide the basis for hedge
portfolio tests that attempt to simultaneously exploit both of these anomalies.
4.2 Hedge portfolio tests
SUE and accrual or cash-based hedge portfolios are constructed to determine if the
abnormal returns documented in Bernard and Thomas (1990) can be replicated, and whether or

15

not the accrual anomaly documented by Sloan (1996) holds on a quarterly basis. We form hedge
portfolios taking corresponding long and short positions in firms from extreme decile rankings
for either SUE, accruals or cash flows. As noted earlier, the abnormal returns are calculated
from 18 days after the earnings announcement date for quarter t to 17 days after the earnings
announcement date for quarter t+2. SUE deciles are numbered 1 through 10 with SUE1
representing firms with the most negative unexpected earnings and SUE10 representing firms
with the most positive unexpected earnings. Likewise, accrual deciles are numbered 1 through
10 with ACC1 representing firms with the largest income decreasing (negative) accruals and
ACC10 representing firms with the largest income increasing (positive) accruals. For cash flow
portfolios, CFO1 represents firms with the lowest level of operating cash flows and CFO10
represents firms with the highest level of operating cash flows. For the tests using quintiles
rather than deciles, a similar convention is used with 1 and 5 representing the lowest and highest
level of the respective partitioning variable.
To ensure the hedge portfolio strategy is implementable, the entire distribution of the
partitioning variable must be known prior to the portfolio formation date. For example, the
distribution of SUEs is unknown until the last earnings announcement has been made in a given
quarter, and the distributions of accruals and cash flows are unknown until all financial
statements have been publicly released in a given quarter. To mitigate this concern, the decile
cut-offs for the quarterly SUE portfolios are based on the previous quarters SUE distribution as
in Bernard and Thomas (1989). For the accrual or cash flow classifications, firms are classified
into deciles or quintiles based on the distribution of accruals from the same quarter of the
previous year. This better reflects the effect of the integral approach to quarterly reporting,
whereby certain expenses are estimated during the first three quarters and the cumulative effect

16

is corrected in the fourth quarter (Rangan and Sloan 1998).13 The primary results are replicated
using an ex-post distribution of SUE, accruals and cash flows with no qualitative change in
results.
The hedge portfolio tests examine if SUEs, accruals, and cash flows are efficiently priced
by taking a long position in firms with extreme positive (negative) SUEs or cash flows (accruals)
and a short position in firms with extreme negative (positive) SUEs or cash flows (accruals). If
the hedge portfolio yields consistently positive returns in subsequent quarters, this indicates
market mispricing of the current accounting information in the portfolio formation quarter.
4.2.1 Replication of post-earnings announcement drift
As a check on the validity of the data and to provide a benchmark for our subsequent
combined SUE and accrual (cash flow) strategies, we first implement a SUE hedge portfolio
strategy in an attempt to exploit the post-earnings announcement drift phenomenon. Taking a
long position in firms with large positive unexpected earnings (SUE10) and a corresponding
short position in firms with large negative unexpected earnings (SUE1) earns positive excess
returns of 6.88% over the following two quarters, or approximately 13.8% annualized.14 A time
plot of the average abnormal returns for each of the 36 quarters in our sample period is depicted
in Figure 1. As suggested by Bernard and Thomas, if risk is an omitted variable that is driving
the results then it should manifest itself as either a higher incidence of losses or as a few
extremely large losses. The incidence of losses in Figure 1 is 19.4% (7 out of 36 quarters),

13

Quarterly accruals in the fourth quarter in the lowest (highest) deciles are significantly smaller (larger) than
extreme accruals in quarters 1 through 3. Thus a classification based on the prior quarters distribution adds
considerable noise to the classifications, especially for fourth quarter observations.
14
This is the return to a trading strategy where positions are taken starting 18 days after the earnings announcement
date, which will be used as the starting date when computing the return to the joint SUE and accrual or cash flow
strategies (see section 4.2). When returns are calculated starting the second day after the earnings announcement,
the cumulative abnormal return is 7.1%, or approximately 14.1% annualized, which is comparable to the 6.8% over
the following 120 trading days reported in Bernard and Thomas (1989, Table 2).

17

which is somewhat higher than the frequency of losses reported by Bernard and Thomas (1989).
As noted in their study, this loss frequency compares favorably to that yielded by a unit beta
portfolio, where the incidence of loss quarters is 39% over the years 1935-1968 (see Fama and
MacBeth 1973). Moreover, for the current sample the most extreme loss is only 2.1%, which
is smaller than the most extreme loss in Bernard and Thomas (1989). Finally, losses occur only
once in adjacent quarters, and the cumulative abnormal return over these two quarters is 2.85%.
Thus, there is not a sustained negative effect of implementing this strategy over an extended
period. The sum of all negative quarters is only -11.6% while the sum of all positive quarters is
approximately 262%. These results corroborate the Bernard and Thomas (1989, 1990) findings
of post-earnings announcement drift that is not likely explained by omitted risk factors.
4.2.2 Examination of quarterly accrual and cash flow anomalies
To provide for a direct comparison between the SUE and accrual (cash flow) anomalies,
we next attempt to replicate Sloan's (1996) annual accrual (cash flow) pricing anomalies with
quarterly data.
Hedge portfolios are formed using quarterly decile classifications based on the magnitude
of accruals or operating cash flows with abnormal returns accumulated over the two quarters
after the portfolio formation date. The hedge portfolios are formed by taking a long position in
ACC1 firms and a short position in ACC10 firms. Figure 2a depicts these two-quarter abnormal
returns associated with each of the thirty-six quarters in our sample period. The average (median)
two-quarter excess return accruing to this strategy is 5.56% (5.50%) with a standard error of
0.771% (significant at .001). As shown, the accruals-based hedge portfolio yields negative
returns in only 5 of 36 quarters or 13.9% of the time. Moreover, the largest negative return is
7.95% and the sum of all negative returns is only 10.7%, while the sum of all positive returns is

18

211%. Thus, it appears the market misprices quarterly accruals and this mispricing can be
exploited to generate significantly positive abnormal returns on average.
Figure 2b presents returns to a quarterly cash flow strategy where we take a long position
in CFO10 firms and a short position in CFO1 firms. The mean (median) excess return accruing
to this strategy is 3.77% (3.64%) with a standard error of 0.848% (significant at .01). Figure 2b
reveals that this strategy generates negative excess returns in 7 of 36 quarters or 19.4% of the
time. While considerably less viable than the quarterly accruals strategy, these results
nevertheless suggest that the market fails to fully impound into prices the future earnings
implications of current operating cash flow information.
4.2.3 Joint SUE/accrual and SUE/cash flow strategies.
To this point, the SUE, accruals, and cash flow strategies have been examined
independently of one another. If, indeed, the markets mispricing of accruals (cash flows) is
distinct from the post-earnings announcement drift phenomenon, then it should be possible to
form trading strategies that capitalize on both forms of mispricing to yield even larger excess
returns than previously documented.
For example, some firms with large positive unexpected earnings shocks may attempt to
mitigate these shocks by creating large negative (income decreasing) accruals that shift expenses
forward or delay revenues. Given the negative autocorrelation tendencies for large accruals
coupled with Sloans and our finding of market over-reaction to accruals, these firms would
likely exhibit positive earnings changes and positive abnormal returns in the subsequent
quarter(s). Conversely, firms faced with large negative unexpected earnings shocks may attempt
to smooth earnings and/or make their situation look better by using large income increasing
accruals. If the market over-estimates the persistence of these income increasing accruals, then

19

these firms would be expected to exhibit negative abnormal returns in the subsequent
quarter(s).15 Note that in both of these situations, the subsequent market correction for accruals
mispricing reinforces the post-earnings announcement drift that would be present in the absence
of large accruals.
The results of the joint strategies are summarized in two contingency tables in Table 3
and graphically in Figure 3. Panel A of Table 3 presents the abnormal returns earned from
portfolios constructed by grouping firms according to unexpected earnings and accrual
realizations, while Panel B presents results where firms are partitioned by unexpected earnings
and cash flow realizations.16 The top number in each cell represents the mean cumulative sizeand risk-adjusted return earned over the two quarters subsequent to the portfolio formation date
averaged across the 36 quarters in our sample period. The number in parentheses represents the
number of firm/quarters that comprise each cell. To simplify our presentation, quintiles 2
through 4 have been condensed into a single cell, while the extreme quintiles (1 and 5) are
presented separately. Shaded cells in Table 3 represent cells where both of the partitioning
variables give congruent signals for future earnings and, hence, would be used in a hedge
portfolio strategy. This presentation format allows for several insights into the individual and
joint anomalies.
First, it is immediately apparent that joint strategies will be more profitable than the
individual strategies outlined in the previous section. For example, in the unexpected earnings

15

A similar logic applies to cash flows, although in this case we are looking for firms with large positive unexpected
earnings accompanied by large positive cash flows, versus firms with large negative unexpected earnings and large
negative cash flows.
16
The hedge portfolios in this section utilize extreme quintiles instead of deciles. The rationale for switching to
quintiles is that focusing on the intersection of extreme deciles essentially reduces the number of firms in each
portfolio by a factor of 10 which introduces more variability into the estimates. Using the intersection of extreme
SUE/accrual quintiles adds stability to our estimates and enhances the power of our tests. Bernard and Thomas
(1989) also utilize quintiles when comparing the continuously balanced strategy to the companion portfolio
approach (p.21, Figure 5).

20

and accruals matrix in panel A, the average abnormal returns to the long position (SUE5/ACC1 =
5.84%) and the short position (SUE1/ACC5 = -6.11%) are each roughly as large as the total
hedge portfolio returns generated by the individual strategies reported earlier (6.88% for SUE,
5.56% for accruals). Thus a hedge portfolio strategy formed by taking a long position in
SUE5/ACC1 firms and a short position in SUE1/ACC5 firms will earn an abnormal return of
11.94% that is roughly double that of either individual strategy.
Second, notice that post-earnings announcement drift is not present when the accruals
ranking signals mispricing in the opposite direction. Specifically, firms returns in the lowest
SUE group do not drift downward if earnings contain large income decreasing accruals
(SUE1/ACC1 = -0.29%, insignificantly different from zero). Similarly, firms returns in the
highest SUE group do not drift upward if earnings contain large income increasing accruals
(SUE5/ACC5=0.76%, insignificantly different from zero). Thus, the effect of post-earnings
announcement drift is affected by the magnitude of accruals associated with the earnings that are
announced.
Finally, note that the average abnormal returns associated with the firms falling into a
given SUE grouping (column) always decrease as we move down the table while the abnormal
returns for a given ACC grouping (row) always increase as we move from left to right in the
table. The consistency in the pattern of abnormal returns across cells suggests that the
differences in returns are more likely due to the mispricing associated with the joint
SUE/accruals signals than to some omitted variable(s).
Similar observations can be made for the abnormal returns associated with unexpected
earnings and cash flow groups reflected in Panel B of Table 3. Consistent with our earlier
evidence that the cash flow mispricing is less pronounced, the average abnormal return to the long

21

position (SUE5/CFO5) is 4.10% while average return associated with the short position
(SUE1/CFO1) is -4.43%. Both of these average returns are smaller than their respective
counterparts in Panel A. Nevertheless, a strategy combining unexpected earnings with cash flow
rankings earns average abnormal returns of 8.53% over the subsequent two quarters which is
larger than the abnormal returns generated by either of the individual strategies. Moreover, as
was the case for accruals, the effect of post-earnings announcement drift is affected by the
magnitude of cash flows. As shown, firms with large positive unexpected earnings but large
negative cash flows earn returns insignificantly different from zero (SUE5/CFO1 = 0.99%) as do
firms with large negative unexpected earnings but large positive cash flows (SUE1/CFO5 = 1.10%).
The effect of accruals mispricing on the magnitude of the post-earnings announcement
drift is even more evident in Figure 3, which plots cumulative daily abnormal returns over 120
trading days starting 18 days past the quarterly earnings announcement. The dark solid lines in
Figure 3 depict the standard post-earnings announcement drift in the highest and lowest SUE
quintiles, yielding a hedge portfolio abnormal return of approximately six percent. The abnormal
return plots change substantially, however, if accruals are added as an additional partitioning
variable. Heavy dashed lines in Figure 3 depict the average abnormal return associated with firmquarters in the highest (lowest) SUE quintile and the largest income decreasing (increasing)
accrual quintile. Notice that firms with large positive unexpected earnings that use incomedecreasing accruals to mitigate the magnitude of the positive earnings surprise exhibit
substantially larger upward drift than the average for all SUE5 firms. Similarly, firms with large
negative unexpected earnings that use income-increasing accruals to mitigate the level of the
negative earnings surprise experience a significantly larger downward drift than the average for

22

all SUE1 firms. Finally, the thin dashed lines in Figure 3 depict the abnormal returns accruing to
firms in the highest (lowest) SUE quintile and the largest income increasing (decreasing) accrual
quintile. In these cases, where the earnings surprise is driven by a large accruals component,
there is essentially no post-earnings announcement drift. Thus, it is clear that the level of accruals
embedded within an earnings surprise significantly alters the abnormal return behavior over the
following quarters. As shown in Figure 3, the mispricing of accruals can either magnify or
mitigate the drift in prices subsequent to earnings announcements.
Figures 4a and 4b graphically present the two-quarter average abnormal returns to
implementable hedge portfolio strategies based jointly on unexpected earnings and either
accruals or cash flow rankings across the 36 quarters in our sample. Figure 4a depicts quarterly
abnormal returns to the joint SUE and accrual strategy (SUE/ACC strategy). As shown in the
contingency table, taking a long position in firms with positive unexpected earnings and income
decreasing accruals (i.e. SUE5/ACC1) and an offsetting short position in firms with negative
unexpected earnings and income increasing accruals (i.e. SUE1/ACC5) earns average abnormal
returns of 11.94% with a standard error of 1.68% (significant at .0001). Of the 36 quarters in our
sample, 32 quarters yield positive abnormal returns while negative abnormal returns occur in
only four quarters. Moreover, the sum of all positive quarters is 448% while the sum of all
negative quarters is -22.5% with the bulk of the negative abnormal returns coming in the fourth
quarter of 1993 (-15.0%).17 Thus, combining the two individual anomalies clearly generates
additional abnormal returns, with minimal (if any) increase in risk.18

17

One potential explanation is the change in corporate tax rates in the 3rd quarter of 1993 and the subsequent hit to
earnings induced accrual based earnings management in the fourth quarter of that year (See Weiss 1999 for an
example).
18
Even greater abnormal returns are used when combining extreme deciles, although these are riskier in terms of
standard deviation and frequency of losses (See table 5).

23

The abnormal returns accruing to the joint SUE and cash flow strategy (SUE/CFO
strategy) presented in Figure 4b, while significantly positive, are less dramatic than those
observed for the joint SUE/accruals strategy. Taking a long position in firms with large positive
unexpected earnings and high cash flows (i.e. SUE5/CFO5) and a short position in firms with
large negative unexpected earnings and low cash flows (i.e. SUE1/CFO1) yields average
abnormal returns of 8.53%, with a standard error of 1.46% (significant at .001). This strategy is
negative in only 5 of the 36 quarters suggesting no increase in risk over the individual SUE or
CF strategies reported earlier. Moreover, the sum of the excess returns across all positive
quarters is 324%, while the sum across all negative quarters is only 31.9%. Again, the largest
single loss occurs in the fourth quarter of 1993 (-16.9%). Thus, the joint SUE/CFO strategy also
appears to be viable, although not as impressive as the SUE/ACC strategy. This suggests that the
market mispricing of cash flow information is not as pervasive and/or as dramatic as the
mispricing of accruals.
4.3 Regression based portfolio tests
A comparison between the individual and joint strategies can also be made in a regression
framework. To examine the hedge portfolios using a regression approach, the following models
are estimated:

CSARt, t+2 = + 1 SUE1 + 2 SUE5 + 3 ACC1 + 4 ACC5 + 5 SUE1*ACC1

+ 6 SUE1*ACC5 + 7 SUE5*ACC1 + 8 SUE5*ACC5
(11)
CSARt, t+2 = + 1 SUE1 + 2 SUE5 + 3 CFO1 + 4 CFO5 + 5 SUE1*CFO1
+ 6 SUE1*CFO5 + 7 SUE5*CFO1 + 8 SUE5*CFO5

(12)

where SUE1(5) = 1 if firm j is in the lowest (highest) SUE quintile, zero otherwise.
ACC1(5) = 1 if firm j is in the lowest (highest) accrual quintile, zero otherwise.
CFO1(5) = 1 if firm j is in the lowest (highest) cash flow quintile, zero otherwise.

24

The rationale for equations (11) and (12) is that the indicator variables pick up the mean
effect of being in a specific quintile. Thus, by taking appropriate linear combinations of the
parameters, different hedge portfolios can be examined. The benefit to this approach is that
additional factors posited to affect the excess returns can be added as control variables to rule out
other potential explanations for our results.19 Furthermore, because the regression equation
examines the effect of SUE, accruals, and cash flows simultaneously, estimated abnormal returns
can be computed after controlling for the correlation among the partitioning variables.
Equations (11) and (12) are estimated on a quarterly basis and the mean values over time
are reported in Table 4. To mitigate potential bias, t-statistics are computed using the sampling
distribution of the parameter estimates over time, and p-values are computed using a tdistribution with 35 degrees of freedom.
The main effects that are presented would be the same as the accrual hedge portfolio if
there were no significant interaction effects (although based on quintiles instead of deciles).
With respect to the accrual and cash flow strategy in Panel A, the magnitude of the joint SUE
and accrual strategy (11.94%) is comprised of both SUE and accrual main effects. Moreover, as
indicated by the 6 coefficient, there is a significantly negative interaction effect of
approximately 1.89% for firms with large negative unexpected earnings and large income
increasing accruals. Similarly, in Panel B the magnitude of the joint SUE and cash flow strategy
(8.53%) is comprised of both SUE and cash flow main effects, and there is a significantly
negative interaction (5 = 2.10%) for firms with large negative unexpected earnings and large
negative cash flows. We also see a significantly negative interaction (7 =2.00%) for firms
19

As a robustness check, the natural log of the ratio of book value of common equity to market value of common
equity is added as a control variable. This variable is statistically significant in both the accrual and cash flow
regressions, however abnormal returns accruing to the individual and joint strategies are essentially unchanged.

25

with large positive unexpected earnings but large negative cash flows. Thus, it appears that
significant post-earnings announcement drift documented in earlier studies is mitigated to a large
degree when the mispricing associated with accruals (cash flows) moves in the opposite
direction.

5. Diagnostic Tests
5.1 Sensitivity to the choice of a starting date.
As mentioned previously, 18 days after the earnings announcement was chosen as the start
of the accumulation period. While this is a conservative estimate, there may be some concern
that the returns to either the cash flow based or accrual based strategy are earned by trading on
information before it is actually known. If this is indeed the case, the bulk of the abnormal
returns should accrue at the start of the accumulation period when seemingly unknowable
information is being traded on. To explore this issue, daily cumulative abnormal returns for the
joint SUE and accrual strategy are plotted over the following two quarters. The results (not
presented) show a smooth upward and downward drift that appears unaffected by the starting
date chosen. Results for the joint SUE and cash flow anomaly are qualitatively similar.
5.2 Continuously balanced strategy
A problem in formulating an implementable trading strategy arises when using the hedge
portfolio approach. As noted in Bernard and Thomas (1989), implementing this strategy requires
taking new positions in size control portfolios on a daily basis. This raises the question of
whether the abnormal returns would remain under an easily implementable zero investment
strategy. To address this concern, Bernard and Thomas (1989) also use an alternative to the
companion portfolio approach. Specifically, they compute abnormal returns using what they call

26

a continuously balanced approach. This approach begins by identifying all firms that announce
earnings on a given day. If firms in both extreme SUE, accruals or cash flow deciles report
earnings on the same day, appropriately weighted offsetting long and short positions are taken in
these firms. If firms from only one extreme portfolio announce on a given day, then no position
is taken in these firms until an offsetting match in the other extreme portfolio becomes available.
Buy and hold returns are then computed on each individual hedge portfolio from that point
forward.20
To investigate this concern, the individual accrual strategy and the joint SUE and accrual
strategy (based on quintiles) are replicated using the continuously balanced approach.
Untabulated results show 120-day abnormal returns of 7.84% for the individual accrual strategy,
and 12.91% for the joint SUE and accrual strategy. These returns are of comparable magnitude
to the returns accruing to the equally weighted hedge portfolio approach reported in Table 5.
Thus it appears that equivalent abnormal returns could be earned using a much less costly
approach.
5.3 Returns around subsequent quarterly earnings announcement dates
A final robustness check examines the three-day returns surrounding the subsequent
quarterly earnings announcement dates. Bernard, Thomas, and Whalen (1997) argue that
abnormal returns clustered at future earnings announcement dates are less likely to be due to
omitted risk factors and more likely to reveal a market anomaly with respect to accounting
signals. To examine this issue, three-day returns beginning two days prior to the COMPUSTAT
earnings announcement date are computed for the following two quarterly announcements.
Results show that while the earnings announcement period constitutes 5% (6/120days) of the

20

For the most restrictive strategy (i.e. the joint SUE and Accrual strategy), 90.5% of the time a match becomes
available within 3 days. For the individual accrual strategy, a match is found 98.5% of the time.

27

total accumulation period, 22.0% of the abnormal returns for the quarterly accrual strategy and
21.9% of the abnormal returns for the joint SUE and accrual strategy are earned in the three-day
windows surrounding the next two quarters earnings announcements. While these percentages
are lower than the 40% reported by Sloan (1996), the difference is likely due to the difference in
sample periods and the rise in voluntary pre-earnings disclosures being issued by firms in recent
years, particularly when earnings are expected to fall below analysts' expectations. For example,
The Wall Street Journal (June 23, 1997) reports that earnings guidance rose from around 250
firms in 1994 to about 2000 firms in 1996 (and more than 700 firms through the first quarter of
1997). Given that our sample spans 1988-1997, earnings announcements during this time period
are more likely to be preempted by pre-announcements than in Sloans sample, which ends in
1991.
As a check on the validity of earnings pre-announcements as a potential explanation,
returns to the long and short portfolios are examined separately, as it is more likely that bad news
is disclosed early (e.g. Skinner 1994; The Wall Street Journal 1997). Results show that on
average, 46.3% of returns to the long position are earned in the three-day windows surrounding
the future earnings announcement dates, while essentially zero abnormal returns are earned in the
three-day windows for the short (bad news) position. Thus, it appears that voluntary
predisclosure of information by management, particularly for bad news situations, may be
affecting the returns earned at the earnings announcement date.

6. Summary and Conclusion

This paper provides evidence that the market systematically misestimates the future
earnings implications of the accrual and cash flow components of current quarterly earnings.

28

The markets over-estimation (under-estimation) of the persistence of accruals (cash flows) leads
to mispricing that can be exploited to generate significant positive abnormal returns over the two
quarters after the portfolio formation date. The accruals/cash flow mispricing appears to be
largely independent of the post-earnings announcement drift phenomenon widely documented in
previous literature. Thus, trading on the joint SUE and accruals (cash flow) signals earns greater
abnormal returns than trading on any of the individual anomalies. Moreover, there appears to be
little or no additional risk associated with trading on these joint signals.
Our findings have several important implications for extant research and suggest a
number of areas for future research. Information content studies relating security returns to
accruals and cash flows assume correct market pricing of earnings components. Yet evidence in
Sloan (1996) and this paper suggests the market systematically overprices (underprices) the
accrual (cash flow) component of earnings. Thus, studies demonstrating a stronger
contemporaneous association between returns and accrual earnings relative to cash flows should
be reexamined in light of this mispricing. Future information content studies should explicitly
control for this mispricing by allowing for possible price reversals in the research design.
Much of the extant earnings forecasting literature relies on time series models that
extrapolate past earnings. Our findings suggest that one may be able to exploit the different
persistence properties of accrual and cash flow components of earnings to improve upon extant
forecasting models that rely exclusively on past earnings.
Understanding sources of intertemporal differences in market anomalies is largely
unexplored in the literature. Our results also show that post-earnings announcement drift is
exaggerated or mitigated based on the level of accruals embedded within the earnings surprise.
This finding suggests that intertemporal differences in post-earnings announcement drift are

29

likely due, in part, to intertemporal differences in the magnitude of accruals contained within
earnings surprises.
While our results suggest that accruals, in general, are mispriced, we do not address
whether there is greater mispricing for certain types of accruals (e.g., current versus long-term
accruals) which warrants further attention. Moreover, investigating whether the discretionary
component of accruals suffers from greater mispricing than the non-discretionary component is
another interesting area for future research. Finally, understanding what causes the market to fail
to fully impound the future earnings implications of current accrual (cash flow) signals is a
perplexing question that deserves further investigation.

30

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Table 1a. Mean (median) values of selected characteristics for ten portfolios formed quarterly on the magnitude of accruals. Sample
consists of 41,237 firm quarters over the years 1988-1997.
Quarterly Portfolio Accrual Ranking
1

Income decreasing
2
3

Income increasing
8
9

10

Panel A: Components of Earnings

Accruals

Cash Flows

Standardized Unexpected Earnings (SUE)

-0.105
(-0.073)

-0.041
(-0.035)

-0.027
(-0.025)

-0.019
(-0.017)

-0.013
(-0.012)

-0.007
(-0.006)

-0.001
(-0.001)

0.007
(0.007)

0.020
(0.020)

0.070
(0.054)

0.082
(0.069)

0.047
(0.045)

0.037
(0.036)

0.030
(0.029)

0.024
(0.023)

0.019
(0.018)

0.014
(0.012)

0.007
(0.006)

-0.005
(-0.006)

-0.051
(-0.039)

-1.39
(-0.066)

-0.259
(0.048)

-0.078
(0.066)

0.048
(0.094)

0.084
(0.083)

0.171
(0.122)

0.188
(0.132)

0.260
(0.145)

0.292
(0.147)

0.547
(0.207)

1.08
(1.08)

1.05
(1.05)

1.03
(1.02)

1.02
(1.02)

1.00
(1.01)

1.01
(1.02)

1.03
(1.04)

1.07
(1.06)

1.09
(1.09)

1.10
(1.09)

6.6
1.70

7.4
1.80

7.8
1.86

8.0
1.84

8.0
1.78

7.9
1.74

7.7
1.74

7.6
1.80

7.3
1.83

6.6
1.81

Panel B: Risk Proxies

Beta

Mean Size Decile

Median Market-to-Book
Accruals
Cash Flows
SUE
Beta

=
=
=
=

Size Decile =
Mkt-to-Book =

Earnings minus cash from operations, scaled by average total assets.

Cash from operations, as reported on the statement of cash flows, scaled by total assets.
Seasonally differenced quarterly earnings divided by the standard deviation of the forecast error.
firm specific coefficients from a time series regression of the individual firm return over the risk free rate on the corresponding size decile return over the risk free rate. Regressions
are based on the 60 months prior to the month of the earnings announcement.
average decile based on classifications of all NYSE/AMEX firms, where 1 contains the smallest firms and 10 contains the largest firms.
Ratio of market Value of Common Equity to Book Value of Common Equity, measured at the end of the prior quarter.

33

Table 1b. Mean (median) values of selected characteristics for ten portfolios formed quarterly on the magnitude of operating cash
flows. Sample consists of 41,237 firm quarters over the years 1988-1997
Quarterly Portfolio Cash Flow Ranking
1

10

Panel A: Components of Earnings

0.053
(0.049)

0.012
(0.016)

0.002
(0.004)

-0.004
(-0.003)

-0.010
(-0.007)

-0.014
(-0.012)

-0.019
(-0.017)

-0.024
(-0.022)

-0.035
(-0.031)

-0.077
(-0.057)

Cash Flows

-0.060
(-0.046)

-0.011
(-0.009)

0.002
(0.003)

0.010
(0.011)

0.017
(0.017)

0.024
(0.023)

0.031
(0.030)

0.039
(0.038)

0.052
(0.049)

0.102
(0.082)

Standardized Unexpected Earnings

(SUE)

-0.200
(-0.039)

-0.158
(0.041)

-0.112
(0.075)

-0.047
(0.066)

-0.040
(0.069)

-0.040
(0.106)

-0.000
(0.106)

0.101
(0.138)

0.121
(0.171)

0.245
(0.221)

1.12
(1.11)

1.09
(1.09)

1.06
(1.06)

1.03
(1.04)

1.01
(1.02)

1.03
(1.04)

1.00
(1.01)

1.03
(1.02)

1.05
(1.05)

1.08
(1.05)

6.3
1.61

6.9
1.54

7.4
1.52

7.6
1.56

7.8
1.66

8.0
1.81

8.1
1.94

8.1
2.09

7.9
2.17

7.3
2.22

Accruals

Panel B: Risk Proxies

Beta

Mean Size Decile

Median Market-to-Book
Accruals
Cash Flows
SUE
Beta

=
=
=
=

Size Decile =
Mkt-to-Book =

Earnings minus cash from operations, scaled by average total assets.

Cash from operations, as reported on the statement of cash flows, scaled by total assets.
Seasonally differenced quarterly earnings divided by the standard deviation of the forecast error.
firm specific coefficients from a time series regression of the individual firm return over the risk free rate on the corresponding size decile return over the risk free rate. Regressions
are based on the 60 months prior to the month of the earnings announcement.
average decile based on classifications of all NYSE/AMEX firms, where 1 contains the smallest firms and 10 contains the largest firms.
ratio of market Value of Common Equity to Book Value of Common Equity, measured at the end of the prior quarter.

34

Table 2. Results from non-linear generalized least-squares estimation of the stock price reaction
to information in current financial statement information. CSAR is the cumulative size and risk
adjusted return following the release of financial statements; Qt+i equals earnings for quarter i;
Accruals equals earnings minus cash from operations; CashFlow equals cash from operations as
reported on the statement of cash flows. Variables are scaled by average total assets to ensure
cross-sectional comparability.

Panel A: Post-Earnings Announcement Drift Specification

Qt+1 = Qt-3 + 0 + 1(Qt - Qt-4) + vt+1
CSARt+1 = 0 + 1(Qt+1 Qt-3 - 0 - 1*(Qt - Qt-4)) + t+1
Parameter
1
1*
1
Test of Market Efficiency
Likelihood ratio statistic
Marginal Significance level

Estimate
0.306
0.093
1.819

Asymptotic Std. Error

0.005
0.033
0.001

1 = 1*
43.55
0.001

Panel B: Decomposition of current earnings into accrual and cash flow components
Qt+1 = Qt-3 + 0 + 1Accrualst + 2CashFlowt - 1Qt-4 + vt+1
CSARt+1 = 0 + 1(Qt+1 - Qt-3 - 0 - 1*Accrualst - 2*CashFlowt + 1*Qt-4) + t+1
Parameter
1
1*
2
2*
1
1*
1

Estimate
0.234
0.295
0.247
0.134
0.301
0.092
1.776

Test of Market Efficiency

Likelihood ratio statistic
Marginal Significance level

1 = 1* and 2 = 2*
113.44
0.001

35

Asymptotic Std. Error

0.006
0.037
0.006
0.037
0.007
0.042
0.058

Table 3. Abnormal returns for a holding period of two quarters based upon quarterly rankings
of unexpected earnings (SUE) and either accruals or cash flows. Quintiles 2 through 4 have been
condensed into one cell. Mean values reported are computed as a mean across 36 quarters. The
number of observations per cell is reported in parentheses and is based on the total number of
firm quarters in a given cell spanning the years 1988-1997. Shaded cells represent observations
that have congruent signals for future unexpected earnings.
Panel A: Unexpected Earnings (SUE) and Accrual classifications
SUE Quintile

ACC1

SUE1
-0.29%
(2612)

SUE2-4
1.70%*
(3751)

SUE5
5.84%*
(1705)

2.16%*
(8068)

ACC2-4

-2.55%*
(4029)

0.09%
(16764)

3.08%*
(4156)

0.10%
(24949)

ACC5

-6.11%*
(1302)

-1.57%*
(4792)

0.76%
(2126)

-1.74%*
(8220)

-2.40%*
(7943)

0.02%
(25307)

3.11%*
(7987)

Accrual Quintile

Panel B: Unexpected Earnings (SUE) and Cash Flow classifications

SUE Quintile

CFO1

SUE1
-4.43%*
(2081)

SUE2-4
-0.45%
(4253)

SUE5
0.99%
(1760)

-1.19%*
(8094)

CFO2-4

-1.89%*
(4409)

-0.00%
(16328)

3.44%*
(4133)

0.23%
(24870)

CFO5

-1.10%
(1453)

0.61%
(4726)

4.10%*
(2094)

1.22%*
(8273)

-2.40%*
(7943)

0.02%
(25307)

3.11%*
(7987)

Cash Flow Quintile

Significantly different from zero at =0.01 level

36

Table 4. Regression-based estimates of size-adjusted abnormal returns over the two quarters
following a quarterly earnings announcement. Portfolios formed using extreme SUE and Accrual
quintiles, ranked on a quarterly basis. Return accumulation begins 18 days after the quarter t
earnings announcement date and ends 17 days after the quarter t+2 earnings announcement.
Parameter estimates are computed as the mean estimate across all 36 quarters, and t-statistics are
computed using the sampling distribution of the parameter estimates. Significance levels are
based on a t-distribution with 35 degrees of freedom.
Panel A: Joint SUE and Accruals Regression Parameter Estimates
CSARt, t+2 = + 1t SUE1 + 2t SUE5 + 3t ACC1 + 4t ACC5 +
5t SUE1*ACC1 + 6t SUE1*ACC5 + 7t SUE5*ACC1 + 8t SUE5*ACC5 + t
Parameter

Mean Estimate:

.0009

-.0265

.0298

.0160

-.0166

-.0066

-.0189

.0114

-.0065

(t-Statistic)

(0.19)

(3.99)**

(4.20)**

(2.95)**

(3.32)**

(0.55)

(1.66)*

(0.802)

(0.60)

Accrual and SUE hedge portfolio: 11.94% (t=7.13)**

Panel B: Joint SUE and Cash Flow Regression Parameter Estimates

CSARt, t+2 = + 1t SUE1 + 2t SUE5 + 3t CFO1 + 4t CFO5 +
5t SUE1*CFO1 + 6t SUE1*CFO5 + 7t SUE5*CFO1 + 8t SUE5*CFO5 + t
Parameter

Mean Estimate:

.0001

-.0187

.0345

-.0044

.0061

-.0210

.0017

-.0200

.0004

(t-Statistic)

(0.01)

(2.65)**

(4.94)**

(0.75)

(1.23)

(1.90)*

(0.16)

(1.67)*

(0.05)

Cash flow and SUE hedge portfolio: 8.53% (t=5.83)

* Significant at = 0.05, one tailed

** Significant at = 0.01, one tailed
Results are based upon 41,237 observations.

37

Table 5. Cumulative size and risk adjusted returns accruing to hedge portfolios. Means are
computed as a mean across 36 fiscal quarters over the years 1988-1997. Individual strategies are
based on taking offsetting long and short positions in the appropriate extreme deciles. Joint
strategies are computed using intersection of extreme deciles as well as extreme quintiles.
Hedge portfolio partition

1Q Abnormal Returns
(Standard Deviation)

2Q Abnormal Returns
(Standard Deviation)

4.24%*
(4.63%)

6.88%*
(6.03%)

Accrual

2.76%*
(2.98%)

5.56%*
(4.63%)

Cash Flows

2.09%*
(3.48%)

3.77%*
(5.06%)

9.35%*
(12.94%)

15.87%*
(17.48%)

7.05%*
(6.01%)

11.94%*
(10.06%)

5.83%*
(7.23%)

12.73%*
(14.05%)

5.05%*
(5.54%)

8.53%*
(8.77%)

Individual strategies:
SUE

Joint Strategies:
Accruals & SUE
Deciles

Quintiles

Cash Flows & SUE

Deciles

Quintiles

* Significantly different from zero at the 0.01 level

38

Figure 1. Two-quarter abnormal returns to a strategy taking a long

(offsetting short) position in firms with the largest positive (negative)
unexpected earnings. Based on 36 quarters over the years 1988-1997.
0.3

0.1
Mean Ret
6.88%
97

96

96

95

95

94

94

93

93

92

92

91

91

90

90

89

89

0
88

Abnormal Return

0.2

Sum Pos
262%

-0.1

Sum Neg
-11.6%

-0.2

Minimum
-2.10%

-0.3
Year

39

Table 1a. Mean (median) values of selected characteristics for ten portfolios formed quarterly on the magnitude of accruals. Sample
consists of 41,237 firm quarters over the years 1988-1997.
Quarterly Portfolio Accrual Ranking
Income decreasing
2
3

Income increasing
8
9

10

Panel A: Components of Earnings

Accruals
Cash Flows
Standardized Unexpected Earnings
(SUE)

-0.105
(-0.073)

-0.041
(-0.035)

-0.027
(-0.025)

-0.019
(-0.017)

-0.013
(-0.012)

-0.007
(-0.006)

-0.001
(-0.001)

0.007
(0.007)

0.020
(0.020)

0.070
(0.054)

0.082
(0.069)

0.047
(0.045)

0.037
(0.036)

0.030
(0.029)

0.024
(0.023)

0.019
(0.018)

0.014
(0.012)

0.007
(0.006)

-0.005
(-0.006)

-0.051
(-0.039)

-1.39
(-0.066)

-0.259
(0.048)

-0.078
(0.066)

0.048
(0.094)

0.084
(0.083)

0.171
(0.122)

0.188
(0.132)

0.260
(0.145)

0.292
(0.147)

0.547
(0.207)

1.08
(1.08)

1.05
(1.05)

1.03
(1.02)

1.02
(1.02)

1.00
(1.01)

1.01
(1.02)

1.03
(1.04)

1.07
(1.06)

1.09
(1.09)

1.10
(1.09)

6.6
1.70

7.4
1.80

7.8
1.86

8.0
1.84

8.0
1.78

7.9
1.74

7.7
1.74

7.6
1.80

7.3
1.83

6.6
1.81

Panel B: Risk Proxies

Beta
Mean Size Decile
Median Market-to-Book
Accruals
Cash Flows
SUE
Beta

=
=
=
=

Size Decile =
Mkt-to-Book =

Earnings minus cash from operations, scaled by average total assets.

Cash from operations, as reported on the statement of cash flows, scaled by total assets.
Seasonally differenced quarterly earnings divided by the standard deviation of the forecast error.
firm specific coefficients from a time series regression of the individual firm return over the risk free rate on the corresponding size decile return over the risk free rate. Regressions
are based on the 60 months prior to the month of the earnings announcement.
average decile based on classifications of all NYSE/AMEX firms, where 1 contains the smallest firms and 10 contains the largest firms.
Ratio of market Value of Common Equity to Book Value of Common Equity, measured at the end of the prior quarter.

33

Table 1b. Mean (median) values of selected characteristics for ten portfolios formed quarterly on the magnitude of operating cash
flows. Sample consists of 41,237 firm quarters over the years 1988-1997.
Quarterly Portfolio Cash Flow Ranking
1

10

Panel A: Components of Earnings

0.053
(0.049)

0.012
(0.016)

0.002
(0.004)

-0.004
(-0.003)

-0.010
(-0.007)

-0.014
(-0.012)

-0.019
(-0.017)

-0.024
(-0.022)

-0.035
(-0.031)

-0.077
(-0.057)

Cash Flows

-0.060
(-0.046)

-0.011
(-0.009)

0.002
(0.003)

0.010
(0.011)

0.017
(0.017)

0.024
(0.023)

0.031
(0.030)

0.039
(0.038)

0.052
(0.049)

0.102
(0.082)

Standardized Unexpected Earnings

(SUE)

-0.200
(-0.039)

-0.158
(0.041)

-0.112
(0.075)

-0.047
(0.066)

-0.040
(0.069)

-0.040
(0.106)

-0.000
(0.106)

0.101
(0.138)

0.121
(0.171)

0.245
(0.221)

1.12
(1.11)

1.09
(1.09)

1.06
(1.06)

1.03
(1.04)

1.01
(1.02)

1.03
(1.04)

1.00
(1.01)

1.03
(1.02)

1.05
(1.05)

1.08
(1.05)

6.3
1.61

6.9
1.54

7.4
1.52

7.6
1.56

7.8
1.66

8.0
1.81

8.1
1.94

8.1
2.09

7.9
2.17

7.3
2.22

Accruals

Panel B: Risk Proxies

Beta
Mean Size Decile
Median Market-to-Book
Accruals
Cash Flows
SUE
Beta

=
=
=
=

Size Decile =
Mkt-to-Book =

Earnings minus cash from operations, scaled by average total assets.

Cash from operations, as reported on the statement of cash flows, scaled by total assets.
Seasonally differenced quarterly earnings divided by the standard deviation of the forecast error.
firm specific coefficients from a time series regression of the individual firm return over the risk free rate on the corresponding size decile return over the risk free rate. Regressions
are based on the 60 months prior to the month of the earnings announcement.
average decile based on classifications of all NYSE/AMEX firms, where 1 contains the smallest firms and 10 contains the largest firms.
ratio of market Value of Common Equity to Book Value of Common Equity, measured at the end of the prior quarter.

34

Figure 2a. Two-quarter abnormal returns to a strategy taking a long

(offsetting short) position in firms with the largest income increasing
(income decreasing) accruals. Based on 36 quarters over the years
1988-1997.
0.3

0.1
Mean Ret
5.56%
97

96

96

95

95

94

94

93

93

92

92

91

91

90

90

89

89

0
88

Abnormal Return

0.2

-0.1

Sum Pos
211%
Sum Neg
-10.7%

-0.2

Minimum
-7.95%

-0.3
Year

Figure 2b. Two-quarter abnormal returns to a strategy taking a long

(offsetting short) position in firms with the largest positive (negative)
operating cash flows. Based on 36 quarters over the years 1988-1997.

0.3

0.1
Mean Ret
3.77%
97

96

96

95

95

94

94

93

93

92

92

91

91

90

90

89

89

0
88

Abnormal Return

0.2

Sum Pos
158%

-0.1
Sum Neg
-20.3%
-0.2
Minimum
-7.07%
-0.3
Year

40

Figure 3. Abnormal returns for extreme SUE and joint SUE

and Accrual quintiles for a fixed 120-day window. Quintile
classifications are based on an overall sample of 41,237 firmquarters spanning the years 1988-1997.
0.08
SUE5/ACC1
(n=1705)

0.06

0.04

SUE5
(n=7987)

Abnormal Return

0.02

SUE5/ACC5
(n=2126)

SUE1/ACC1
(n=2612)

-0.02

SUE1
(n=7943)

-0.04

SUE1/ACC5
(n=1302)
-0.06

-0.08
18

30

45

60

75

90

105

Days Relative to Quarterly Earnings Announcement

41

120

137

Figure 4a. Two-quarter abnormal returns to a strategy taking a long (offsetting

short) position in firms with both the largest income decreasing (income
increasing) accruals and the largest postive (negative) unexpected earnings.
Based on 36 quarters over the years 1988-1997. Based on quintile
classifications.
0.3

Mean Ret
11.94%

0.1

Sum Pos
448%
97

96

96

95

95

94

94

93

93

92

92

91

91

90

90

89

89

0
88

Abnormal Return

0.2

-0.1

Sum Neg.
-22.5%

-0.2

Minimum
-15.0%

-0.3
Year

Figure 4b. Two-quarter abnormal returns to a strategy taking a long

(offsetting short) position in firms with both the largest positive (negative)
unexpected earnings and the largest postive (negative) operating cash
flows. Based on 36 quarters over the years 1988-1997.

0.3

0.1

Mean
Ret
8.53
%
97

96

96

95

95

94

94

93

93

92

92

91

91

90

90

89

89

0
88

Abnormal Return

0.2

Sum
Pos

-0.1

-0.2

-0.3
Year

42