Accrual Reversals, Earnings and Stock Returns

Accounting accruals anticipate future economic benefits. They are intended to reverse upon the realization of the anticipated future benefits, such that their reversals have no net impact on future earnings. In practice, however, we show that extreme accruals exhibit a high frequency of subsequent reversals that do impact future earnings. We demonstrate that these reversals explain a number of previously documented results, including the low persistence of accruals and the negative relations between accruals and both future earnings changes and future stock returns. We also corroborate our findings using a hand-collected sample of inventory write-downs, demonstrating that extreme positive inventory accruals are followed by a disproportionately high frequency and magnitude of subsequent inventory write-downs. Our results suggest that extreme accruals contain a significant amount of estimation error that has predictable consequences for future accruals, earnings and stock returns.