The q - Theory Approach to Understanding the Accrual Anomaly

Interpreting accruals as working capital investment, we hypothesize based on q-theory that firms optimally adjust their accruals in response to discount rate changes. A higher discount rate means less profitable investments and lower accruals, and a lower discount rate means more profitable investments and higher accruals. Our evidence supports this optimal investment hypothesis: (1) adding an investment factor into standard factor regressions substantially reduces the magnitude of the accrual anomaly, often to insignificant levels; (2) accruals covary negatively with discount rate estimates from the dividend discounting model, and for the most part, with estimates from the residual income model; (3) accruals with low accounting reliability covary more with capital investment than accruals with high accounting reliability; and (iv) expected returns to accruals-based trading strategies are time-varying, suggesting that the deterioration of the accrual effect in recent years might be temporary and likely to mean-revert in the near future. ∗University of Georgia; †University of Michigan and the National Bureau of Economic Research; ‡Yale School of Management. For helpful comments, we thank Andrew Ang, Sreedhar Bharath, Long Chen, Mozaffar Khan (discussant), Reuven Lehavy, Paolo Pasquariello, Amiyatosh Purnanandam, Joanna Wu, and seminar participants at Emory University, the 18th Annual Conference on Financial Economics and Accounting at New York University, and CRSP Forum 2008. We especially thank Douglas Skinner (the Editor) and an anonymous referee for helpful advice that has greatly helped improve the paper. Lu Zhang acknowledges the financial support provided by the NTT Program of Asian Finance and Economics at the Stephen M. Ross School of Business at the University of Michigan. This manuscript supersedes our working papers previously circulated as “The accrual anomaly: Exploring the optimal investment hypothesis” and “Understanding the accrual anomaly.” All remaining errors are our own.