Accruals, Investment, and Future Firm Performance

ABACUS, Forthcoming

36 Pages Posted: 7 Feb 2012 Last revised: 27 Feb 2020

See all articles by Jenny Chu

Jenny Chu

University of Cambridge - Judge Business School

Date Written: July 31, 2019

Abstract

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.

Keywords: accruals anomaly; earnings fixation; investment anomaly; negative working capital; research and development (R&D) accounting

JEL Classification: G12, G14, M41

Suggested Citation

Chu, Jenny, Accruals, Investment, and Future Firm Performance (July 31, 2019). ABACUS, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1999685 or http://dx.doi.org/10.2139/ssrn.1999685

Jenny Chu (Contact Author)

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

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