Investors’ Expectation of Loss Reversal and Test of Accruals Mispricing

• In Event: Financial Accounting and Reporting II

Abstract

This study reconciles the findings in recent studies regarding the disappearing mispricing of accruals and sustained mispricing of cash flows. We attribute the contrasting results to the negative future stock returns of the firms having both highly negative accruals and highly negative cash flows. For these firms, aside from the previously documented performance-related delisting effects, it appears that investors expect large losses to reverse but are, in fact, negatively surprised by the persistence of negative cash flows. Investors’ different priors of the future earnings behavior of loss versus profit firms partially explain the contrasting results in prior studies. Our results also suggest that tests of accruals mispricing using asset-deflated accruals may not be desirable when there is a disproportionate number of small firms in the sample that have large losses as the effect of loss persistence dominates the effect of accruals reversal for these firms.

Authors

• Jung Hoon Kim, Florida International University

• Young Jun Kim, Seoul National University