Why Do Accruals Predict Earnings?

• In Event: Forecasting Profitability

Abstract

Firms with high accruals tend to have lower future earnings. We propose a new explanation for this phenomenon based on the way sales, profits, and working capital respond to changes in a firm’s product markets. These effects arise in the absence of measurement error in accruals or investment-related changes in profitability. Empirically, we show that high accruals predict a long-lasting drop in both profits and profitability even though accruals are positively related to sales growth going forward. Accruals also predict a significant increase in future competition, suggesting that high accruals are correlated with abnormally high—and, in equilibrium, transitory—true profitability that attracts new entrants to the industry. Overall, the predictive power of accruals is better explained by product-market effects than by measurement error in accruals or diminishing marginal returns from investment.

Authors

• Robert J Resutek, University of Georgia

• Jonathan Lewellen, Dartmouth College, NBER