The Accruals anomaly, as it has come to be known, was made famous by Richard Sloan in his landmark 1996 research paper “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?”¹. In this paper, Sloan hypothesised that because investors tend to “fixate” on reported earnings instead of distinguishing the cash flow and accrual components of earnings, this represented an investment opportunity. His proof involved two steps.
Firstly, he measured the persistence of earnings – how much of next years earnings can be predicted by this years earnings. For earnings in general this figure was 84c for each dollar. He then repeated this measurement, but separated the earnings into two components, a cash flow component and an accruals component. His results were clear:
- For the cash flow component, around 86c in every dollar of cash persisted into next year; and
- For the accruals component, around 77c in every dollar persisted into next year.