Sloan’s seminal paper demonstrated that the base rate effects of accruals analysis were solid. However, like all financial studies, we need to recognise the limitations of this study and subsequent research:
- Firstly, the market is adaptive and will incorporate these findings (as per Green, Hand and Soliman 2009, there is already evidence that this is occurring);
- The study is based on top level aggregate data which contains many errors and generalilsations. As a result there will be a significant variance in results at an individual stock level. This offers both opportunities and risks.
- The sheer quantity of financial information allows for data mining that can enable many possible results.
A good indication of the limitations of this research was provided by Dechow, Ge and Schrand. Their meta analysis of > 300 studies related to earnings quality began by noting that…
“earnings quality is defined only in the context of a specific decision model”
… and then concluded:
“our … general observation about the state of the literature viewed in its entirety is that there is no measure of earnings quality that is superior for all decision models”
In essence, there is no simple, one size fits all, answer. We need to understand the individual questions we are asking and frame our analysis accordingly.
A starting point is to use the aggregate level of accruals to provide a rough Bayesian base rate probability. This base rate can then be adjusted depending upon the stock specific factors at work in each case. In this process we would start by ….