What drives the accrual spread evidence from a contemporary decomposition approach

What drives the accrual spread? Evidence from a contemporary decomposition approach Viet Nga Cao*a, Frankie Chaub and Krishna Paudyalc Abstract We examine the main drivers of the accrual spread and the profitability of accrual-based trading strategies by disaggregating total accrual into three components: investment in working capital that supports growth, accrual estimation error, and temporary working capital fluctuation Several findings emerge First, stock returns are inversely related to working capital investment that supports growth and accrual estimation error, particularly in firms with higher long-term growth or are exposed to a higher degree of financial constraints Second, investment in working capital drives the accrual spread through risk, whereas accrual estimation error does so through mispricing The positive relationship between temporary working capital fluctuation and stock returns is also risk-based, implying that timing the input market may amplify firms’ exposure to the cyclicality of the product market Finally, an implementable trading strategy based on a modified version of accrual estimation error can generate superior risk-adjusted returns to investors JEL Classification: M41, G12, G14 Keywords: accrual decomposition, earnings management, financial constraint, q-theory a Monash University, 900 Dandenong Road, Caulfield East, VIC 3145, Australia Email: Viet.Cao@monash.edu b Durham University Business School, Mill Hill Lane, Durham DH1 3LB, United Kingdom Email: h.c.f.chau@dur.ac.uk c Department of Accounting and Finance, University of Strathclyde, 100 Cathedral Street, Glasgow G4 0LN, United Kingdom Email: Krishna.Paudyal@strath.ac.uk * Corresponding author We thank Eric Lam and other participants of the 2013 EFMA Annual Meeting, Reading, UK, participants of the 2013 FMA Annual Conference, Chicago, US, and Robert Faff, Andrew Marshall and Cameron Truong for their helpful comments and suggestions Any remaining errors are ours INTRODUCTION Sloan’s (1996) seminal work shows that long positions in stocks of low accrual firms and short positions in stocks of high accrual firms can generate positive abnormal returns (hereafter the accrual spread) More recently, Allen et al (2013) examine Sloan’s functional fixation hypothesis by decomposing total accrual into three components: (a) investment in working capital that supports growth (MDDGROWTH), (b) accrual estimation error (MDDERROR), and (c) temporary fluctuation in working capital (MDDMATCH) and provide evidence in favor of the hypothesis Whilst Sloan’s functional fixation hypothesis has been rigorously examined by Allen et al (2013), detailed examinations of other theories of the accrual spread2 using the components of total accrual remain Similarly, no study has been devoted to examining the possibility of profitable trading strategies using the three components of accrual To fill these voids, we decompose total accrual into its three components as in Allen et al (2013) and study several theories of the accrual spread and the possibility of profitable trading strategies Several studies document a positive association between the accrual spread and measures of firm growth For example, Fairfield et al (2003) argue that the accrual spread arises due to either diminishing marginal returns on physical investment or accounting conservatism Similarly, Zhang (2007) confirms a positive relationship between firms’ employee growth and the accrual spread Building on the works of Fairfield et al (2003) and Zhang (2007), Wu et al (2010) demonstrate that the accrual spread is a manifestation of q-theory where management maintains high working capital (i.e high accrual) in anticipation of low discount rates Q-theory could be particularly useful in explaining the accrual spread contributed by the growth-related component (MDDGROWTH) of total accrual, as this is the part of accrual which responds to changes in firms’ investment opportunity sets The functional fixation hypothesis of Sloan (1996) suggests that the positive accrual spread arises because investors fail to distinguish between the persistence levels of cash-based and accrual-based earnings When predicting firms’ future earnings, investors tend to overestimate (underestimate) the persistence of accrual- (cash-) based earnings leading to mispricing of stocks As mispricing is corrected, lower (higher) returns are realized in the stocks of high (low) accrual firms For example, earnings management (Chan et al., 2006; Kothari et al., 2006), analyst upward bias or agency problem (Bradshaw et al., 2001; Teoh and Wong, 2002), investors’ failure to recognize the variation in accrual reliability (Richardson et al., 2005), and firm growth (Fairfield et al., 2003; Zhang, 2007; Wu et al., 2010) Allen et al (2013) suggest that the second accrual component, i.e MDDERROR, reflects either earnings management or management’s poor forecasts Kothari et al (2006) and Chan et al (2006) suggest that the accrual spread is attributable to earnings management when realized growth fails to meet investors’ expectations Hence, we argue that MDDERROR may contribute to the accrual spread through earnings management In addition, Lakonishok et al (1994) suggest that investors are prone to error-in-expectation bias when firm growth is high If management also suffers from the same bias, they may over-estimate future growth opportunities and over-invest, which may result in the accrual spread (Wei and Xie, 2008) Hence MDDERROR may also contribute to the mispricing of the accrual spread due to over-investment The sources of the final accrual component relating to working capital fluctuation (MDDMATCH) and its impact on the accrual spread are less understood Allen et al (2013) suggest that MDDMATCH reflects management’s taking advantage of temporary mispricing in the input market Building on Allen et al.’s (2013) insights, we conjecture that the relationship between MDDMATCH and stock returns can be explained by risk More specifically, firms that time the input market may face an amplified exposure to the cyclicality of the product market The additional input that the firm accumulates may support future sales when the product market condition improves By contrast, if the future product market condition deteriorates, the additional input from previously timing the input market may become a burden as it ties up the firm’s financial resources when final products become slow-moving Before embarking on the tests of alternative theories of accrual spread, we verify Allen et al.’s (2013) finding that MDDGROWTH and MDDERROR (MDDMATCH) are negatively (positively) related to raw returns and therefore contribute to (mitigate) the accrual spread Hereafter, we primarily concentrate on testing the validity of the various other hypotheses of the accrual spread by examining the roles of the three components of accrual We also shed new light on the risk versus mispricing nature of these accrual components Finally, we develop an implementable trading strategy based on the mispricing of a specific component of accrual The study makes several contributions to the literature While Wu et al (2010) suggest that the accrual spread is partially explained by q-theory, we provide the first evidence that MDDGROWTH, i.e the accrual component reflecting the working capital investment that supports growth, is responsible for this accrual explanation The observed steeper slope of stock returns on MDDGROWTH amongst more financially constrained firms suggests that the relationship between MDDGROWTH and stock returns is likely to be a manifestation of q-theory with investment friction as stipulated by Li and Zhang (2010) We also find a more pronounced relationship between MDDGROWTH and stock returns amongst firms with higher growth, suggesting that MDDGROWTH contributes to the accrual spread through firm growth (Fairfield et al., 2003; Zhang, 2007; Wu et al., 2010) Using the asset pricing framework of Avramov and Chordia (2006), we show that the relationship between MDDGROWTH and stock returns is driven by risk as it can be explained by several factor models.3 Second, we contribute to the mispricing strand of the accrual anomaly literature by examining the potential mispricing of MDDERROR, an accrual component that reflects accrual estimation error MDDERROR remains significantly negatively related to risk-adjusted stock returns, suggesting that it contributes to the accrual spread through mispricing The results further show that the inverse relationship between MDDERROR and stock returns becomes increasingly prominent for firms with higher long-term growth or which are exposed to a higher degree of financial constraints This is possible because high firm growth may expose investors to error-in-expectation (Lakonishok et al., 1994) and induce management to manage earnings (Kothari et al., 2006; Chan et al., 2006) Financial constraints may also trigger upwards earnings management (Jha, 2013) while curbing over-investment (Wei and Xie, 2008) Hence, our results suggest that earnings management is likely to be the source of mispricing of MDDERROR which leads to the accrual spread Third, this study provides new evidence on the relationship between fluctuation in working capital (MDDMATCH) and stock returns We find that the positive relationship between MDDMATCH and stock returns increases with firm growth and the degree of financial constraints Further, the positive relationship between MDDMATCH and stock returns, which partially mitigates the accrual spread, can be explained by the asset pricing factor models Therefore, the results support our view that the relationship between MDDMATCH and stock returns is driven by risk, as timing the input market may amplify firms’ exposure to the product market condition Not only we extend the understanding of the contribution of this accrual Hence, our investigation differs from Allen et al (2013) who associate both MDDGROWTH and MDDERROR with the accrual spread through their lack of persistence relative to cash-based earnings component to the accrual spread, but also identify a potential source of systematic risk arising from working capital management Finally, our analysis is also of value to investors wishing to take advantage of mispricing Based on our findings of the mispricing of accrual estimation error (MDDERROR), we modify the portfolio sorting dimension to include only the information that is available to investors at the time of portfolio formation and develop a long-short trading strategy The profitability of this new trading strategy, which has not been examined earlier, is about 60% higher than the conventional accrual-based trading strategies The profitability of our strategy can be improved further (up to 1.38% per month in raw returns and 1.33% in risk-adjusted returns) when it is implemented amongst high growth or financially constrained firms HYPOTHESES DEVELOPMENT Although the accrual spread is known to be a worldwide phenomenon4, what actually drives it remains debatable Several possible explanations have been put forward in the extant literature For example, Sloan (1996), in his functional fixation hypothesis, suggests that investors fail to recognize the difference in the persistence of the accrual and cash components of earnings leading to the mis-valuation of firms Zhang (2007), however, fails to find evidence to support the functional fixation hypothesis Using a novel accrual decomposition approach, Allen et al (2013) document that the growth-related accrual component and accrual estimation error are both less persistent than the cash-based component of earnings They conclude that the accrual spread is driven by the mispricing of these two components due to investors’ functional fixation, as Sloan (1996) suggests The accrual decomposition approach of Allen et al (2013) is different from the previous approaches (such as Jones, 1991; Defond and Park, 2001; Xie, 2001) in the way ‘abnormal’ accrual is measured While the other approaches consider the accrual component not related to growth as ‘abnormal’, Allen et al (2013) suggest that part of it reflects temporary fluctuation in working capital associated with realized future benefits They find that the accrual spread is For evidence on the accrual spread in international markets, see LaFond (2005) and Pincus et al (2007) In the U.S market, Fama and French (2008) report that the accrual spread is among the most robust phenomena driven by the growth-related component (MDDGROWTH) and accrual estimation error (MDDERROR) By contrast, the component reflecting temporary working capital fluctuation (MDDMATCH) moderates it MDDGROWTH and MDDMATCH reflect ‘good accrual’ associated with realized future benefits, whereas MDDERROR reflects accrual estimation not eventually materialized This paper utilizes the more refined accrual decomposition approach of Allen et al (2013) to examine several other theories of the accrual spread Wu et al (2010) suggest that qtheory and an investment-based risk factor partially explain the accrual spread By contrast, Hirshleifer et al (2012) examine whether the return predictability of total accrual reflects firm risk or characteristics and find support for the latter Their results lend support to a mispricing explanation irrespective of the mechanisms A more refined accrual decomposition approach will extend our understanding of (a) how different mechanisms may give rise to the accrual spread and (b) through which mechanisms each accrual component contributes to that spread 2.1 Firm growth and the accrual spread A growing strand of the literature views the accrual spread as a function of firm growth Accrual reflects, at least in part, firm growth as it represents firms’ investment in working capital Fairfield et al (2003) and Zhang (2007), among others, document that the accrual spread is driven by the growth information contained in the accrual Fairfield et al (2003) also attribute the accrual spread to either diminishing marginal returns on investment or accounting conservatism Building on the works of Fairfield et al (2003) and Zhang (2007), Wu et al (2010) argue that q-theory can explain a large part of the total accrual spread This theory maintains that management rationally adjusts firms’ investment in working capital as the discount rate changes When discount rates (expected returns) are lower, more investment projects become profitable and firms invest more in both fixed- and working-capital Hence, to the extent that total accrual reflects firms’ investment in working capital, higher accrual would be associated with lower expected stock returns, and vice versa In line with this prediction, Wu et al (2010) document that the returns on the accrual-based trading strategies can be partially explained by Fama and French’s (1996) three-factor model augmented with an investment-based factor (i.e returns to the portfolio long in low-investment stocks and short in high-investment stocks) Firms’ investments serve two purposes, (a) to maintain the current production capacity, and (b) to support changes in operation scale (either contraction or expansion) An example of investment for the first purpose is to replace fully depreciated assets, which tends to be routine On the other hand, investment to support growth tends to be more sensitive to expected changes in discount rates as they affect firms’ investment opportunity sets High growth firms, having a higher proportion of their investment to support growth, are likely to be more sensitive to discount rate changes Since q-theory attributes the accrual spread to the negative relationship between working capital investment and discount rates, the accrual spread is expected to be more pronounced among high growth firms As MDDGROWTH consists of “accrual related to growth in the working capital base required to support changes in the firm’s scale of operations” (Allen et al., 2013, p.118), we argue that the q-theory explanation for the accrual spread operates through MDDGROWTH Specifically, q-theory explains the negative relationship between MDDGROWTH and stock returns, and this relationship becomes more prominent with firm growth The negative relationship between MDDGROWTH and stock returns is manifest in a positive MDDGROWTH spread5 and we conjecture that: H1a: The MDDGROWTH spread is positive, and its magnitude increases with firm growth The relationship between the total accrual spread and firm growth might also be driven by accrual estimation error (MDDERROR) Allen et al (2013) argue that MDDERROR reflects either management’s poor forecasts or earnings management Kothari et al (2006) suggest that the accrual spread is attributable to earnings management in order to prolong stock overvaluation due to positive investor sentiment They further argue that earnings management is more likely to take place when realized growth fails to meet investor expectation Chan et al (2006) suggest that earnings management tends to happen when a firm’s realized growth is slower than the historical level and management wishes to delay reporting the slow growth Lakonishok et al (1994) suggest that investors investing on high growth firms are prone to error-in-expectation bias whereby they expect a higher level of growth than the firm can deliver as a result of their The MDDGROWTH spread is defined as the hedge return to the portfolio long in low MDDGROWTH stocks and short in high MDDGROWTH stocks extrapolation of past growth into the future Hence, we conjecture that MDDERROR contributes to the relationship between firm growth and the accrual spread through earnings management Further, high growth firms are more likely to witness management’s poor forecasting if the management is also subject to error-in-expectation bias Wei and Xie (2008) suggest that when management overestimates future growth, they over-invest and face a subsequent negative stock market reaction Working capital may be accumulated in response to management’s overestimation of future growth that is not eventually realized Hence, management’s estimation error, captured by MDDERROR, contributes to the relationship between firm growth and the accrual spread Overall, both earnings management and management’s over-estimation of future growth imply a positive relationship between firm growth and the MDDERROR spread:6 H1b: The MDDERROR spread is positive and its magnitude increases with firm growth Finally, we examine the way in which temporary fluctuation in working capital (MDDMATCH) may contribute to the accrual spread Allen et al (2013) describe MDDMATCH as reflecting management’s taking advantage of temporary mispricing in the input market For example, facing a temporarily low price in the input market, management may stock inventories to a higher level than normal Consistent with the expectation that the inventory level will eventually converge to the normal level, Allen et al (2013) report that MDDMATCH exhibits the strongest reversal pattern out of all the accrual components.7 We argue that firms timing the input market face an amplified exposure to the cyclicality of the product market These firms face the risk that the accumulated input will not materialize into future benefits when the future product market condition deteriorates Investors may therefore request the additional premium to hold the stocks of firms with high MDDMATCH, causing a positive association between MDDMATCH and future returns This positive relationship would translate into a negative MDDMATCH spread, defined as the return to the portfolio long in low MDDMATCH firms and short in high MDDMATCH firms Further, when firms have high long-term growth potential, management is more likely to take advantage of the The MDDERROR spread is defined as the hedge return to the portfolio long in low MDDERROR stocks and short in high MDDERROR stocks Allen et al (2013) argue that the strong reversal pattern of MDDMATCH questions the practice of associating accrual reversal with earnings management in the literature We formalize our conjecture on risk versus mispricing of the accrual components in section 2.3 input market in anticipation that the additionally accumulated input will help support future sales (or reduce production costs) Hence, we expect a positive relationship between firm growth and the magnitude of the MDDMATCH spread and expect that: H1c: The MDDMATCH spread is negative and its magnitude increases with firm growth 2.2 Financial constraints and the accrual spread The extent to which firms are financially constrained is likely to affect the accrual spread for several reasons Wu et al (2010) suggest that management adjusts working capital in response to changes in discount rates (expected returns) When discount rates are lower, more potential projects become investable and firms increase their working capital level accordingly Hence, a higher working capital level (which corresponds to higher total accrual) is associated with lower expected future returns In a two period setting, Li and Zhang (2010) analytically show that the negative slope of stock returns on corporate investment is steeper (i.e more negative) when firms are subject to higher investment adjustment costs They report supporting evidence for their conjecture on the slopes of returns on several investment-related variables when investment adjustment costs are measured by financial constraints Applying this interpretation of q-theory to the context of the accrual spread, we expect the negative slope of stock returns on accrual to be more negative when firms face higher financial constraints Hypothesis H1a attributes the q-theory explanation to MDDGROWTH Hence, we also conjecture that the negative relationship between MDDGROWTH and stock returns is more pronounced in more financially constrained firms: H2a: The magnitude of the MDDGROWTH spread increases with the degree of financial constraints Financial constraints may also affect the accrual spread through MDDERROR DeAngelo et al (1994) show that firms facing financial difficulties manage earnings downwards to utilize the contractual re-negotiation opportunities However, Rosner (2003) reports that firms that eventually go bankrupt (ex post), but not appear in distress ex ante, manipulate their earnings upwards Firms which are close to covenant violations are also more likely to manage earnings upwards (Jha, 2013) In addition, financial constraints may also indirectly motivate management to manage earnings upwards through the adverse impact of financial constraints on firm growth (Chan et al., 2006; Kothari et al., 2006) These scenarios may give rise to a positive association between financial constraints and the MDDERROR spread On the other hand, financial constraints may curb the degree of over-investment (Wei and Xie, 2008) and hence should reduce the MDDERROR spread Taken together, although financial constraints are likely to affect the accrual spread due to MDDERROR, the sign of the relationship between financial constraints and the MDDERROR spread remains an empirical question: H2b: The magnitude of the MDDERROR spread is significantly related to the degree of financial constraints Finally, we examine how financial constraints affect the relationship between temporary working capital fluctuation (MDDMATCH) and stock returns As argued above, firms involved in timing the input market face an amplified exposure to the cyclicality of the product market, which may attract a premium in holding their stocks (hypothesis H1b) We argue that when firms face financial constraints, timing the input market may incur more inherent risk as the limited financial resources would be stretched even further to fund the temporary accumulation of inputs.9 Hence, financial constraints may amplify the exposure of those firms involved in timing the input market to future product market condition Accordingly, these firms may attract an even higher risk premium when also facing financial constraints: H2c: The magnitude of the MDDMATCH spread increases with the degree of financial constraints 2.3 Risk versus mispricing of the accrual spread Our investigation also addresses the much debated question of whether the accrual spread arises because of the compensation for risk or mispricing Hirshleifer et al (2012) report that the accrual spread is due to the mispricing of total accrual By contrast, Wu et al (2010) argue that part of the anomaly is a manifestation of q-theory, and the accrual spread can be partially explained by the Fama and French three-factor model augmented with an investment-based factor We argued in sections 2.1 and 2.2 that MDDGROWTH is likely to be associated with the q-theory explanation for the accrual spread, as Wu et al (2010) advocate MDDERROR is potentially mispriced as a result of earnings management or management’s error in estimating Livdan et al (2009) also suggest that financial constraints expose firms to aggregate shocks as they limit firms’ ability to smooth the dividend stream 9 capital (MDDMATCH), and (c) accrual estimation error (MDDERROR) to study several explanations for the accrual spread Different from other accrual decomposition approaches, Allen et al.’s (2013) approach extracts information on temporary working capital fluctuation from the non-growth part of total accrual Hence, this approach results in a more refined measure of accrual estimation error and a new component (MDDMATCH) not previously well understood Allen et al (2013) document that MDDGROWTH and MDDERROR (MDDMATCH) are (is) negatively (positively) related to raw stock returns, hence contributing to (mitigating) the accrual spread While Allen et al (2013) use these accrual components to study Sloan’s functional fixation hypothesis, this paper examines the validity of several other explanations for accrual spread It also sheds new light on the less known component of total accrual (i.e temporary working capital fluctuation) and proposes a profitable trading strategy based on another component (i.e accrual estimation error) We find that the negative relationship between MDDGROWTH and stock returns becomes more prominent amongst firms which have higher long-term growth or are more financially constrained Using the asset pricing framework of Avramov and Chordia (2006), we also find that this negative relationship can be explained by several multi-factor models The results show that the contribution of MDDGROWTH to the accrual spread is consistent with the implication of q-theory While confirming Wu et al.’s (2010) finding, we present new evidence that identifies the specific component of total accrual responsible for the accrual spread under qtheory Similar to MDDGROWTH, the negative relationship of MDDERROR to stock returns becomes more prominent amongst higher growth or more financially constrained firms However, this relationship remains significant even after adjusting returns for risk using the CAPM, the Fama and French three-factor model, the Carhart four-factor model and the investor sentiment augmented model The results suggest that the contribution of MDDERROR to the accrual spread is consistent with the earnings management explanation proposed by Chan et al (2006) and Kothari et al (2006) The contrasting natures of MDDGROWTH and MDDERROR documented in this paper contribute to the debate on risk versus mispricing in the literature Allen et al (2013) suggest that these two accrual components contribute to the accrual spread through mispricing in accordance 27 with Sloan’s (1996) functional fixation hypothesis Hirshleifer et al (2012) compare the risk and mispricing of total accrual and find that the accrual spread is attributable to the latter By contrast, our results suggest that the relationship with stock returns of MDDGROWTH is riskbased Finally, apart from Allen et al.’s (2013) finding that MDDMATCH is positively related to raw stock returns and hence mitigates the accrual spread, relatively little is known about this accrual component We find that the MDDMATCH spread increases with firm growth and financial constraints Its relationship with stock returns can be explained by several multi-factor models The results support our view that the relationship between MDDMATCH and stock returns is also risk-based, as timing the input market may amplify firms’ exposure to the product market condition Firms engaging in input market timing may tie up their funds in working capital when there is insufficient product market demand, while doing so may benefit firms in improved product market condition In addition to contributing to the debate on the sources of the accrual spread, this study has valuable implications for investors wishing to exploit stock mispricing We propose a longshort strategy based on a modified version of accrual estimation error that generates about 60% more profit than 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