Accrual intentions: Investors miss vital clues for smart stock buys

There are plenty of judgment calls associated with accrual accounting, giving managers some wiggle room in recognizing expenses and income. But can investors spot the wiggle? Do they identify and price that discretionary portion of earnings correctly? The W. P. Carey School's Dahlia Robinson looked at the issue and discovered that most investors don't. There's opportunity here for investors with the savvy to take advantage of the price corrections that follow when earnings realities catch up with earnings-release hype. But Robinson questions whether there's a regulatory imperative lurking in her findings, as well: "Maybe requiring some accrual information in the earnings announcement would be beneficial for the market."

A flurry of stock trades often follows earnings statements and, unsurprisingly, that's not always a good thing for those making the buys. But, it can be even worse when companies don't disclose accrual-related details in earnings releases, according to Dahlia Robinson, an Assistant Accountancy Professor at the W. P. Carey School of Business.

She has found that without accruals information in the relatively easy-to-read earnings statement, investors may not evaluate and price discretionary accruals correctly. That's bad news for the unenlightened, and good news for those in the know. It means that savvy investors could take advantage of the price corrections that follow when earnings realities overtake new-release statements.

Dissecting discretion

In the world of accrual accounting, income counts when "earned," regardless of whether the customer has paid for purchases, and expenses hit the income statement when "incurred," even if the bills have yet to be settled. So, for instance, the "bad debt" that's recorded against credit sales is actually based on corporate managers' estimates.

Investors must rely on financial disclosures to assess what estimates management made. That may take some doing, as the accrual accounting method gives managers a little wiggle room in recognizing expenses and earnings in financial statements. Can investors spot the wiggle? Do they identify and price that discretionary portion of earnings correctly. Often, they don't, Robinson says. And she should know. She studied investor reactions to earnings statements for four years.

Robinson collected earnings announcement releases from 1999 through 2002 — studying these documents, as well as the investor behavior that followed them for around 16,000 firm quarters. Along with investor reactions to earnings announcement, she looked at investor behavior that followed filings with the Securities and Exchange Commission (SEC). Then, she tracked long-term results as stock prices varied through the following year.

Working with Henock Louis of Penn State and Andrew Sbaraglia of Florida International University, Robinson probed deeper into abnormal earnings — those that deviate from what analysts expect — by mathematically calculating expected accruals from earnings statements. The research team theorized that if accrual information appeared in the earnings announcement, investors would estimate the level of managerial discretion in earnings. That way, they would correctly price the discretionary and the non-discretionary components of firm financials.

Conversely, the team felt investors would be less likely to discern discretionary versus non-discretionary earnings for firms that didn't disclose accrual details. "In a rational world, you would expect investors to put more weight in the non-discretionary component of accruals," Robinson says. After all, she notes, they are what they are. There's no fudging on those numbers, as there could be with the discretionary values.

Besides, she adds, "people know that earnings with high-discretionary accruals are more likely not to persist, and you should price them accordingly." Do investors set the right price? Not always, the researchers found. "For firms that do not provide balance sheet information in their earnings announcement releases, investors don't price discretionary and non-discretionary components of earnings differently," Robinson says.

In fact, they put the same weight on the two, and they shouldn't. That's because, over the long run, prices tend to drop for stocks of companies with high-discretionary accruals. "The discretionary component should be discounted relative to the one that managers cannot control." Investors know that, but according to Robinson, they don't always act on that knowledge.

She and her fellow researchers wondered if there was a rational explanation for this accrual anomaly where investors don't respond correctly to the discretionary part of earnings. "Could it be about non-disclosure of accrual information in earnings announcements?" she asks. The research team decided to find out.

Show and tell

Accrual information may show up in SEC filings, but that doesn't mean investors understand it. "We know from prior literature that investors don't respond as well to SEC filing information as they do to earnings-release information," Robinson notes. She adds that there are many possible reasons for this well-documented phenomenon, including "information overload" due to the tremendous amount of financial disclosure in an SEC filing.

"Earnings announcement information is easier to assess, and so investors tend to pay more attention to it." Unfortunately, not all companies disclose enough information in earnings announcements for investors to tease out the discretionary versus non-discretionary components of accruals.

When companies do give enough balance-sheet detail in their earnings releases to ferret out those components, Robinson called them "disclosers." Non-disclosers were those companies that waited until their SEC filings before they offered a financial statement complete enough to be dissected into discretionary and non-discretionary accruals.

For such non-disclosers, the researchers found that there was a partial correction in stock price once SEC filings came to light, and investors had enough information to distinguish between the two accrual types. But, the price correction was "not complete," Robinson maintains. She adds that this is consistent with the notion that investors can't quite digest all that SEC detail, anyway.

For the disclosers, there was no adjustment once the SEC filing came down the pike. "Pricing errors only happened with non-disclosing firms," Robinson says. "If investors have the information at the earnings announcement, they can reasonably make an estimate of discretionary or non-discretionary accruals and price those components properly."

For companies that disclose accrual details in earnings statements, the researchers found no correction at all. "If the information is available at the earnings announcement, investors correctly price the two components of accruals," Robinson states. "They recognize that the discretionary component should have a lower weight than the non-discretionary component."

Ups and downs

The researchers also found that firms with low discretionary accruals in their earnings statements tended to have positive returns for the following year. Those with high discretionary accruals generally had negative returns. That trend leads to an accruals-based trading strategy. If investors went with long-term buys in firms with low discretionary accruals, they would have made 10.8 percent annual return during the period Robinson et al. studied.

But, knowing that those firms with high discretionary accruals will likely go down in price, there's money to be made in them with a short seller's strategy. Going short in a stock means borrowing shares while the stock is high priced, selling those share immediately, then buying the stock back once the price has dropped. The stock borrower returns the shares after the price has fallen, then pockets the difference between the high and low sales prices.

During the time period the researchers studied, the average negative return for those high-discretionary-accruals firms was 4.7 percent. If an investor had been short in those stocks, that's the amount she could add to her earnings. When added to the 10.8 percent return on the firms with low discretionary accruals, that's a whopping 15.5 percent return. "I'm sure there are researchers who do this investment strategy," Robinson says.

"If you go short in those high-discretionary-accrual firms and go long in the low ones, you can make money doing it." Still, making money off the accrual anomaly isn't necessarily the take-away Robinson's research tells her is valuable. Perhaps there's a regulatory imperative lurking in her findings, as well, she concludes. "Maybe requiring some accrual information in the earnings announcement would be beneficial for the market."

Bottom Line

• Investors tend to pay more attention to information in earnings announcements than SEC filings.
• When earnings announcements fail to disclose enough financial detail for investors to discern discretionary versus non-discretionary accrual numbers, investors make errors in pricing accruals.
• After SEC files are released, stock prices generally correct for those overpriced discretionary accruals.
• Investors could make money looking for discretionary versus non-discretionary accrual information in SEC filings. Going long in firms with low discretionary accruals and short in those with high ones could result in double-digit ROI.