How Does the Market Read Information Conveyed by Accruals

I apply return decomposition to explain the return predictability of accruals by exploring how fundamental information is incorporated into stock prices in the time series. I find that the underperformance of high accruals stocks mainly comes from the underperformance in the cash flow news component with the effect being stronger for low accruals quality stocks. In addition, high discretionary accruals stocks experience lower total returns and cash flow news both before and after portfolio formation. No such pattern is observed for stock portfolios based on nondiscretionary accruals. At the aggregate level, innovations in total accruals are negatively associated with contemporaneous returns through the discount rate news. Higher aggregate accruals predict higher future market returns due to both the expected return component and the discount rate news component. Overall, the results lend supports to the earnings fixation hypothesis, agency theory of earnings management, and Hirshleifer, Hou and Teoh (2009)’s conjecture that aggregate accruals contain information about market discount rates.