Earnings Quality and Stock Returns

By Konan Chan, Louis K. C. Chan, Narasimhan Jegadeesh, Josef Lakonishok. 2006

555 citations recorded by the source corpus.

An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flow) are reliably, negatively associated with future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses -- earnings manipulation, extrapolative biases about future growth, and under-reaction to business conditions -- to explain accruals' predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, and discretionary versus nondiscretionary components of accruals.

Subfields: Accounting, Finance, Strategy and Management

View Paper: https://www.semanticscholar.org/paper/1f8d20690b280af829d06a2d3c21f984526a5ae5

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Citations in the corpus

The Stock Market and Corporate Investment: A Test of Catering Theory (2009, background): “This interpretation, though plausible, is not consistent with previous findings (e.g., Chan et al., 2001) that show that firms with abnormally soft earnings actually have relatively poor operating performance in subsequent years.”
Earnings Manipulation and Expected Returns (2013, background): “(2005); Chan, Chan, Jegadeesh, and Lakonishok (2006); Cooper et al. (2008); Hirshleifer et al.”
The Quality of Accounting Information in Politically Connected Firms (2011, unknown): “…actions by the SEC (Dechow, Sloan, and Sweeney, 1996), lawsuits (Francis, Philbrick, and Schipper, 1994), a higher cost of both debt and equity capital (Francis, LaFond, Olsson, and Schipper, 2004, 2005) and poor future returns (Chan, Chan, Jegadeesh, and Lakonishok, 2006). accruals quality.”
Why is the Accrual Anomaly not Arbitraged Away? The Role of Idiosyncratic Risk and Transaction Costs (2006, background): “The small negative return for the short position seems, at first blush, to be at odds with prior work (e.g., Houge and Loughran, 2000, Chan et al., 2006; Beneish and Vargus, 2002; Desai et al., 2004) where the short position represents a substantial portion of the abnormal returns to the accrual s”
Share Repurchases as a Potential Tool to Mislead Investors (2010, unknown): “Developing a proxy for managerial intent — earnings quality To gauge earnings quality, we follow Sloan (1996) and Chan et al. (2006) to define accruals in Eq.”
The Predictive Value of Expenses Excluded from Pro Forma Earnings (2002, unknown): “See Dechow (1994), Finger (1994), Sloan (1996), Richardson et al. (2002), Dechow et al. (1998), Hribar (2000), Chan et al. (2001), Xie (2001), Liu and Thomas (2000), Fairfield et al. (2001), Barth et al. (2001), Thomas and Zhang (2001), and Liu et al. (2002).”
Overpriced Shares, Ill-Advised Acquisitions, and Goodwill Impairment (2011, unknown): “Following Chan et al. (2006) and Polk and Sapienza (2009), we define discretionary accruals as the difference between the firm’s total accruals and “normal accruals,” deflated by average total assets.”
Accruals Quality, Stock Returns, and Macroeconomic Conditions (2010, unknown): “The exclusion of low-priced stock is not unusual in asset pricing tests (Jegadeesh and Titman 2001; Bali et al. 2005; Chan et al. 2006).”
The other side of value: The gross profitability premium. (2013, methodology): “(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)”
How far can we trust earnings numbers? What research tells us about earnings management (2013, methodology): “Chan et al. (2006) use a different method to calculate DACCs, but they also conclude that the accrual anomaly is significantly related to DACCs, and not related at all to NDACCs. Pincus et al. (2007) consider the role of AM and the accruals anomaly in an international setting. Similar to Xie (2001) ”