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Why do accruals predict earnings?

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  • Lewellen, Jonathan
  • Resutek, Robert J.

Abstract

Higher accruals are associated with lower subsequent earnings. We show this phenomenon can be explained by the way sales, profits, and working capital respond to changes in a firm's product markets. Empirically, high accruals predict high subsequent sales growth but a long-lasting drop in both profits and profitability. Accruals also predict an increase in future competition, suggesting that accruals are correlated with abnormally high—and, in equilibrium, transitory—true profitability that attracts new entrants to the industry. Overall, the predictive power of accruals is better explained by product-market effects than by measurement error in accruals or diminishing returns from investment.

Suggested Citation

  • Lewellen, Jonathan & Resutek, Robert J., 2019. "Why do accruals predict earnings?," Journal of Accounting and Economics, Elsevier, vol. 67(2), pages 336-356.
    • Handle: RePEc:eee:jaecon:v:67:y:2019:i:2:p:336-356
    DOI: 10.1016/j.jacceco.2018.12.003
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    References listed on IDEAS

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    Cited by:

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    3. Le, Ha Thi Thu & Tran, Ha Giang & Vo, Xuan Vinh, 2021. "Audit quality, accruals quality and the cost of equity in an emerging market: Evidence from Vietnam," International Review of Financial Analysis, Elsevier, vol. 77(C).
    4. Brian M. Burnett & Gregory W. Martin & David A. Reppenhagen, 2021. "Managerial discretion in revenue recognition amidst financial restatements and implications for GAAP compliance," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 48(5-6), pages 869-894, May.
    5. Moritz Scherrmann & Ralf Elsas, 2023. "Earnings Prediction Using Recurrent Neural Networks," Papers 2311.10756, arXiv.org.
    6. Xia Chen & Qiang Cheng & Ying Hao & Qiang Liu, 2020. "GDP growth incentives and earnings management: evidence from China," Review of Accounting Studies, Springer, vol. 25(3), pages 1002-1039, September.
    7. Liu, Chengcheng & Li, Qing & Lin, Yu-En, 2023. "Corporate transparency and firm value: Does market competition play an external governance role?," Journal of Contemporary Accounting and Economics, Elsevier, vol. 19(1).
    8. Nezlobin, Alexander & Sloan, Richard G. & Giedt, Jenny Zha, 2022. "Construct validity in accruals quality research," LSE Research Online Documents on Economics 112165, London School of Economics and Political Science, LSE Library.
    9. Penman, Stephen & Zhu, Julie, 2022. "An accounting-based asset pricing model and a fundamental factor," Journal of Accounting and Economics, Elsevier, vol. 73(2).

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