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The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly

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  • Patricia M. Dechow

    (University of Michigan)

  • Weili Ge

    (University of Michigan)

Abstract

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

Suggested Citation

  • Patricia M. Dechow & Weili Ge, 2006. "The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly," Review of Accounting Studies, Springer, vol. 11(2), pages 253-296, September.
    • Handle: RePEc:spr:reaccs:v:11:y:2006:i:2:d:10.1007_s11142-006-9004-1
    DOI: 10.1007/s11142-006-9004-1
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    Cited by:

    1. Panos N. Patatoukas, 2014. "Detecting news in aggregate accounting earnings: implications for stock market valuation," Review of Accounting Studies, Springer, vol. 19(1), pages 134-160, March.
    2. Adam Esplin & Max Hewitt & Marlene Plumlee & Teri Lombardi Yohn, 2014. "Disaggregating operating and financial activities: implications for forecasts of profitability," Review of Accounting Studies, Springer, vol. 19(1), pages 328-362, March.
    3. Kevin Ke Li, 2011. "How well do investors understand loss persistence?," Review of Accounting Studies, Springer, vol. 16(3), pages 630-667, September.
    4. Theodore E. Christensen & Kenneth J. Merkley & Jennifer Wu Tucker & Shankar Venkataraman, 2011. "Do managers use earnings guidance to influence street earnings exclusions?," Review of Accounting Studies, Springer, vol. 16(3), pages 501-527, September.
    5. Nerissa C. Brown & Theodore E. Christensen, 2014. "The quality of street cash flow from operations," Review of Accounting Studies, Springer, vol. 19(2), pages 913-954, June.
    6. Mohammadreza Tavakoli Baghdadabad & Girijasankar Mallik, 2025. "Breaking down value: a novel method," Empirical Economics, Springer, vol. 69(3), pages 1467-1525, September.
    7. Beisland, Leif Atle & Mersland, Roy, 2013. "Earnings Quality in the Microfinance Industry," EconStor Open Access Book Chapters, in: Microfinance in Developing Countries: Issues, Policies and Performance Evaluation, pages 83-106, ZBW - Leibniz Information Centre for Economics.
    8. Patricia M. Fairfield & Karen A. Kitching & Vicki Wei Tang, 2009. "Are special items informative about future profit margins?," Review of Accounting Studies, Springer, vol. 14(2), pages 204-236, September.
    9. Mark T. Bradshaw, 2011. "A discussion of “Do managers use earnings guidance to influence street earnings exclusions?”," Review of Accounting Studies, Springer, vol. 16(3), pages 528-538, September.
    10. Patricia M. Fairfield, 2006. "Discussion of “The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly”," Review of Accounting Studies, Springer, vol. 11(2), pages 297-303, September.

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    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • M4 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting

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