Accounting numbers are supposed to be reliable and relevant. However, due to the use of accrual based accounting, reliability can be flawed. Accruals are used to make earnings more relevant than cash flows, hence they put every business transaction into the period in which they belong, but at the cost of reducing reliability. Furthermore, accruals can be used to increase or decrease earnings in one period and if they are used correctly this variation will be reversed with following cash flows. These variations of earnings can have an impact on share prices and corporate decision making. Thus, Allen, Larson and Sloan (2013) investigate to what extent accruals are reversed and what impact they have on the stock market. First, this critical review will summarize the article, then it will critique data, methodology and findings before it finishes with a conclusion.
Table of Contents
1. Introduction
2. Summary
3. Critique of Data used
4. Critique of Methodology and Models
5. Critique of Findings
6. Conclusion
Objectives and Topics
The primary objective of this critical review is to evaluate the study by Allen, Larson, and Sloan (2013) regarding the impact of accrual reversals on earnings and stock returns. It aims to determine how accruals influence stock market performance, assess the effectiveness of the proposed methodology in distinguishing between "good accruals" and "accrual estimation error," and identify the implications of these findings for investors and earnings management.
- Analysis of the relationship between accruals, cash flows, and stock returns.
- Evaluation of the "good accruals" vs. "accrual estimation error" framework.
- Assessment of the data quality and the significance of the empirical methodology used.
- Investigation into how estimation errors impact earnings persistence and market mispricing.
- Discussion of limitations, including the focus on short-term horizons and exclusion of external factors.
Excerpt from the Book
Critique of Data used
The article uses data of the time frame from 1962 to 2009 of about 2,680 US publicly listed companies, which is a large time frame with a large group of companies and hence this sample is significant. For a serial correlation, which is one statistical method they are using, a large time frame is necessary, as it tries to find patterns in data (Kim, Kim and Ergün, 2015). All data is taken of the COMPUSTAT database, which is a reliable and commonly used data source and only relatively few mistakes in data can be detected (Hribar, 2016). Further, all financial service companies were excluded from the sample in order to enhance the significance of results. This approach is reasonable as accruals are a relatively small part of financial service company’s earnings and using data of those companies might blur overall results.
In general, the data used is valid, but it does have some limitations. Firstly, only data from US publicly listed companies is used, however, most companies in the US are not publicly listed but privately owned. Moreover, companies from outside the US were not considered and considering them could lead to different results as most countries use different accounting standards and legislation, which can have a large impact on reported earnings and accruals.
Summary of Chapters
Introduction: This section establishes the reliability issues inherent in accrual-based accounting and introduces the study's objective to examine the extent and impact of accrual reversals on the stock market.
Summary: This chapter provides an overview of how the original authors categorize accruals into good accruals and estimation errors to analyze their effect on future earnings and cash flows.
Critique of Data used: This section assesses the validity, sample size, and database source of the empirical study, while noting the limitations regarding the focus on US-listed companies.
Critique of Methodology and Models: This chapter reviews the ex-post perspective and the specific models used to distinguish accrual types, verifying their validity against established academic literature.
Critique of Findings: This part discusses the discovery of the dual-process nature of accruals and the implications of estimation errors for earnings management and persistence.
Conclusion: This final chapter synthesizes the contributions of the study to the field and suggests avenues for future research involving external factors and international datasets.
Keywords
Accruals, Accrual Reversals, Earnings Persistence, Stock Returns, Accrual Estimation Error, Good Accruals, Earnings Management, Financial Reporting, COMPUSTAT, Earnings Quality, Cash Flows, Market Mispricing, Accounting Standards, Investment Analysis.
Frequently Asked Questions
What is the core focus of the reviewed article?
The article investigates how earnings, cash flows, and accruals influence stock returns, specifically looking at how accrual variations are reversed over time.
What are the primary thematic areas?
The themes include earnings persistence, the quality of accruals, the distinction between good accruals and estimation errors, and their subsequent impact on stock prices.
What is the main research objective?
The objective is to analyze to what extent accruals are reversed, how long these reversals take, and the effect this has on investor decision-making and market valuations.
Which methodology is employed in the study?
The study utilizes an ex-post perspective on accruals, using data from COMPUSTAT, and applies statistical methods like Pearson and Spearman correlation coefficients to detect patterns and serial correlation.
What is covered in the main body of the work?
The main body critiques the data selection, the validity of the models used for distinguishing accrual types, the findings regarding company growth vs. working capital management, and the limitations of the current research framework.
Which keywords best characterize this work?
Key terms include Accrual Reversals, Earnings Quality, Earnings Management, Stock Returns, and Earnings Persistence.
How does the author define "accrual estimation error" in terms of earnings?
The author identifies the accrual estimation error as the least persistent part of earnings, which serves as a significant indicator of lower earnings quality and potential stock market mispricing.
Why did the reviewers highlight the exclusion of non-current operating assets?
The reviewers noted this as a limitation because non-current accruals can have a substantial impact on earnings quality, which is currently ignored by the model's short-term perspective.
- Quote paper
- Johannes Laake (Author), 2016, A Critical Review of Allen, E., Larson, C.R. and Sloan, R.G. (2013). Accrual reversals, earnings and stock returns. Journal of Accounting and Economics, 56 (-), pp.113-255., Munich, GRIN Verlag, https://www.hausarbeiten.de/document/365551
