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Percent Accruals

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Percent Accruals” by Nader Hafzalla, Russell J. Lundholm, and E. Matthew Van Winkle delves into the effectiveness of accruals-based trading strategies in relation to the benchmarks employed to identify extreme accruals. Introducing “percent accruals” as a measure that scales accruals by earnings instead of total assets, the authors reveal how this alternative approach leads to a significant shift in data sorting.

Their findings indicate that trading strategies based on percent accruals yield larger annual hedge returns compared to traditional accruals measures, primarily due to improved long positions in low accrual stocks. Furthermore, the study demonstrates that percent accruals are more effective in targeting firms with the greatest disparities between sophisticated and naïve forecasts – a result that supports the earnings fixation hypothesis.

The analysis also reveals that percent accruals apply equally well to both loss and gain firms, independent of the presence of special items, providing valuable insights into accrual benchmarks and their impact on market efficiency and excess returns.

Abstract Of Paper

We document how the effectiveness of an accruals-based trading strategy changes with the benchmark used to identify an extreme accrual. We measure “percent accruals” as accruals scaled by earnings, rather than total assets, and show that this seemingly small change produces a radically different sort of the data. We find that a trading strategy based on percent accruals yields significantly larger annual hedge returns than the traditional accruals measure, and does so mostly by improving the long position in low accrual stocks. The hedge returns are also significant in all but the lowest quintile of arbitrage risk. We show that percent accruals more effectively select firms where the difference between sophisticated and naïve forecasts are the most extreme. As such, our results are consistent with the earnings fixation hypothesis and are inconsistent with some alternative explanations for the accrual anomaly. We also find that percent accruals are not dependent on the presence or absence of special items and identify misvalued stocks just as well for loss firms as for gain firms, in contrast to the traditional accruals measure.

Original paper – Download PDF

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Author

Nader Hafzalla
affiliation not provided to SSRN

Russell J. Lundholm
University of British Columbia – Sauder School of Business

E. Matthew Van Winkle
Voyant Advisors

Conclusion

In conclusion, the “Percent Accruals” research by Nader Hafzalla, Russell J. Lundholm, and E. Matthew Van Winkle provides a novel perspective on accruals-based trading strategies by examining the impact of using different benchmarks for extreme accrual identification.

The study introduces percent accruals as a measure that scales accruals by earnings instead of total assets, resulting in remarkably distinct data sorting. The findings reveal that percent accruals-based trading strategies achieve significantly larger annual hedge returns than traditional accruals measures, primarily by improving the long position in low accrual stocks.

Furthermore, percent accruals effectively target firms with the largest discrepancies between sophisticated and naïve forecasts, corroborating the earnings fixation hypothesis. Additionally, the authors demonstrate that percent accruals are applicable regardless of special items’ presence and perform equally well for both loss and gain firms.

This research offers valuable insights into the influence of accrual benchmarks on market efficiency and excess returns, highlighting the potential benefits of adopting alternative metrics in trading strategies.

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FAQ

Q1: What is the main focus of the research paper “Percent Accruals” by Nader Hafzalla, Russell J. Lundholm, and E. Matthew Van Winkle?

The research paper explores the effectiveness of accruals-based trading strategies by examining the impact of different benchmarks used to identify extreme accruals. It introduces “percent accruals,” a measure that scales accruals by earnings instead of total assets, and investigates its implications for data sorting and trading strategy returns.

Q2: How do trading strategies based on percent accruals compare to traditional accruals measures in terms of hedge returns?

The findings indicate that trading strategies based on percent accruals yield significantly larger annual hedge returns compared to traditional accruals measures. This improvement is attributed, in large part, to enhanced long positions in low accrual stocks.

Q3: What insights does the research provide regarding the effectiveness of percent accruals in targeting specific firms, and how does it relate to the earnings fixation hypothesis?

The study demonstrates that percent accruals more effectively select firms with the most extreme differences between sophisticated and naïve forecasts. This finding aligns with the earnings fixation hypothesis, suggesting that market participants may have a fixation on earnings-related information. The results offer insights into the accrual anomaly and market efficiency.

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