The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors

Source: Dechow, P. M. & Dichev, I. D. (2002). The Accounting Review 77(s-1), 35–59.

TL;DR

Proposes a measure of earnings (accrual) quality based on how well a firm's working-capital

accruals map into realized cash flows. Accruals require estimates of future cash flows; **estimation

errors reduce accrual quality. Firms with low accrual quality have less persistent earnings**, and

accrual quality is a priced characteristic — the basis for an accrual-quality factor.

A quality dimension of earnings: accruals that don't convert into cash signal noisy or managed

earnings, which predict lower earnings persistence and (in later work) lower returns / higher cost of

capital.

Regress current working-capital accruals on prior, current, and future operating cash flows.

The residual standard deviation of this regression measures accrual estimation error — low

fit = low accrual quality.

Sort firms on accrual quality and relate it to earnings persistence and returns (the AQ factor of

Francis et al., 2005).

Larger accrual estimation errors are associated with smaller, more volatile firms, longer

operating cycles, and less persistent earnings.

Accrual quality is subsequently shown to be priced (a risk/quality factor).

A foundational accounting-quality construct underlying the accruals anomaly (Sloan, 1996) and

quality-factor investing; it formalizes why "earnings you can't trace to cash" are lower quality.

The measure mixes intentional manipulation with innocent estimation noise.

Whether accrual quality is a priced risk factor or a mispricing is debated.

Dechow, P. & Dichev, I. (2002) — The Quality of Accruals and Earnings — The Accounting Review

Sloan, R. (1996) — Do Stock Prices Fully Reflect Information in Accruals and Cash Flows? — The Accounting Review

Francis, J., LaFond, R., Olsson, P. & Schipper, K. (2005) — The Market Pricing of Accruals Quality — Journal of Accounting and Economics