Earnings decompose into a cash-flow component and an accrual component. The accrual component is less persistent, but investors "fixate" on the bottom-line earnings number and fail to discount it. A strategy that buys low-accrual firms and shorts high-accrual firms earned roughly 10% per year in abnormal returns. This is the founding paper of the accrual anomaly.
What anomaly it documents
Predictor: the accrual component of earnings (earnings minus cash flow from operations), scaled by total assets.
Direction:negative — high accruals predict low future returns; low (or negative) accruals predict high future returns.
Mechanism: accruals are more subjective and less persistent than cash flows. Investors who anchor on reported earnings overvalue high-accrual firms (whose earnings will mean-revert downward) and undervalue low-accrual firms.
OSAP predictor: Accruals, classified 1_clear.
How to construct it
Sorting variable: operating accruals via the balance-sheet method — the change in non-cash working capital minus depreciation and amortization, scaled by average total assets. (The later Hribar-Collins cash-flow-statement method is cleaner and avoids merger/divestiture contamination.)
Universe: US nonfinancial firms with required Compustat items.
Portfolio formation: annually, after financial statements are public (e.g., 3–4 months after fiscal year-end).
Long / short: long the lowest-accrual decile, short the highest-accrual decile.
Weighting: equal-weighted in the original; value-weighting substantially shrinks the effect.
Rebalancing: annual.
Evidence and replication
Period
Sharpe (approx)
Ann. Return
T-stat
Source
IS (1962–1991)
~0.7
≈10.4% hedge return
significant
this paper
OOS (post-1996)
declining
materially weaker
—
Green, Hand & Soliman 2011
OSAP replication
clear, positive IS
—
—
Chen & Zimmermann 2022
The original low-minus-high accrual hedge earned about 10.4% per year in size-adjusted abnormal returns.
The anomaly is a textbook McLean-Pontiff case: heavily published and then arbitraged. Green, Hand & Soliman (2011) document its decline as hedge-fund capital flowed in during the 2000s.
Value-weighted and large-cap-only versions are much weaker — the effect leans on smaller firms.
Why it might work
Earnings fixation / functional fixation (the thesis): investors process the headline earnings number without decomposing its persistence, so they are systematically surprised when high-accrual earnings reverse. This is a mispricing story.
Limits to arbitrage: the anomaly concentrates in smaller, costlier-to-trade, hard-to-short names, which is why it persisted before becoming widely known.
Risk-based alternatives: weaker; some link accruals to investment/growth (the q-theory connection to asset growth), suggesting partial overlap with the investment factor rather than pure mispricing.
Limitations and risks
Post-publication decay: among the clearest examples of an anomaly shrinking after it was published and traded.
Small-cap dependence: value-weighting and large-cap filters cut the premium sharply.
Measurement: balance-sheet accruals are contaminated by mergers/divestitures; use the cash-flow-statement definition (Hribar-Collins 2002).
Turnover and shorting costs: annual rebalance is manageable, but the short leg (high-accrual, often glamorous growth names) can be costly to borrow.
Overlap: correlated with investment/asset-growth and external-financing anomalies.
Key references
Sloan, R. (1996) — Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? — The Accounting Review — DOI: 10.2308/tar-9608042309
Hribar, P. & Collins, D. (2002) — Errors in Estimating Accruals: Implications for Empirical Research — Journal of Accounting Research
Green, J., Hand, J. & Soliman, M. (2011) — Going, Going, Gone? The Apparent Demise of the Accruals Anomaly — Management Science
Richardson, S., Sloan, R., Soliman, M. & Tuna, I. (2005) — Accrual Reliability, Earnings Persistence and Stock Prices — Journal of Accounting and Economics
Chen, A. & Zimmermann, T. (2022) — Open Source Cross-Sectional Asset Pricing — Critical Finance Review
