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LIUQING WANG DO STOCK PRICE FULLY REFLECT INFORMATION IN ACCRUALS AND CASH FLOWS ABOUT FUTURE EARNINGS RICHARD G. SLOAN Oct 2013 University of Pennsyvania The Accounting Review Vol 71. No 3 July 1996 Pp 289-315

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CONTENTS LIUQING WANG// PAGE 1 1OVERVIEW2 2PERSISTENCE OF ACCRUALS AND CASH FLOWS7 3FIXATION ON EARNINGS12 4ABNORMAL RETURN18 5RETURN CLUSTER22 6CONCLUSIONS25 7SUMMARY27

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LIUQING WANG// PAGE 2 OVERVIEW 1

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LIUQING WANG// PAGE 3 Accruals = (ΔCA – ΔCash) – (ΔCL – ΔSTD – ΔTP) – Dep where ΔCA = change in current assets ΔCash = change in cash/cash equivalents ΔCL = change in current liabilities ΔSTD = change in debt included in current liabilities ΔTP = change in income taxes payable Dep = depreciation and amortization expense Questions this paper answered Do the two components of earnings differ? Do stock prices fully reflect the difference between the two components? ABSTRACT Two Components of Earnings: Accruals and Cash Flows

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LIUQING WANG// PAGE 4 The importance of analyzing the accrual and cash flow components of current earnings is frequently emphasized Valuation theory prices stock by discounting further dividends which are generated from future earnings related to current earnings. While both components (cash flows and accruals) contribute to current earnings, current earnings performance is less likely to persist if it is attributable to the accrual component of earnings as opposed to the cash flow component. Cash flow from operations (CFO), as a measure of performance, is less subject to distortion than is the net income figure. The accrual system, which produces the income number, relies on accruals, deferrals, allocations and valuations, all of which involve higher degrees of subjectivity than what enters the determination of CFO RESEARCH MOTIVATIONS

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LIUQING WANG// PAGE 5 Samples The data analysis was conducted on stocks From 1962 – 1991 (30 years) 40,679 firm-year observations (financial statement and stock price data) Excluding banks, life insurance or property and casualty companies as the accruals are not available for those firms SAMPLE & MEASUREMENT Measurement

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LIUQING WANG// PAGE 6 DESCRIPTIVE STATISTICS

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LIUQING WANG// PAGE 7 LOGIC Hypothesis 1 The persistence of current earnings performance is decreasing in the magnitude of the accrual component of earnings and increasing in the magnitude of the cash flow component of earnings Hypothesis 2 (i) The earnings expectations embedded in stock prices fail to reflect fully the higher earnings persistence attributable to the cash component of earnings and the lower earnings persistence attributable to the accrual component of earnings Hypothesis 2 (iii) The abnormal stock returns predicted in H2 (ii) are clustered around future earnings announced dates Hypothesis 2 (ii) A trading strategy taking a long position in the stock of firms reporting relatively low levels of accruals and a short position in the stock of firms reporting relatively high levels of accruals generates positive abnormal stock returns

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LIUQING WANG// PAGE 8 PERSISTENCE OF ACCRUALS AND CASH FLOWS 2

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LIUQING WANG// PAGE 9 Earning performance attributable to the accrual components of earnings is less persistent than earnings performance attributable to the cash flow component of earnings TEST OF H1

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LIUQING WANG// PAGE 10 Results from Ordinary Least Squares Regressions of TEST OF H1

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LIUQING WANG// PAGE 11 Results from Ordinary Least Squares Regressions of TEST OF H1

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LIUQING WANG// PAGE 12 Results from Ordinary Least Squares Regressions of TEST OF H1 From the results, we can see that there is significant difference between accruals and cash flows.

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LIUQING WANG// PAGE 13 FIXATION ON EARNINGS 3

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LIUQING WANG// PAGE 14 Whether stock prices reflect the different properties of the accrual and cash flow components of earnings TEST OF H2 (I) Rational expectations test developed by Mishkin (1983)

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LIUQING WANG// PAGE 15 Whether stock prices reflect the different properties of the accrual and cash flow components of earnings TEST OF H2 (I) Market efficiency imposes the constraint that Market efficiency imposes the dual constraint that

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LIUQING WANG// PAGE 16 Whether stock prices reflect the different properties of the accrual and cash flow components of earnings TEST OF H2 (I) Market efficiency imposes the constraint that Market efficiency imposes the dual constraint that

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LIUQING WANG// PAGE 17 Results from Nonlinear Generalized Least Squares Estimation of the Stock Price Reaction to Information in Current Earnings about Future Earnings TEST OF H2 (I) Actual ValuesDecile Rankings

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LIUQING WANG// PAGE 18 Results from Nonlinear Generalized Least Squares Estimation of the Stock Price Reaction to Information in the Accruals and Cash Flows Components of Current Earnings about Future Earnings TEST OF H2 (I) Actual ValuesDecile Rankings From the results, we can see that investors fail to distinguish the difference between accruals and cash flows

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LIUQING WANG// PAGE 19 ABNORMAL RETURN 4

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LIUQING WANG// PAGE 20 Abnormal stock returns can be earned by exploiting investors’ inability to distinguish correctly between the accrual and cash flow components of earnings TEST OF H2(II)

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LIUQING WANG// PAGE 21 Abnormal stock returns can be earned by exploiting investors’ inability to distinguish correctly between the accrual and cash flow components of earnings TEST OF H2(II)

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LIUQING WANG// PAGE 22 Abnormal stock returns can be earned by exploiting investors’ inability to distinguish correctly between the accrual and cash flow components of earnings TEST OF H2(II) From the results, we can see that there is a robust negative relation between the accrual component of earnings and future stock returns.

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LIUQING WANG// PAGE 23 RETURN CLUSTER 5

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LIUQING WANG// PAGE 24 The abnormal stock returns documented in H2(ii) are clustered around the subsequent year’s earnings announcements. TEST OF H2(III) Announcement period & non-announcement period One Year Announcement period announcement date two days

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LIUQING WANG// PAGE 25 The abnormal stock returns documented in H2(ii) are clustered around the subsequent year’s earnings announcements. TEST OF H2(III) Announcement period returns v.s. non-announcement period returns

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LIUQING WANG// PAGE 26 CONCLUSIONS 6

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LIUQING WANG// PAGE 27 Conclusions & Explanation The persistence of earnings performance is shown to depend on the relative magnitudes of the cash flow and accrual components of earnings. Stock prices act as if investors fail to identify correctly the difference properties of these two components of earnings. This does not necessarily imply investor irrationality: ̶ The information acquisition costs and processing costs associated with implementing the strategy outlined in this paper in real time are non-trivial. ̶ Returns to exploiting the strategy are potentially limited by price pressure effect. CONCLUSIONS Additional issues for future research Lower persistence of earnings performance attributable to the accrual component of earnings is due to earning management Whether earnings management is made with the intent to temporarily manipulating stock prices and the motivations for any such stock price manipulations

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LIUQING WANG// PAGE 28 SUMMARY 7

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LIUQING WANG// PAGE 29 Lights this paper throws This paper let us rethink about investors’ rationality. More specifically, classic economic theory assumes that investors all think rationally, but “rationally” can be different for different people due to each investor’s knowledge limitations and information cost. We may get different conclusions about market efficiency from different perspectives. In this paper, market is efficient on earnings level but it is not efficient if we divided earnings into accruals and cash flows. It is always important to combining quantitative analysis with industrial knowledge. SUMMARY Questions This paper doesn’t explain why the market is efficient on total earning level, despite that the market is not efficient when consider accruals and cash flows separately. In other words, although investors fail to interpret the information about future earnings hidden in current earnings due to inability to distinguish the different properties of accruals and cash flows, their expectations of future earnings are not affected.

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