Outline

1.Original study by Sloan

2. Trading Strategy

3. Results

4. Further test (exclude cash heavy industry)

5. Comparison with other countries

6. Behavioral explanations

7. Limitations

Introduction

We aim to investigate if the U.S stock market results of Sloan (1996) are valid in
Singapore and thus test for semi-strong efficiency of the Singapore Stock Exchange.

The accrual anomaly challenges the efficient market hypothesis, as it suggests that
abnormal returns can be earned by implementing a fairly straightforward strategy
based on publicly available information. In a frictionless rational asset pricing
framework (Fama and French 2008), the higher average returns for low-accrual firms
would need to reflect compensation for higher systematic risk

Competing Explanations for Accrual Anomaly

While the accrual anomaly has been well documented in the literature, several
hypotheses have been put forward to explain the anomaly. However, to date, there
has been no agreement on which hypothesis is dominant. The hypotheses can be
categorized into three main types:

1. Risk explanation – Accrual anomaly simply captures variation in risk-return

relation. Low accrual firms are fundamentally riskier than high accrual firm and
thus low accrual firms are priced to yield higher returns. If this interpretation is
 right, the markets could be potentially efficient and we would observe an accrual
anomaly because we have not identified the correct risk factor in our model.

For instance, Kahn (2008) measures risk using a four-factor model and found that
risk explain a substantial portion of the variation in average returns to high and low
accrual firms. In particular, firms in the extreme accrual deciles were found to
have a higher risk of financial distress. Wu et al. (2010) also provides a rational
explanation for the accrual anomaly – They interpret accruals as working capital
investment and attribute the accrual anomaly to firms optimally adjusting
investments in response to discount rate changes, as predicted by the q-theory of
investment.

2. Mispricing explanation – Investors do not use current earnings accurately to estimate

future earnings. More clearly, investors fail to distinguish between the accrual and
cash flow components of current earnings, despite the empirical finding that accruals
are less persistent than cash flows. Thus, when forming their expectations of future
earnings, investors overweight accruals (underweight cash flows) and are
subsequently surprised if accruals turn out to be less persistent than expected. This
leads to abnormal positive returns for low accrual companies and abnormal negative
returns for high accrual companies. For the US market, Sloan (1996) documents that
excess returns of a hedge strategy based on accrual differences are statistically
significant

Collins et al. (2003) further show that there is less accrual mispricing exhibited by
firms with high institutional ownership relative to firms with low institutional
ownership. Compared to individuals, institutional investors are relatively more
sophisticated and can better understand the different persistence properties of
accrual and cash flow components of earnings, which should lead to more
accurate pricing of earnings component. This could be due to institutional
investors’ superior ability to interpret information from financial statements or from
an informational advantage such as greater access to management.

3. Limits to arbitrage – Mashruwala et al. (2006) argue that market frictions could
make it hard to arbitrage away the accrual anomaly. These frictions include high
transaction costs, high idiosyncratic volatility and low stock liquidity. However, the
 limit to arbitrage explanation is not mutually exclusive and can be consistent with
any mispricing explanation. To the extent that market inefficiencies exist, one
should expect them to be more pronounced when arbitrage risk is higher.

*However, the accrual anomaly is present even among large and liquid firms
(Fama and French 2008).

Other considerations

As noted by Fairfield et al. (2003) and Zhang (2007), large positive accruals tend to
occur during periods of growth and equity issuance. There is a strong negative
relation between equity issuance activity and future returns (Loughran and Ritter,
1995).

The accrual anomaly could also be subsumed by some other empirical anomaly. For
instance, Desai et al. (2004) find that the accrual anomaly vanishes when they
control for value-glamour effects. However, this result holds only if the ratio of
operating cash flow to price is the proxy for the value-glamour effect, which is rather
uncommon in the finance community. More common proxies for the value-glamour
effect, such as book-to-market, earnings-to-price, and cash flow-to-price, give
different and inconclusive results.

Further decomposing the measure of accruals to disentangle the underlying

mechanisms, Zhang (2002) and Chan et al. (2006) identify inventories and accounts
receivable to be the main drivers of the accrual anomaly.

Limitations (depends on our results)

Firstly, the long periods in which abnormal returns are realized (up to three years
after portfolio formation) raise concerns about the interpretation of the evidence as
solely against market efficiency. The errors in the model of expected returns are
magnified when long-term returns are involved.

Secondly, the composition of the hedge return is different. While most of the hedge
returns (about 80%) in Table 2 are attributed to the long portfolio (i.e. the portfolio of
low accruals), the returns in Thomas and Zhang (2002) are mostly attributed to the
short portfolios (about 60%).

Firms in the extreme accrual deciles drive the success of the strategy. These deciles
predominantly consist of small firms, which are a special cause for concern in the
calculation of long-term abnormal returns (e.g. Lyon et al., 1999; Brav and Gompers,
1997).

Thirdly, one shortcoming of the regression models is that they force a linear relation
between accruals and future returns.

Kraft et al. (2006) also argue that most of the accrual anomaly studies lack
appropriate robustness tests and suffer from selection biases. They demonstrate the
importance of robustness tests and suggest that the accrual anomaly is mostly
driven by outliers.

Appendix

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Implications for the Accrual Anomaly. Journal of Business Finance &
Accounting, 39(1‐2), 35-59.

2. Cupertino, C., Martinez, A., & Da Costa, N. (2012). Accrual Anomaly in the
Brazilian Capital Market. Brazilian Administration Review, 9(4), 421-440.

3. Khan, M. (2012). A Simple Model Relating Accruals to Risk, and its

Implications for the Accrual Anomaly. Journal Of Business Finance &
Accounting, 39(1/2), 35-59.

4. Shi, L., & Zhang, H. (2012). Can the earnings fixation hypothesis explain the
accrual anomaly? Review of Accounting Studies, 17(1), 1-21.

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6. Chen, Xia, & Cheng, Qiang. (2002). Abnormal Accrual-based Anomaly and
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