We formally model the implications of reliability for earnings persistence, with our model predicting that less reliable accruals result in lower earnings persistence. Investors do not appear to fully anticipate this lower persistence, leading to significant security mispricing.
Our empirical tests employ a comprehensive categorization of accounting accruals in which each accrual category is rated according to its reliability. Consistent with the predictions of our model, the empirical tests generally confirm that less reliable accruals lead to lower earnings persistence.
Our paper makes three contributions to the existing literature.
First, we directly link reliability to empirically observable properties of accounting numbers. We show that less reliable accruals introduce costs in the form of lower earnings persistence and the associated mispricing.
Second, we provide a comprehensive definition and categorization of accruals. Healy’s (1985) definition has become synonymous with accruals in the accounting literature. Yet we show that his definition excludes several economically significant categories of accruals with low reliability.
Third, we corroborate and extend Sloan’s (1996) findings regarding the mispricing of the accrual component of earnings. The accruals that we find to be the least reliable correspond closely to the adjustments that are made to earnings in arriving at free cash flow.