Equities

Earnings Quality and Short Sellers

Topics - Equities ESG Investing

${ numberSection } ${ text }
Earnings Quality and Short Sellers

Earnings quality is often defined in terms of persistence and sustainability. In this paper, earnings that are more persistent are viewed as higher quality. Examples of low-quality earnings include insufficient allowance for doubtful accounts, insufficient provisions for obsolete inventory, and aggressive revenue recognition practices that bring future revenues into the current period. Common to these examples of low earnings quality is the fact that current earnings are temporarily inflated but cash flows are unaffected.

The lower persistence of earnings resulting from high levels of accruals does not have to be a direct result of earnings management activity. The nature of accrual accounting is to accrue and defer past, current and anticipated future cash receipts and disbursements. The accrual process involves a significant amount of estimation of future cash receipts and payments, and a subjective allocation of past cash receipts and payments. In doing so, the accrual process creates accounts of varying reliability.

Our research shows that firms with high accruals — that is, those that reported income greater than operating cash flows — experience a decline in earnings performance in the following year. Also, firms reporting large accruals have been more likely to be subject to SEC enforcement actions and earnings restatements. Collectively, this suggests that the magnitude of accruals is a good indicator of earnings quality.

In this paper, I examine whether short sellers are able to identify and trade on earnings quality information embedded in accruals. Short sellers have particularly strong incentives to utilize measures of earnings quality because they can directly profit from the lower future performance of high-accrual firms.

Published in

Accounting Horizons Annual

AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.

 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.