Review of Quantitative Finance and Accounting, 22: 97–121, 2004
2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Accrual Effect on Future Earnings
Department of Finance, College of Management, National Taiwan University, 50, Lane 144, Section 4, Keelung
Road Taipei, Taiwan 10660, Tel.: 886-2-23698955, Fax: 886-2-23660764
Goizueta Business School, Emory University, 1300 Clifton Road, Atlanta, GA 30322-2722, USA,
Tel.: (404) 727-4821
Department of Accountancy, College of Business, University of Illinois at Urbana-Champaign, 1206 South Sixth
Street, Champaign, IL 61820, USA, Tel.: (217) 244-0555, Fax: (217) 244-0902; Athens Laboratory of Business
Administration (ALBA), Athinas Ave & 2A Areos Str., Vouliagmeni 16671, Athens, Greece
Abstract. Earnings manipulation has become a widespread practice for US corporations. However, most studies
in the literature focus on whether certain incentives would facilitate managers to manipulate earnings and there
has been little evidence documenting the consequences of earnings manipulation. This paper ﬁlls this gap by
examining how current accruals affect future earnings (the accrual effect) and measuring the size of this effect.
We ﬁnd that the aggregate future earnings will decrease by $0.046 and $0.096, respectively, in the next one and
three years for a $1 increase of current accruals. Over the very long-term (25 years), 20% of current accruals will
reverse. This negative accrual effect is more signiﬁcant for ﬁrms with high price-earnings ratios, high market-to-
book ratios and high accruals where earnings management is more likely to occur. We show that incorporating the
accrual effect is useful in improving the accuracy of earnings forecasts for these ﬁrms. Accordingly, the empirical
results are consistent with the notion that earnings management causes the negative relationship between current
accruals and future earnings. In addition, this paper shows that one recently developed accrual model has better
performance than the popularly cited model in identifying manipulated earnings.
Keywords: earnings management, accrual reversal, cash ﬂow Jones model, earnings prediction
JEL Classiﬁcation: M41
A growing body of recent literature documents that future stock returns can be predicted by
using accounting accruals. For example, Sloan (1996) ﬁnds that stocks with high accruals
consistently underperform stocks with low accruals for three years. Teoh, Welch and Wong
(1998a, 1998b) report that issuing ﬁrms (either IPOs or SEOs) with aggressive inﬂation
of accruals experience worse performance than their counterparts by 20 to 30 percent
over four post-issue years. Chan et al. (2003) further show that the success of an accrual-
based strategy which buys ﬁrms with low accruals and sells ﬁrms with high accruals is not
We appreciate helpful comments from Louis Chan, Josef Lakonishok, Chiawen Liu, two referees and seminar
participants at 2002 PBFEA conference.