Accruals and Future Stock Returns: Tests of the Naïve Investor Hypothesis

Abstract

We explore whether the association between accruals and future returns documented by Sloan (1996) is due to fixation by naïve investors on the total amount of reported earnings without regard for the relative magnitude of the accrual and cash flow components. Contrary to the predictions of the naïve investor hypothesis, we find that the predictive ability of accruals for subsequent annual returns and for quarterly earnings announcement stock returns is not lower for large firms or for firms followed more by analysts or held more by institutions. Further, we find that the ability of accruals to predict future returns does not seem to depend on stock price or transaction volume, measures of transaction costs, also contrary to predictions of the naïve investor hypothesis. These results are robust to regression and hedge portfolio tests. We conclude that the predictive ability of accruals for subsequent returns does not seem to be due to the inability of market participants to understand value-relevant information.