Not All Profit Is Equal: the Accruals Anomaly

Everyone stares at the earnings number. It is the headline, the thing the stock trades on, the number analysts forecast and companies manage. Richard Sloan asked a question almost nobody had bothered with: where did that earnings number actually come from?

Because a dollar of reported profit is not a single thing. It is a blend of two very different substances, and Sloan showed that the market treats them as if they were identical. They are not, and that mistake is worth money.

The problem: profit is part cash, part promise

Accounting earnings can be split cleanly into two components.

The cash component. Money that actually arrived. Customers paid, the cash is in the bank. This part is hard to argue with.

The accrual component. Everything else. This is the accountant's adjustment layer, and it exists for perfectly good reasons: it matches revenues to the period they were earned in rather than the period the cash happened to land. Accruals include things like revenue booked for goods shipped but not yet paid for (receivables), inventory that has been built but not yet sold, and various estimates and provisions.

Accruals are not fraud. They are normal, necessary accounting. But notice what they are: estimates, judgments and expectations. They are the part of profit that depends on somebody's opinion about the future rather than on money that has changed hands.

Sloan's core empirical finding is that these two components behave very differently going forward. The accrual component of earnings is far less persistent than the cash component. A dollar of profit that arrived as cash tends to be repeated next year. A dollar of profit that arrived as an accrual tends to fade, and often reverses.

This makes obvious sense once you see it. Receivables can go bad. Inventory that was built on optimism gets written down. Aggressive estimates get walked back. Cash in the bank does not do any of these things.

The key idea via analogy: two salespeople, same commission

Imagine two salespeople who both report a great month.

The first collected payment on every deal. The money is in the account.

The second booked a pile of orders from customers who have promised to pay later, and confidently marked all of them as sales.

On the monthly report, both look identical. But you know, instinctively, that the first one had a genuinely better month. Some of the second one's promises will not be honoured. Their reported success is partly an expectation, and expectations disappoint.

Now, would you pay the same bonus to both? Obviously not.

The stock market does. That is Sloan's finding. The market takes the headline earnings number, treats it as one uniform substance, and prices it accordingly. It systematically overweights the accrual component and underweights the cash component, exactly reversing what the persistence data says it should do.

The consequence is a straightforward, tradeable pattern. Companies whose earnings are heavily accrual-driven are being overvalued, because the market is extrapolating profits that are about to fade. Companies whose earnings are cash-driven are being undervalued, because the market is discounting profits that will actually persist. Sort stocks by accruals, buy the low-accrual companies, short the high-accrual ones, and you get a significant return. This is the accruals anomaly.

Why it mattered

• It made earnings quality a real, computable thing. Before Sloan, "earnings quality" was a phrase auditors and analysts used vaguely. Afterwards it was a number you could calculate from a balance sheet and a cash flow statement, and rank the entire market on.
• It won the field's top honour. The paper received the American Accounting Association's Seminal Contributions to Accounting Literature Award, and it is one of the very few accounting papers that changed how money is actually managed.
• It is a red flag detector. High accruals are, among other things, what aggressive or fraudulent accounting looks like from the outside. Companies stretching to hit a number do it through the accrual layer, because that is the only layer they can stretch. The signal catches manipulation as a side effect.
• It became standard practice. Accrual screens are now routine at quantitative shops and are a core input to the modern quality factor. Fama and French's profitability factor and the various quality composites are all cousins of this insight.

The honest limitations

• It has decayed. This is a well-documented case of an anomaly weakening substantially after publication. The accruals effect has been much smaller in the decades since 1996. Some researchers have argued it is essentially gone, done in by the very investors who read the paper.
• Accruals are not inherently bad. A rapidly growing company legitimately builds receivables and inventory. Screening naively on high accruals will short some perfectly healthy fast-growing businesses. The signal needs care.
• The effect concentrated in small, hard-to-trade stocks. As with so many anomalies, the strongest returns lived in names where transaction costs and short-selling constraints bite hardest, which is likely part of why the mispricing survived as long as it did.
• The measurement is not standardised. Balance-sheet accruals and cash-flow-statement accruals give different numbers, and how you scale them matters. Different reasonable choices produce noticeably different results.

The one-line takeaway

Sloan split reported profit into the part that arrived as cash and the part that arrived as an accounting estimate, showed the second kind fades while the first kind persists, and demonstrated that the market prices both as if they were the same substance.