Accrual anomaly in the Brazilian capital market.

AutorCupertino, Cesar Medeiros
CargoReport

Introduction

This article investigates the relationship between accruals and stock returns in the Brazilian capital market. This topic is relevant for various users of financial statements. Investment analysts follow the reported results to support their estimates or revise their forecasts. Executives often have bonuses tied to earnings, being rewarded when performance expectations are attained (executive equity compensation). Creditors use earnings as a parameter in contractual debt covenants and to monitor the borrower's capacity to honor obligations (Smith & Warner, 1979). The focus on earnings is so intense that some authors believe the market neglects other performance measures (Chan, Chan, Jegadeesh, & Lakonishok, 2006). The fixation on earnings can carry some hidden pitfalls, mainly because of the often non-convergent interests concerning reported earnings (Jensen & Meckling, 1976).

The present article provides an expanded panorama of the relationship between accruals and stock returns in the Brazilian market. The analyses take into account specific firm characteristics (such as operational performance, risk factors and economic segment), the rationality of agents in pricing earnings and their components, and the implementation of investment strategies that seek to obtain abnormal gains from the level of accruals. The empirical tests applied to the sample permitted analyzing the phenomenon known as accrual anomaly, besides identifying the most important components of the formation, variability and persistence of the accruals of firms listed on the BMF&BOVESPA.

Our aim was to identify whether the market rationally prices earnings in the formation of expectations of future returns. The information available on the market price of assets was incorporated by applying the Mishkin test. This procedure is usually included in the studies of accrual anomaly and permits identifying possible bias between the intrinsic value of an asset and its market value. If there is asymmetry between rational valuation and market valuation, there will be an opportunity for abnormal gains by exploiting the persistence of earnings and their components.

For final verification of the occurrence of accrual anomaly in the Brazilian capital market, we constructed a zero-investment portfolio based on the magnitude of accruals. The occurrence of an anomaly is only confirmed if the zero-investment portfolio provides positive and consistent returns (Bernard, Thomas, & Wahlen, 1997). Sloan (1996) showed that a hedge strategy with a long position in assets of low accruals and a short position in assets of high accruals generates significant abnormal returns. The accrual anomaly has been intensely debated in recent international academic literature in finance (Desai, Rajgopal, & Venkatachalam, 2004; Dopuch, Seethamraju, & Xu, 2010).

However, more than a decade after publication of the seminal article by Sloan (1996), there has been no discussion of this anomaly in the Brazilian market, at least according to our search of the CAPES thesis database and Google Academic. This observation is strange since Brazil has some peculiar characteristics in relation to other countries, especially the USA. For example, Lopes and Galdi (2006, p. 28) points to the strong influence of tax rules in accounting statements in Brazil. Another aspect is international investors' strong interest in the Brazilian market.

This study is also relevant for identifying whether agents (such as portfolio managers) correctly price the components of earnings included in the market price of stocks to form their expectations of future dividends. Lack of knowledge of the components of earnings can increase information asymmetry and contribute to mispricing of assets, enabling wealth to be unduly transferred to companies with low earnings quality.

Literature Review

Accrual anomaly

Sloan (1996) empirically identified that investors tend to overvalue accruals in forming expectations about the future earnings of U.S. firms and are surprised when the persistence of this earnings component is shorter than predicted. In the view of Defond and Park (2001), the market exaggerates in measuring accruals because investors' expectations are biased in anticipating future reversal of this earnings component. As a consequence, companies with high (low) levels of accruals obtain negative (positive) abnormal returns, a phenomenon known as accrual anomaly. Since then, various works have examined this anomaly. Indeed, it is one of the most studied topics in recent studies of capital markets (Green, Hand, & Soliman, 2011).

This research basically has three categories of focus. One group of studies relates accrual anomaly with other anomalies, such as the works of Collins and Hribar (2000), Desai, Rajgopal and Venkatachalam (2004), and Fama and French (2008). The first work identified that accrual anomaly is different than post-earnings announcement drift (the tendency for the cumulative abnormal returns of an asset to accompany an earnings surprise for various days after its announcement, due to an overreaction of the market to the result disclosed). The second work examined accrual anomaly in the context of value glamour (the empirical regularity of firms [value companies] with low sales growth or high book-to-market, earnings-market price or cash flow-market price ratios to perform worse than firms [glamour companies] with contrary indicators). The third work found that, together with momentum (short-term returns tend to follow those observed in the recent past), accrual anomaly has the most evidence in the U.S. market.

A second group includes studies that relate abnormal returns to trading strategies based on accruals. Ali, Hwang and Trombley (2000) identified evidence contrary to the naive investor hypothesis in relation to large firms that are accompanied by analysts or held by institutional investors (the hypothesis postulates that the predictive capacity of accruals in relation to future earnings is small in these cases), and that asset price, trading volume and transaction costs do not condition the predictive capacity of accruals for future returns. Khan (2008), in turn, found that the difference in average returns of companies with very high or very low levels of accruals is explained by the difference in risk of the two types of assets.

The last category relates investors, analysts and other sophisticated users of financial statements with the properties of accruals. In this line, Bradshaw, Richardson and Sloan (2001) concluded that analysts overestimate the persistence of accruals, while Collins, Gong and Hribar (2003) found that the mispricing of accruals is reduced when there is strong institutional control. According to Lev and Nissim (2006), accrual anomaly is not eliminated in the function of systematic structural factors that prevent investors from consistently forming profitable strategies to exploit accrual anomaly, thus restricting the opportunity for arbitrage. Mashruwala, Rajgopal and Shevlin (2006) corroborated the work of Lev and Nissim (2006).

The findings of Sloan (1996) have been confirmed by other researchers, using different time periods and definitions of accruals. Among the relevant findings, there is evidence that the components of accruals, such as inventories and accounts receivable, are associated with the returns of hedge portfolios (Chan et al., 2006; Hribar, 2000; Thomas & Zhang, 2002).

Accrual anomaly is an important discovery in the academic literature. Despite the evidence showing its presence in different markets and periods, the reasons for its occurrence are still an open question. Pincus, Rajgopal and Venkatachalam studied the phenomenon in various markets and identified mispricing of accruals and the existence of anomaly in countries like Australia, Canada, United Kingdom and United States. They indicate as a possible cause the divergence of institutional characteristics of the countries, such as the legal regime and protection of shareholders' rights. With respect to the legal regime, the authors argue that common law systems are more permissive (allow more flexibility) regarding accounting of accruals than are code law systems. Regarding shareholders' rights, in countries where legal protection is weak, there is more room for managerial discretion in detriment to the interests of the shareholders (mainly the minority ones).

Ball, Kothari and Robin (2000) support the idea that the legal regime, particularly regarding the type of governance implemented, impacts accrual anomaly. In common law countries, the corporate governance system tends to be aimed at all shareholders, by intense use of financial statements and other public disclosures to mitigate problems of asymmetric information, whereas in code law countries, the governance system is oriented to the interests of the main shareholders, in a relationship of private communication (insider information). The differences of the governance system can affect the relevance of accounting information, according to the intensity with which the opportunity and conservatism resulting from the adoption of a determined legal regime reduces/increases information asymmetry, encouraging or discouraging a setting propitious for the occurrence of accrual anomaly. But there is also evidence of the presence of mispricing of accruals in countries with different legal regimes, leading to the perception that the anomaly is more reasonably explained by some systematic risk or a behavioral bias of investors in the use of accruals (LaFond, 2005, p. 11).

Accruals in Brazil

Despite the growing number of empirical works on accruals in general, research on accrual anomaly is still incipient in Brazil. Of the clusters identified in the bibliometric analysis, the most common current of investigation in the Brazilian academic literature on accruals is "earnings management", in line with the international trend. Of...

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