Is accrual mispricing related to investor sophistication? Evidence from analysts' forecasts

Abstract

The relationship between accrual inefficiency in analysts' forecasts and analyst following, analysts' forecasting ability, and the relative magnitude of discretionary accruals is analyzed. Results aid in answering two research questions: (1) whether the accrual mispricing anomaly has economic substance or is merely an artifact of missing risk factors; and (2) whether the observed financial analysts' response to accounting accruals is consistent with the accrual mispricing anomaly or its origins lie elsewhere. Sloan [1996] provides evidence of abnormal market returns correlated with the prior year's accrual and cash flow components of earnings. Few possible explanations are presented in the literature for the observed phenomenon: the Naive Investor Hypothesis suggests that market participants "fixate" on earnings figures and erroneously estimate earnings persistence without regard for the impact of accruals. Alternatively there are concerns that the observed abnormal returns are merely compensation for unaccounted risk factors and thus do not constitute a departure from market efficiency. Results of this study provide evidence of accrual misinterpretation among financial analysts consistent with the pattern of mispricing that is observed in the market. This conclusion supports the view of accrual mispricing as a true market anomaly. Moreover, the naive investor hypothesis is supported by the evidence that analysts' response to accounting accruals improves with their forecasting ability and that greater analyst following leads to consensus forecasts being more efficient.