An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Gerhard Barone
University of Texas - Austin

Matt Magilke
University of Utah

Abstract: Several studies show that the stock market behaves as though participants do not understand the implications of current accruals for future earnings. Relying on the historically strong negative correlation between accruals and cash flows, these studies ignore the cash component of earnings in tests of market efficiency related to the pricing of accruals. We re-examine the role of institutional investors in the pricing of accruals by explicitly considering cash flows. We find that for firms with low levels of institutional ownership, prices behave as if investors correctly estimate the persistence of accruals but underestimate the persistence of cash flows. Additionally, we find that for firms with high levels of institutional ownership, prices behave as if investors price cash flows accurately but overestimate the persistence of accruals. Our results are consistent with predictions of the naïve investor hypothesis with respect to cash flows but not with respect to accruals.

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