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

Patricia Dechow
University Of Michigan / University Of California Berkeley

Weili Ge
University Of Washington

Abstract: We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective. As a result, earnings persistence is affected both by the magnitude and sign of accruals. Accruals improve earnings persistence in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by balance sheet adjustments relating to special items. These low accrual firms with special items have higher future stock returns than other low accrual firms. Further analysis reveals that special item-low accrual firms have performed poorly and have declines in investor recognition. However, special items still explain future returns after controlling for these factors. It appears that investors underestimate the probability that special item-low accrual firms will successfully turn themselves around.

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