Do share prices fully reflect the information about future earnings in accruals and cash flow?

Abstract

This article follows the methodology employed by Sloan to evaluate whether share prices fully reflect the information about future earnings contained in the cash flow and accruals components of current earnings. The first hypothesis predicted that the persistence of earnings attributable to the cash flow component of earnings is greater than the persistence of earnings attributable to the accrual component of earnings. The results indicate that this is indeed the case. The second hypothesis predicted that share prices would react as if investors fixate on earnings, and fail to distinguish between the different properties of the cash flow and the accrual components of earnings. In all cases investigated, the null hypothesis of market efficiency was rejected. However, investors did appear to distinguish between the different properties of cash flow and accruals. Market efficiency was rejected as the influence of both components of earnings was underestimated. Thus, although investors were not successful in unscrambling the earnings data, they did not appear to display an earnings fixation.