Twenty years ago, The Accounting Review published the research of a young accounting professor, Richard Sloan, which focused on the fact that stock prices fail to fully reflect information contained in the accrual and cash flow components of current earnings. The findings: stocks perform worse when earnings are largely attributed to accruals rather than to cash flows.
Two decades later, Ryan Casey, assistant professor at the Daniels College of Business, along with colleagues from the University of Illinois at Chicago and Rutgers Business School, built upon that research—now some of the most highly cited in the area of empirical accounting. While prior research defined accruals as the residual of earnings less cash flows from operations, Dr. Casey and his co-authors leveraged the fact that financial statements flow between each other, or “articulate.”
“We built a model that identifies a series of specific accruals,” Dr. Casey says. The researchers dissected accruals to show that the source of the transaction that generated the accruals is important in understanding the accruals’ relation to future profitability and stock returns. Dr. Casey’s paper, “Articulation-based Accruals,” was accepted by Review of Accounting Studies, one of the highest-rated academic accounting journals.
“Our model identifies 13 accrual variables that relate changes in values on the balance sheet to the three other main financial statements: the cash flow, income and owners’ equity statements,” Dr. Casey explains. “This method allows one to see how the specific transactions or financial positions relate to future performances. Prior research showed that the higher the overall accrual, the worse future performance in future earnings and stock price. But by refining the analysis, we found that some accrual-generating sources actually cause positive future returns.”
A simple example, Dr. Casey adds, is accruals created due to an acquisition, where the acquired firm had significant accounts receivable. In such a scenario, these accruals are positively associated with future performance.
Dr. Casey’s approach to using accounting information can help academics and professionals enhance their abilities to interpret financial information. “There are really two practical applications to this,” he says. “First, financial analysis. I could use these measures and develop a strategy to trade stocks and identify mispricing in stocks. Second, we think this will help other academics because we’re enhancing an already well-defined area in accounting literature. We think there is great potential to build on this work.”
The researchers worked with Capital IQ to analyze companies’ public financial statements for their 13 variables. Capital IQ is one of the leading data providers to both academics and professionals. Dr. Casey and his co-authors worked with the firm as they developed their model of financial statement articulation.
Dr. Casey joined Daniels in 2014 from the University of Illinois at Chicago. He researches financial statement analysis and corporate sustainability reporting. In fall 2016, he will teach a new course that he developed, International Accounting Issues in London and Paris, the first course of its kind at the College.
Dr. Casey’s article, “Articulation-based Accruals” is forthcoming in Review of Accounting Studies. Learn more about his work»