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New Research Suggests Accrual Revelation About Earnings and Trading Strategy

Professor Russell Lundholm may not have intended it to turn out this way but may have inadvertently revolutionized the accrual anomaly and not so incidentally points out that no one else seems to have figured this out. “It’s about the composition of earnings and what percent were due to accruals,” he said about his recent paper, published in the January/February American Accounting Association’s Accounting Review.

Think about it this way: a company with a lot of cash…has a lot of cash. It’s obvious that cold, hard cash can be used by a company at any point. Accruals, on the other hand, aren’t always as easily converted into a pile of dollar bills that can be shoved into a truck and sent to debtors or suppliers for items the company needs. Forgive me for going out on a limb here but it then seems obvious that a company low on accruals (or accounting tricks) should reasonably underperform. That’s not the point of the work, though. It’s about looking at earnings minus accruals:

Employing corporate data spanning 19 years, the authors — [Russell] Lundholm, [Nader] Hafzalla (now deceased), and Matt Van Winkle of Voyant Advisers, LLC of San Diego — compare results computed via the traditional method and via the new method for both operating accruals and total accruals. For both operating and total accruals the new method yields significantly better returns, with the sharpest difference being seen for operating accruals (net income minus cash from operations); there, the traditional model yields an annual return that is about 6.5% greater than that of a portfolio of similarly-sized firms, and the new model produces an abnormal annual return that is about 11.7% greater than that of similarly-sized firms.

People have figured out this strategy but the new bit is that Lundholm, Hafzalla and Van Winkle look at it as a new equation: is picking out a stock dud as easy as figuring out who has a bunch of accruals?

Lundholm points to examples where a high level of accruals preceded poor stock performance.

Accruals at Monsanto Co, the world’s biggest seed producer, were 58 percent of earnings for the previous four quarters when the company reported results on January 6, 2010, according to Lundholm. That was in the top 10 percent of all U.S. companies.

Since then, its shares have dropped 13 percent, while the S&P 500 index is up about 16 percent.

Recommended reading in relation to this subject, Lundholm’s paper in its entirety: Percent Accruals by Lundholm, Hafzalla and Van Winkle. We’ll take all the accounting revolutions (or revelations) we can get.

Apparently There’s a Food Chain for Satyam Blamestorming

The head of the Institute of Chartered Accountants in India seems to feel as though 2009’s massive Satyam failure was not, in fact, a failure of the auditors but levels before the auditors and then the auditors. “There were promoter shareholders, executive directors and directors, and the auditors were the last rung. On the other side, there were independent directors, one of whom was a dean of the Indian School of Business, but nobody questions the role of independent directors.”

Amarjit Chopra feels corporate governance (or should that be complete lack of…) is to blame, not the PwC auditors who somehow missed the following:

• $1.09 billion in artificially inflated cash and bank balances (psst, baby auditors, that’s called a material amount)

• $81.59 million in accrued interest that was accrued out of thin air and never existed

• An understated liability of $266.91 million

• An overstated debtors’ position of $575.27 million that was more like $106.33 million (oops)

Maybe PwC should have waited for Chopra’s comments. Had they done so, they wouldn’t have already come out and admitted they missed a few issues on the September 30, 2008 Satyam balance sheet:

The former [Satyam] chairman has stated that the financial statements of the company have been inaccurate for successive years. The contents of the said letter, even if partially accurate, may have a material effect (which is currently unknown and cannot be quantified without thorough investigations) on the veracity of the company’s financial statements presented to us during the audit period. Consequently, our opinions on the financial statements may be rendered inaccurate and unreliable.

So if that’s the case, someone remind me why we even have auditors then? Sure financial statements belong to management but aren’t auditors there to give everything a good once-over to ensure giant fraud is not staring them directly between the eyes? You’d think at least one of those brilliant Indian first years would have realized that cash was a tad high once they started doing the work.