The Implications of Retained and Distributed Earnings for Future Profitability and Market Mispricing

WP 46-07
GEORGE PAPANASTASOPOULOS
University of Peloponnese, Greece
DIMITRIOS THOMAKOS
University of Peloponnese, Greece
and
The Rimini Center for Economic Analysis, Italy
TAO WANG
Queens College,
City University of New York, USA
“THE IMPLICATIONS OF RETAINED AND
DISTRIBUTED EARNINGS FOR FUTURE
PROFITABILITY AND MARKET MISPRICING”
Copyright belongs to the author. Small sections of the text, not exceeding three
paragraphs, can be used provided proper acknowledgement is given.
The Rimini Centre for Economic Analysis (RCEA) was established in March 2007.
RCEA is a private, non-profit organization dedicated to independent research in
Applied and Theoretical Economics and related fields. RCEA organizes seminars and
workshops, sponsors a general interest journal The Review of Economic Analysis, and
organizes a biennial conference: Small Open Economies in the Globalized World
(SOEGW). Scientific work contributed by the RCEA Scholars is published in the
RCEA Working Papers series.
The views expressed in this paper are those of the authors. No responsibility for them
should be attributed to the Rimini Centre for Economic Analysis.
The Rimini Centre for Economic Analysis
Legal address: Via Angherà, 22 – Head office: Via Patara, 3 - 47900 Rimini (RN) – Italy
www.rcfea.org - secretary@rcfea.org

---

The Implications of Retained and Distributed Earnings for Future
Profitability and Market Mispricing*
George Papanastasopoulos
Department of Economics
School of Management and Economics
University of Peloponnese
Tripolis Campus, 22100, Greece

Department of Banking and Financial Management
University of Piraeus
80, Karaoli & Dimitriou Street, Piraeus, 18534, Greece
E-mail: papanast@uop.gr

Dimitrios Thomakos
Department of Economics
School of Management and Economics
University of Peloponnese
Tripolis Campus, 22100, Greece
E-mail: thomakos@uop.gr

Tao Wang
Department of Economics
Queens College and the Graduate Center
City University of New York
Flushing, NY 11367, U.S.A.
E-mail: tao.wang@qc.cuny.edu

First Draft: January 31, 2006
Current Draft: March 27, 2007



* The authors appreciate helpful comments from the seminar participants at the FMA (2006) annual
meetings, at the 1st International Conference in Accounting and Finance, at the City University of New
York and at the University of Piraeus. The authors also thank Gikas Hardouvelis, Yochanan
Shachmurove and Tao Shu (FMA discussant) for insightful comments and suggestions. The usual
disclaimer applies.

1
Electronic copy of this paper is available at: http://ssrn.com/abstract=882108

---

The Implications of Retained and Distributed Earnings for Future Profitability and Market
Mispricing
Abstract: In this paper, we investigate the informational content of retained and distributed
earnings for future profitability and market mispricing. We find that investors act as if the
components of retained earnings (current operating accruals, non current operating accruals
and retained cash flows) have similar implications for future profitability, leading to an
overvaluation of their differential persistence. They also do not distinguish between the
distinct properties of distributed earnings, correctly anticipate the persistence of net cash
distributions to debt holders (net debt repayment) and underestimate the persistence of net
cash distributions to equity holders (dividends minus net stock issues). Our evidence suggests
that the accrual anomaly documented in the accounting literature and the anomaly on net
stock issues documented in the finance literature could be a subset of a larger anomaly on
retained earnings. Overall, our findings on the sources of this anomaly, indicate that it is
primary attributable to investor’s limited attention or limited cognitive power on
understanding managerial empire building tendencies and managerial violation of accounting
principles.

Keywords: retained earnings, distributed earnings, accruals, net stock issues, earnings
management.

JEL classification: M4

2
Electronic copy of this paper is available at: http://ssrn.com/abstract=882108

---

1.
Introduction

In a seminal paper, Sloan (1996) shows that the accrual component of earnings
exhibits lower persistence than the cash flow component of earnings. He also shows that
investors fail to fully understand the differential persistence of accruals and cash flows.
Investors tend to overweight (underweight) accruals (cash flow) when forming earnings
expectations only to be systematically surprised when accruals turn out to be less persistent
than cash flows, especially around future earning announcement time. As a result, low-
accruals firms earn higher abnormal returns than high-accrual firms.
Subsequent research decomposes accruals into different components or considers
broader definitions of accruals and tries to provide some explanations on the accrual anomaly.
Using Jones (1991) model, Xie (2001) shows that discretionary accruals predict returns, but
the nondiscretionary component does not. Thomas and Zhang (2002) report that the abnormal
returns to the accruals trading strategy are largely generated by extreme changes in the
inventory. Fairfield, Whisenant and Yohn (2003a) argue that the accruals anomaly is a subset
of a broader anomaly related to investors’ inability to impound information about growth.1
This paper extends the existing literature in three aspects. First, instead of
concentrating on the accrual component of earnings as in Sloan (1996), we study the
persistence and pricing of every component of earnings. Our analysis begins with an
extended decomposition of earnings into current operating accruals, non-current operating
accruals, retained cash flows, earnings (cash flows) that are distributed to debt holders, and
earnings (cash flows) that are distributed to equity holders. We then group the first three
components of earnings into retained earnings and the last two components of earnings into
distributed earnings because we find that investors price the first three components similarly
and the last two components similarly. 2 In particular, investors tend to overweight
(underweight) retained earnings (distributed earnings) when forming earnings expectations
only to be systematically surprised when retained earnings turn out to be less persistent than
distributed earnings.
Second, given our decomposition of earnings into five components, we examine the
relation among those components. In particular, we pay close attention to the low persistence
of accrual and retained earnings and the high persistence of distributed earnings to equity
holders. Distributed earnings to equity holders are defined as dividends plus stock repurchases

1 Some other studies on accruals include Beneish and Vargus, 2002; Dechow and Dichev, 2002; Zach,
2005; Ng, 2005; Khan, 2006; Richardson, Sloan, Soliman and Tuna, 2005, and 2006.
2 Dechow, Richardson and Sloan (2006) examine the persistence and pricing of free cash flows by
decomposing them into three components. While they use a sample period from 1950 to 2003, we use
a sample period from 1962 to 2003 because the Compustat data prior to 1962 suffers from survivorship
bias (see Fama and French 1992 and Sloan 1996).

3

---

minus stock issues (or net stock issues). The finance literature on net stock issues suggests
that returns after stock repurchase are high (Ikenberry, Lakonishiok, and Vermaelen 1995),
and returns after stock issues are low (Loughran and Ritter 1995). Daniel and Titman (2005)
and Pontiff and Woodgate (2006) show that there is a negative relation between net stock
issues and equity returns.3 With our decomposition of earnings, we are able to examine
whether the accruals anomaly is directly linked with the net issues anomaly. To our
knowledge, this is the first paper in examining the relationship between the accrual (retained
earnings) anomaly and the net stock issues anomaly in a unified framework.
Third, we consider the source of the above-mentioned results on retained earnings.
For this purpose we decompose retained earnings into their discretionary and non
discretionary portions, using the model of Chan, Chan, Jegadeesh and Lakonishok (2006,
“CCJL 06” hereafter) that is based on sales growth. The discretionary portion captures the
impact of managerial manipulation while the non discretionary portion captures the impact of
business conditions. An increase in sales can potentially be coupled with an increase in
inventories, accounts receivable, cash and fixed assets raising the nondiscretionary
component of retained earnings. Therefore the results from this decomposition should shed
lights on the growing literature on earnings quality.
Our results suggest that that there are systematic differences in the persistence among
the distinct components of retained earnings and between the distinct components of
distributed earnings. Accruals have lower persistence and investors overweight them,
consistent with previous findings. Even though retained cash flows have higher persistence
than accruals, investors overestimate it as well. In particular, investors act as if the
components of retained earnings have similar implications for future profitability, leading to
an overvaluation of their differential persistence. For distributed earnings, investors do not
distinguish between each component of distributed earnings, correctly anticipating the lower
persistence of cash distributions to debt holders but underestimating the higher persistence of
cash distributions to equity holders. Thus, investors overestimate the overall lower persistence
of retained earnings and underestimate the overall higher persistence of distributed earnings.
The former is consistent with that of the findings in the accrual anomaly. The latter is
consistent with the “net stock issues” anomaly in the finance literature if we interpret that the
anomaly on the cash distribution to equity holders (defined as dividends minus net stock
issues) can capture the anomaly on “net stock issues”.
A hedge strategy taking a long (short) position in firms that report low (high) retained
earnings generates positive abnormal returns. In particular, the return to the strategy is equal
to 15.6% and positive in 36 of 40 years examined. In addition, the return to a hedge strategy

3 Fama and French (2006) have an examination of the net issues anomaly.

4

---

taking a long (short) position in firms that report high (low) cash distributions to equity
holders is equal to 9.2% and positive in 32 of 40 years examined. However, our results on the
relation of the two anomalies suggest that the anomaly on retained earnings largely subsumes
the anomaly on distributions to equity holders, casting doubts on the independence of the net
stock issuances anomaly found in the finance literature if the anomaly on the cash distribution
to equity holders can capture the anomaly on “net stock issues”. Additional tests also show
that in the presence of retained earnings, total accruals lose their ability to indicate the degree
to which investors overestimate the sustainability of current earnings performance.
We find that abnormal returns are earned only from a hedge portfolio strategy taking
a long (short) position on low (high) discretionary retained earnings. On the other hand, a
hedge portfolio strategy on non discretionary retained earnings does not generate significant
abnormal returns. This result supports the earnings quality explanation on the accrual
anomaly. However, at the same time we find a potentially important role in some cases for the
interaction between the two hypotheses in the generation of abnormal returns. Thus, our
results do not completely rule out the role of managerial earnings management.
Our findings have several implications for the existing literature. First, they give a
distinct role to retained earnings. This has not been emphasized in previous research, where
earnings are typically decomposed into accruals and free cash flows. Our results suggest that
the level of retained earnings is a more comprehensive measure of investor overestimation
about the sustainability of current earnings performance than the level of total accruals.
Second, we provide empirical support to the hypothesis that cash distributions to equity
holders are possibly responsible for the, previous documented, underestimation of the
persistence of the cash component of earnings. In summary, the results in this paper show
that the anomaly on distributed earnings to equity holders (net stock issues) documented in
the finance literature may be a manifestation of a larger anomaly on retained earnings. With
all the above taken together one can argue that to the extent that the two anomalies are closely
related, they are more likely to arise from investor's limited attention or limited understanding
on discretionary decisions made by managers.4
The reminder of the paper is organized as follows. The next section briefly reviews
the literature on the persistence and pricing of the accrual and free cash flow components of
earnings. Section 3 provides a detailed description of our research design concerning the
implications of retained and distributed earnings for future profitability and market
mispricing. In section 4 we present data, sample formation, variables measurement while in
section 5 we provide our empirical results. Section 6 summarizes and concludes.

4 Hirshleifer and Teoh (2003) has a discussion about the effect of investors’ limited attention and
limited processing power.

5

---

2.
Literature Review

Numerous studies have provided a variety of interpretations of Sloan (1996) work on
the accrual anomaly. The anomaly has two parts: why accruals have lower persistence than
the free cash flow component of earnings, and why investors are unable to recognize that fact.
Studies in the existing literature can be divided in two broad categories on the basis of the
approach they adopt. The first set of studies, builds on Sloan’s (1996) subjectivity conjecture.
In particular, Xie (2001), De Fond and Park (2001) and Kothari (2001) interpret Sloan (1996)
results as evidence of manipulation of accruals in earning process, with the implicit
assumption that managers exploit discretionary (abnormal) accruals to manipulate earnings.
Thomas and Zhang (2002) find that it is driven by inventory accruals while Beneish and
Vargus (2002) report that it is driven by income-increasing or positive accruals. Moreover,
Dechow and Dichev (2002) conclude that the lower persistence of accruals is attributable to
their transitory estimation error. In addition, Richardson, Sloan, Soliman and Tuna (2005,
“RSTT 05” hereafter) draw a link between Sloan’s (1996) notion of subjectivity and the well-
known concept of reliability. Specifically, they provide a comprehensive definition and
categorization of accounting accruals in which each accrual category is rated according to its
reliability and they document that less reliable accruals leads to lower earnings persistence
and that investors do not fully anticipate this earnings persistence, leading to significant
security mispricing.
The second set of studies adopts the viewpoint that the differential persistence and
mispricing of accruals is applied more broadly to firm’s business conditions (growth or
correlated economic characteristics with firm growth). Specifically, Fairfield, Whisenant and
Yohn (2003a, “FWY 03a” hereafter) find that the lower persistence of the accrual component
of earnings is a special case from a more general negative relation between future earnings
performance and growth in net operating assets. They suggest that this relation arises from
conservative bias in accounting or from the lower rate of economic profits associated with
diminishing marginal returns to new investment opportunities, or both. Moreover, they find
that market appears to equivalently overprice accruals and growth in non current operating
assets and conclude that the accrual anomaly documented in Sloan (1996) is a subset of a
larger growth (in net operating assets) anomaly. In follow-up research, Fairfield, Whisenant
and Yohn (2003b, “FWY 03b” hereafter) argue that the lower persistence relative to cash
flows is driven by growth in investment base that is not matched by growth in income.
Variants of this economic explanation are embraced in Cooper, Gulen and Schill (2005) to
interpret the negative relation of growth in total assets with future stock return and in Titman,

6

---

Wei and Xie (2004) and Anderson, Garcia-Feijoo (2006) studies to interpret the negative
association of capital expenditures and future stock returns. In addition, recent research by
Zach (2005), Ng (2005), Khan (2005) focuses on economic variables associated with firm
growth to interpret Sloan’s (1996) results. 5 In particular, Zach (2005) argues that the
mispricing of accruals is attributable to various corporate events such as mergers and
divestitures, Ng (2005) that it is a compensation for default risk and Khan (2006) that it is
subsumed by a four factor model motivated from ICAPM.
In follow up research, Richardson, Sloan, Soliman and Tuna (2006, “RSTT 06”
hereafter) decompose accruals into a “growth” and an “efficiency” component and find that
both components contribute to the lower persistence of accruals, with the efficiency
component having the strongest relation. Their main conclusion is that temporary accounting
distortions provide the most compelling explanation for the lower persistence of the accruals.
However, “RSTT 06” document that they can rule out a supplementary role for explanations
related to firm’s business conditions, such as diminishing marginal returns to new investment.
Finally, “CCJL 06”, consistent with “TZ 02”, finds that Sloan’s (1996) results are related to
inventory accruals. They also decompose working capital accruals into their discretionary and
non discretionary portions based on their relation with sales and find that the associated
mispricing is primary attributable to earnings management. However, consistent with the
explanation related to firm’s business conditions, “CCJL 06” also find positive abnormal
stock returns for portfolio strategies on accounts payable accruals.

Previous research has focused more on analyzing the informational content of
accruals for future profitability and market mispricing than that of free cash flows. Dechow,
Richardson and Sloan (2006, “DRS 06” hereafter) conducts a detailed investigations of the
persistence and pricing of the free cash flow component of earnings by decomposing them
into three distinct categories: retained cash flows (applied to the firm’s cash balance), cash
flows distributed to debt holders (applied for debt financing) and cash flows distributed to
equity holders (applied for equity financing). “DRS 06” demonstrates that the higher
persistence of cash component of earnings is due to cash applied for equity financing. They
find that stock prices act as if investors correctly anticipate the implications of cash
distributions to capital providers (cash that is applied for debt and equity financing) for future
profitability and overestimate the persistence of cash that is applied to the firm’s cash balance.
While most studies treated accruals and free cash flows as relatively homogenous
component of earnings, this paper examines the idea that the well-documented accrual
anomaly is consistent with a general market mispricing of retained earnings.


5 Zach (2005), Ng (2005) and Khan (2005) have considered in their analysis only current operating
accruals following Halley (1985) and Sloan (1996) definition of accruals.

7

---

3.
Research Design


Halley (1985) defined accruals as growth in working capital less depreciation
expense.6 This definition is narrow since it focuses on working capital accruals relating to
current net operating assets and ignores accruals relating to non-current net operating assets.
FWY 03a” and “FWY 03b” incorporate in their analysis accruals relating to non-current
operating assets, but label them as a generic form of growth. Subsequent research by “RSST
05”, “DRS 06” and “RSST 06” point out that accruals relating to non-current operating assets
are also accounting accruals and developed a more comprehensive definition of accounting
accruals. In our analysis, current operating accruals CACC are defined as growth in net
t
current operating assets (net working capital)
N
∆ WCA , non current operating
t
accruals NCACC 7 as growth in net non current operating assets
N
∆ NCOA and total
t
t
accruals TACC as growth in net operating assets N
∆ OA :
t
t
To understand better the above measures of accruals, it is useful to distinguish total
equity TE into net operating assets NOA and net financial assets NFA :
t
t
t
TE = NOA + NFA



(1)
t
t
t
The most common financial asset is cash holdings (cash and short investments) C and the
t
most common financial liability is total debt, which is defined as the sum of short-term debt
STD and long-term debt LTD . Therefore, net financial assets NFA are equal to:
t
t
t
NFA = C − STD −LTD




(2)
t
t
t
t
Change in financial assets is defined as change in cash holdings and change in financial
liabilities is defined as net financial expense (interest expense minus interest income) NFE
t
minus cash flows distributed to debt holders (reduction in short and long term debt)
DIST _ D . Therefore, growth in net financial assets NFA is equal to:
t
t
N
∆ FA = C
∆ − (NFE − DIST _D )



(3)
t
t
t
t
We also distinguish growth in net operating assets into growth in net working capital assets
and net non current operating assets and get the following expression for growth in total
equity:

T
∆ E = N
∆ WCA + N
∆ NCOA + C
∆ − NFE +DIST _ D (4)
t
t
t
t
t
t
Recall also the standard clean surplus equation:

6 This definition is closely related with the definition of operating accruals used in the FASB’s
Statement of Financial Accounting Standard Number 95 “Statement of Cash Flows’
7 This definition of accruals differs slightly from the accrual definition used in “RSTT 05” and “RSTT
06” studies in that it considers investments and cash advances.

8

---

T
∆ E = NI − DIST _ E




(5)
t
t
t
where:
•
NI : Net Income at time t.
t
•
DIST _ E : Cash flows distributed to equity holders at time t.
t
Substituting equation (4) to the clean surplus equation and assuming that net financial
expense is paid in cash we get:
= ∆
+ ∆
+ ∆ +
+
⇔
NI
NWCA
NNCOA
C
DIST _ D
DIST _ E
t
t
t
t
t
t
⇔
=
+
+ ∆ +
+

(6)
NI
CACC
NCACC
C
DIST _ D
DIST _ E
t
t
t
t
t
t
With the above-extended decomposition of net income we begin our empirical
analysis regarding the persistence and valuation of the components of retained and distributed
earnings. Net income will be also decomposed into total retained earnings by aggregating
current operating accruals, non current operating accruals and retained cash flows and into
total distributed earnings by aggregating cash flows distributed to debt holders and equity
holders:.
NI = RE + DIST





(7)
t
t
t
To the best of our knowledge, this is the first paper in the existing literature that uses the
above two decompositions as basis for empirical analysis. Prior research focused on the
decomposition of net income into total accruals and into total free cash flows:
NI = TACC + FCF





(8)
t
t
t
We organize our hypothesis tests into four groups. First, we compare the persistence
of each component of the net income. Second, for the pricing tests, we examine whether
information about the persistence of these components is reflected in stocks prices using the
Mishkin framework (1983). Thirdly, we investigate whether retained earnings reflects more
information than total accruals about the degree to which the sustainability of current earnings
performance provokes excessive investor optimism. Finally, we examine the source of the
anomaly on retained earnings by decomposing them into their discretionary and non
discretionary portions using the model of “CCJL 06”
Let us develop our hypotheses carefully. Starting, with the components of retained
earnings, we predict that high current and non current operating accruals indicate low
sustainability of current earnings performance since they are often derived from earnings
management. Earnings management can arise from the violation of accounting rules with
respect to the nature, timing and magnitude of revenues and expenses recognition or from
empire building incentives. In the first case, high current and non current operating accruals
may arise as managers violate accounting principles to shift reported income from the future
to the present and vice versa while in the second case as they over-invest. However, even if

9

---