Conditional Persistence of Earnings Components and Accounting Anomalies
We suggest that the failure of investors to distinguish between an earnings component’s autocorrelation coefficient (unconditional persistence) and the marginal contribution of that component’s persistence to the persistence of earnings (conditional persistence) drives the post earnings-announcement drift, the post-revenue-announcement drift, and the accrual anomaly.
When the conditional persistence of revenue surprises is high (low) relative to its unconditional persistence, both the post-earnings-announcement drift and the post-revenue-announcement drift are high (low), because investors’ under-reaction to revenues and earnings is stronger when the persistence of revenue surprises is more strongly associated with the persistence of earnings surprises.
Also, the mispricing of accruals decreases substantially when the conditional persistence of accruals is high relative to its unconditional persistence, because investors’ overreaction to accruals is mitigated when the persistence of accruals is indeed most strongly associated with the persistence of earnings.
In general, our empirical findings suggest that investors’ misperception of conditional persistence is a driver behind the three anomalies that we study.