The reversal of abnormal accruals and the market valuation of earnings surprises

If the market anticipates the reversing nature of abnormal working capital accruals, then the reported magnitude of earnings surprises that contain ab normal accruals will differ from the underlying magnitude that is priced by the market. We expect the market's perception of this difference to affect the ERCs associated with earnings surprises that contain abnormal accruals . We test our predictions using an abnormal accruals measure that captures the difference between reported working capital and a proxy for the market' s expectations of the level of working capital required to support current sales levels. Consistent with our hypotheses, we find higher ERCs when abno rmal accruals suppress the magnitude of earnings surprises, and lower ERCs when abnormal accruals exaggerate the magnitude of earnings surprises. We a lso find results consistent with analysts predictably considering the rever sing implications of abnormal accruals in revising future earnings forecast s. These findings are consistent with market participants anticipating the reversing implications of abnormal accruals. However, analysis of subsequen t stock returns provides evidence that market participants do not fully imp ound the pricing implications of abnormal accruals at the earnings announce ment date.