An exclusive focus on bottom-line income misses important information about the quality of earnings. Ac-cruals
(the difference between accounting earnings and cash flow) are reliably, negatively associated with
future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality
earnings, are associated with poor future returns. We explore various hypotheses — earnings manipulation,
extrapolative biases about future growth, and under-reaction to changes in business conditions —to explain
accruals’ predictive power. Distinctions between the hypotheses are based on evidence from operating per-formance,
the behavior of individual accrual items, discretionary versus nondiscretionary components of
accruals, and special items. We check for robustness using within-industry comparisons, and data on U.K.
stocks
