Penman and Zhang (2002)

Reference

Accounting Conservatism, the Quality of Earnings, and Stock Returns^aa

Stephen H. Penman and Xiao-Jun Zhang

The Accounting Review, Volume 77, Issue 2 (April, 2002), 237-264.

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Synopsis

This paper shows that conservative accounting interacts with changes in investment to produce temporary distortions in earnings. The paper also shows that stock prices act as if investors do not anticipate the temporary nature of these distortions. In essence, the paper shows that firms with extreme changes in their LIFO reserves, R&D expenditures and advertising expenditures have temporary distortions in their earnings. A trading strategy of going long in firms with unusually high changes in these variables and short in firms with unusually low changes in these variables produces annual hedge portfolio returns of about 9%.