Limited Investor Attention and Stock Mar

November 17, 2010
Limited Investor Attention

and
Stock Market Misreactions
to Accounting Information
David Hirshleifer∗ , Sonya S. Lim∗∗ , and Siew Hong Teoh∗
We provide a model in which a single psychological constraint, limited investor atten-

tion, explains both under- and over-reaction to different earnings components. Investor
neglect of information in current-period earnings about future earnings induces post-
earnings announcement drift and the profit anomaly. Neglect of earnings components
causes accruals and cash flows to predict abnormal returns. We derive new untested
empirical implications relating the strength of the drift, accruals, cash flow, and profit
anomalies to the forecasting power of current earnings-related information for future
earnings, the degree of investor attention to different types of information, and the
volatilities of and correlation between accruals and cash flows. We also show that owing
to costs of attention, in equilibrium some investors may decide not to attend to the
implications of earnings or its components.
∗
The Paul Merage School of Business, University of California, Irvine, Irvine, CA 92697-
3125; Hirshleifer: http://web.merage.uci.edu/∼Hirshleifer/; Teoh: http://web.merage.uci.edu/∼steoh/
∗∗
Department of Finance, DePaul University, 1 E. Jackson Blvd, Chicago, IL 60604,
[email protected]
Formerly entitled “Limited Investor Attention and Earnings-Related Under- and Over-
reactions.” This paper was presented at the American Accounting Association Annual
Meetings in San Francisco. We thank Jennifer Altimuro (the conference discussant),
Peng-Chia Chiu, Phil Davies, Tim Haight, Danling Jiang, Kuan-Hui Lee, Rose Liao,
Dong Lou, Angie Low, Lin Sun, and Yinglei Zhang for helpful discussions and comments.
Limited Investor Attention
and
Stock Market Misreactions
to Accounting Information
Abstract
We provide a model in which a single psychological constraint, limited investor atten-

tion, explains both under- and over-reaction to different earnings components. Investor
neglect of information in current-period earnings about future earnings induces post-
earnings announcement drift and the profit anomaly. Neglect of earnings components
causes accruals and cash flows to predict abnormal returns. We derive new untested
empirical implications relating the strength of the drift, accruals, cash flow, and profit
anomalies to the forecasting power of current earnings-related information for future
earnings, the degree of investor attention to different types of information, and the
volatilities of and correlation between accruals and cash flows. We also show that owing
to costs of attention, in equilibrium some investors may decide not to attend to the
implications of earnings or its components.
1 Introduction
Market reactions to earnings and earnings components present a striking puzzle. Stock
prices on average under-react to earnings surprises (post-earnings announcement drift),
but over-react to the operating accruals component of earnings.1 Earnings- and accruals-
related patterns of return predictability are often referred to as ‘anomalies,’ ‘under-’ and
‘over-reactions,’ or as reflecting investor ‘optimism,’ ‘pessimism,’ or ‘naiveté’. Such
labels offer little guidance as to the sources of these effects. Furthermore, a procedure of
conjecturing a separate psychological bias for each misreaction pattern creates a problem
of model overfitting; explanatory power is bought at the expense of predictive power.
We explore here the implications of a single well-established psychological constraint,
limited investor attention, for the ability of earnings and earnings components to forecast
abnormal returns. We argue that limited attention offers a parsimonious explanation for
both under- and over-reactions to earnings and earnings components. The model of lim-
ited attention that we provide is consistent with post-earnings announcement drift, the
accrual anomaly, the cash flow anomaly, and the profit anomaly. In addition to provid-
ing an integrated approach to earnings-related anomalies, our model offers new empirical
implications about the determinants of the strength of mispricing effects. Specifically, we
derive new untested implications for how return predictability is related to the volatili-
ties, correlations, and earnings forecasting power of these components.
Attention requires effort, and since the amount of information available is vast, must
be selective (see, e.g., Kahneman (1973)). There is evidence from the experimental
laboratory that limited attention affects how both naive and sophisticated individual
investors, as well as financial professionals, interpret accounting data (see the review
of Libby, Bloomfield, and Nelson (2002)). Such evidence suggests that attentional con-
straints may be a source of investor misvaluation of accounting information.
Empirical research provides several indications that limited investor attention con-
tributes to post-earnings announcement drift. Market reactions to earnings surprises are
muted when the news is released to the media during low attention periods. After-hours
1
Evidence of post-earnings announcement drift is provided by Ball and Brown (1968) and Bernard
and Thomas (1989); on the accrual and cash flow anomalies, see Sloan (1996) and Collins and Hribar
(2000). Most empirical tests that control for possible risk factors have not supported a rational risk
premium explanation for these return patterns (see the abovementioned studies, and Bernard, Thomas,
and Wahlen (1997)).
1
earnings announcements are impounded into price gradually in the days after the dis-
closure (Francis, Pagach, and Stephan (1992)). The volume-reaction and two-day stock
price reaction to news that is released to the media on Fridays and on days with many
competing announcements are weaker and post-earnings announcement drift is stronger
than when news is released on other days of the week and on days with few competing
announcements (DellaVigna and Pollet (2009), Hirshleifer, Lim, and Teoh (2009)).2
There are also indications that limited investor attention may play a role in the
accrual anomaly. Institutional investors, as professionals, should be more attentive to
earnings components than individuals. Consistent with this, the accrual anomaly is
stronger among stocks with lower ownership by active institutional investors (Collins,
Gong, and Hribar (2003)). Furthermore, managers seem to use their accounting discre-
tion to exploit investors’ neglect of accruals information.3 Analysts, whether for agency
or psychological reasons, tend to neglect accruals information in forming their forecasts
(Teoh and Wong (2002)). Finally, the accrual anomaly is not present among the subset
of firms that disclose the level of accruals at the date of the original earnings announce-
ment (Chen, DeFond, and Park (2002)). This suggests that the accrual anomaly is
caused by a subset of investors who attend to the earnings announcement but not to the
later financial reporting of accruals.
Contributing to a focus on earnings by both individual investors and financial pro-
fessionals, the business media discuss earnings much more than cash flow and accruals
numbers. As related by the well-known stock analyst Abby Joseph Cohen, “Many partic-
ipants in the investment business still rely on EPS [earnings per share], to the exclusion
of important measures of firm performance, such as revenues and cash flow. . . ” (Co-
hen (2005)). This emphasis is useful for investors with limited attention and processing
power. If an investor must select between earnings and cash flow to focus upon, the best
choice is the signal that is most informative about firm value. Empirically, stock returns
are more strongly related to news about contemporaneous earnings than about cash flow
(Dechow (1994)). Nevertheless, since cash flow is incrementally informative relative to
earnings, the neglect of how earnings is divided between cash flow and accruals causes
2
Furthermore, firms seem to take limited investor attention into account in timing the release of
earnings news. There is evidence that firms defer the release of bad earnings news to Fridays rather
than other weekdays (Bagnoli, Clement, and Watts (2005), DellaVigna and Pollet (2009)), and to after-
hours rather than trading hours (Patell and Wolfson (1982), Bagnoli, Clement, and Watts (2005)).
3
This is confirmed in an extensive literature on earnings management prior to new issues of equity
(Teoh, Welch and Wong (1998b, 1998a)), in order to meet benchmarks (DeGeorge, Patel, and Zeck-
hauser (1999)), and for other purposes; and evidence that abnormal accruals (a proxy for the use of
discretion by firms) are misvalued (Teoh, Welch and Wong (1998b, 1998a) and Xie (2001)).
2
systematic bias.
Consistent with some past literature on limited attention, in our model some investors
condition only on subsets of publicly available information signals in valuing a stock.
Risk averse investors who are fully attentive to the relevant information item are willing
to bear only a limited amount of risk in order to exploit mispricing. In consequence,
equilibrium stock prices reflect a weighted average of the beliefs of investors who attend
to different signals, with weights that depend on the relative numbers in each investor
group and their risk tolerances; see also the discussion in footnote 9. This approach,
which is by now familiar, serves as the building block for our new findings about the
effects of limited attention toward earnings and earnings components.
In the model, some investors attend to the implications of current-period earnings
for future prospects, and a subset of these investors also attend separately to the accrual
and cash flow components of earnings. (Further motivation of the assumption that some
investors neglect earnings information is provided in Section 2 and Section 5.) Using
the signals they attend to, investors form valuations of the firm. In equilibrium, prices
underreact to earnings surprises because of the subset of investors who do not incorporate
this information into their expectations of future earnings.
Investors who do attend to earnings but do not distinguish between earnings compo-
nents misvalue firms with abnormal levels of accruals. Empirically, the level of accruals is
a less favorable forecaster than cash flow of firm profitability (Sloan (1996)). Regardless
of whether this difference in forecasting power is a consequence of earnings management
or of the general nature of the accounting system, a rational investor should take this
fact into account in valuing firms. In our model, an investor who attends to earnings but
does not impound the information in earnings components into his valuation overvalues
high-accruals firms and undervalues low-accruals firms. Since misvaluation is eventually
corrected, this effect can, under appropriate conditions, cause high accruals to predict
low subsequent abnormal returns, and high cash flows to predict high subsequent abnor-
mal returns. Thus, the analysis reconciles underreaction to earnings with overreaction
to accruals.
Using this framework, we provide untested empirical implications about the direction
and strength of the forecasting power of earnings surprises, accruals, and cash flow for
future returns. The intuition starts from the fact that, conditional upon high accruals,
contemporaneous earnings also tend to be high, which causes investors to forecast higher
future earnings. In this situation, an investor who attends to earnings but neglects
accruals is overoptimistic because he forecasts high future earnings based upon high
3
current-period earnings. When cash flow is high, an individual who neglects this fact is
overpessimistic (even if he also neglects earnings).
These effects imply the direction and strength of accruals or cash flows as return
predictors depends on how favorably these variables predict future earnings relative to
the forecasting power of current-period earnings as a predictor of future earnings; and
on what information investors neglect. The predictive powers of these variables for
future earnings are influenced by the relative variability of cash flows and accruals, the
correlation of these earnings components, and the quality of accruals. In consequence,
the more variable are accruals relative to cash flows, the stronger is the cash flow anomaly
relative to the accrual anomaly; higher correlation between cash flows and accruals tends
to weaken the accrual anomaly; and lower quality of accruals (a weaker incremental
ability of accruals to forecast future earnings) tends to strengthen the accrual anomaly.
When some investors neglect earnings, and others attend to earnings but neglect
accruals, stock prices underreact to earnings, and overreact to accruals relative to cash
flow. If enough attention is paid to earnings, the relative overreaction to accruals out-
weighs the general underreaction to earnings, so that overall price overreacts to accruals.
Thus, in our setting the condition for the accrual anomaly to exist differs from that sug-
gested by Sloan (1996), that accruals are a stronger forecaster than cash flows of future
earnings. Furthermore, there tends to be stronger underreaction to cash flow than to
earnings; the ratio of the cash flow effect on returns to the accruals effect on returns is
greater in absolute value than the ratio of the variance of accruals to the variance of
cash flow.
We also show that owing to investor neglect of the implications of earnings news
for future earnings, the current level of earnings predicts stock returns even after con-
trolling for the current earnings surprise. Thus, the model explains the profit anomaly
(Balakrishnan, Bartov, and Faurel (2010), Chen, Novy-Marx, and Zhang (2010)). The
demands of inattentive investors are based on prior beliefs about expected future earn-
ings as reflected in indicators such as the previous year’s earnings or analyst forecasts
of the current year’s earnings. These indicators are less accurate than realized current
year earnings as predictors of future earnings. In consequence, mispricing is correlated
with the current level of earnings.
Finally, we consider a setting where individuals decide the level of attention by bal-
ancing the cost of attention against the expected benefits. We show that in equilibrium
some investors may decide not to attend to the implications of public information about
earnings or its components. This analysis explains why inattentive investors who trade
4
based upon their inattentive expectations (rather than simply remaining on the sidelines)
can survive in the long run.
This paper is part of a recent theoretical literature on how constraints on informa-
tion processing affect investor behavior. The approach followed here is similar in spirit
to that of Hirshleifer and Teoh (2003), who study the effects on market prices of in-
vestors neglecting relevant accounting information or strategic aspects of the disclosure
and reporting environment. A key difference here is that we examine the implications
of limited attention for market misvaluation in relation to earnings surprises, the level
of earnings, accruals, and cash flows. Other recent papers model the allocation of at-
tentional resources (Gabaix and Laibson (2005), Peng (2005), and Hirshleifer, Lim, and
Teoh (2008)), how limited learning capacity affects asset price comovement (Peng and
Xiong (2006)) and the speed of price adjustment to fundamental shocks (Peng (2005)
and Peng and Xiong (2006)), how delayed processing of new information affects the
dynamics of asset price volatility (Peng and Xiong (2002)), how neglect of demographic
information affects asset prices (DellaVigna and Pollet (2007)) and how informed parties
make disclosure decisions when observers have limited attention (Hirshleifer, Lim, and
Teoh (2008)).
2 The Economic Setting

We assume that there are three types of investors: those that ignore all current earnings-
related information, those that attend only to a subset of that information, and those
that attend to all publicly available information. All investors are ex ante identical, and
differences in how much of the public information set they process depend on the cost
they have incurred to obtain information. We assume that inattentive investors, apart
from the specific signals that they ignore, update beliefs as rational Bayesians.
There are 2 dates. At date 1, cash flow c1 , accruals a1 , and earnings e1 = c1 + a1
are realized. Investors update their prior beliefs based upon whatever public signals
they observe. At date 2 terminal earnings, cash flows, and accruals, e2 , c2 , and a2 , are
realized, where e2 = c2 + a2 , and the firm is liquidated. In general, accounting accruals
must reverse out, so we assume that a2 = −a1 .
Prices are set by trading in a securities market with no private information, so that
a rational individual has nothing to learn from market price. An inattentive individual
who is unaware of his signal neglect will also think he has nothing to learn from market
price. We therefore assume that inattentive investors do not update their beliefs based
5
upon market price.4
Nevertheless, if an investor understood his attentional limits, he could in principle
adjust for them by deferring to the belief implicit in market price. Indeed, a discrepancy
between an investor’s valuation and the market price could alert the investor to his
information neglect. In general, however, the same constraints on processing power and
memory that make it hard to attend to some public signal also make it hard to use price
or other indicators to compensate optimally for the failure to attend to it.5 For example,
an investor may just not think about the source of the discrepancy between the market
price and his own valuation. So long as some fraction of inattentive investors have
imperfect self-awareness, results similar to those derived here will obtain. Furthermore,
even if individuals always attend to market price and are fully aware of their information
neglect, similar results to those we derive here could be obtained so long as there is ‘noise’
in market price arising from liquidity trading.6
In general, attending to more information is costly. Since investors have finite cogni-
tive resources, attending to some information implies less time and resources for other
activities. We assume that there are different investor groups indexed by i who attend to
different information sets. Fully attentive investors attend to all date 1 publicly available
information; investors with limited attention attend to subsets of date 1 public informa-
tion. The decision to incur a cost to attend to the information set precedes the trading
decision. At this stage, we focus on the trade decision at date 1 taking the information
set as given. Later in Section 4.2 we analyze the decision of how much information an
individual attends to if there is a cost to attending to information.
4
Observing the ‘wrong’ price is an event which, as perceived by the investor, is not supposed to occur
in equilibrium. In the Perfect Bayesian Equilibrium concept of game theory setting the individual’s
posterior beliefs in such a situation equal to the prior belief can be consistent with equilibrium. Similar
results would hold so long as some disagreement remains between the attentive and inattentive investors,
i.e., inattentive investors do not always abandon their beliefs in favor of the information implicit in the
market price.
5
Since in reality people face many relevant signals, they try to leverage their attention by focusing on
more important information items. However, we cannot know perfectly which are more important before
processing them, which makes it hard to determine how to optimally compensate for information neglect.
Section 5 discusses evidence suggesting that individuals fail to compensate fully for the consequences
of limited attention in making decisions.
6
In such a setting, an individual who attends to a given public signal in effect has a sort of ‘private’
information, so different individuals who attend to different public signals will trade and profit at the
expense of liquidity traders, in the spirit of the models of Grossman and Stiglitz (1976) and Diamond
and Verrecchia (1981). This approach is discussed more fully in Section 5.
6
We assume that investors have a mean-variance utility function

i i A
E [C2 ] − vari (C2i ), (1)
2
where C2i is terminal consumption, A is the coefficient of absolute risk aversion, and i
superscripts denote the expectation or variance as formed by group i.
We assume that the decision-making investors have an initial wealth endowment (i.e.,
claims to terminal consumption) of W , and zero shares of the risky security. In addition,
mechanistic noise traders bring to the market a stochastic per capita supply of the single
risky security of x0 (i.e., supply per member of the decision-making population), which
is normally distributed with mean zero and variance Vx , uncorrelated with the other
exogenous random variables (earnings and its components).7 At date 1, the individual
can buy or sell the security in exchange for ‘cash’ (claims to terminal consumption) at
price S1 . The position in the security he attains is denoted xi . Let S2 be the true value
of the stock, which is conclusively revealed to all at date 2. Then letting k i be the cost
of attending to the information set used by attention group i, the consumption of an
individual in group i is
C2i = W − k i + xi (S2 − S1 ). (2)
Thus, an individual in attention group i solves

i i A
max x (E [S2 ] − S1 ) − vari (xi S2 ). (3)
xi 2
As a preliminary building block, we verify in our setting a standard finding about

stock prices as a weighted average of investor expectations of terminal cash flows as
adjusted by a risk premium. Differentiating the objective with respect to xi , equating
to zero and solving yields
E i [S2 ] − S1
xi = . (4)
A vari (S2 )
In several behavioral models, there are both rational and imperfectly rational in-
vestors who are risk averse and who maximize their expected utilities with respect
to their correct or incorrect beliefs. In this literature, prices in equilibrium reflect a
weighted average of the valuations of the rational and irrational traders. Even if there
7
For most of the paper it is not necessary that x0 be stochastic. However, in Section 4 ‘noise’ or
‘liquidity’ trading is needed for inattentive investors to earn positive expected profits from trading. As
in Grossman and Stiglitz (1976), noise creates scope for other investors to earn expected profits from
trading.
7
are no market imperfections, both groups influence prices significantly owing to the finite
risk-bearing capacity of each group.
Letting f i denote the fraction of investors in attention group i, the security price is
determined by the market clearing condition
X
f i xi = x0 . (5)
i
Substituting for xi from (4), and solving for S1 gives

P i i
λ E [S2 ] − Ax0
S1 = i P i , (6)
iλ
where
fi
λi ≡ . (7)
vari (S2 )
By normality, the λi ’s are constants independent of the signal realizations used by in-
vestors to condition beliefs.
This confirms that in equilibrium prices are a weighted average of the beliefs about
terminal cash flows of different investors adjusted by a risk premium (Ax0 / i λi ), with
P
weight λi / i λi on each information set. By (7), ceteris paribus λi is increasing in f i .

P
Thus, the greater the likelihood of each investor being inattentive, the greater the weight
that inattentive investors play in determining prices.
To focus on the effect of investor attention on investor mean beliefs, we follow the
heuristic trading approach of Verrecchia (2001), in which the biases of traders are mani-
fested in their expectations (first moments) but not second moments. So for tractability
we model the expectations of attentive and inattentive investors (6) as depending on i,
but the variances in (7) as independent of i, vari (S2 ) = var(S2 ).8
So the equilibrium price simplifies to
X
S1 = f i E i [S2 ] − A var(S2 )x0 . (8)
i
In this setting rational investors exploit a trading strategy that earns predictable
abnormal returns relative to a fully rational asset pricing benchmark. Nevertheless,
even though markets are perfect and there are no restrictions on either long positions or
8
It is not essential that the groups all assess variance as the unconditional variance; for example,
all results would still hold if variance were assessed as the variance conditional upon all the available
public signals.
8
short-selling, fully attentive investors do not completely arbitrage away the mispricing
generated by inattentive investors. The reason they do not is because doing so is risky.
The intuition behind the traditional notion that rational investors dominate price is
that rational investors trade to arbitrage away mispricing. However, if prices were set
solely by the rational investors, imperfectly rational investors would perceive a profit
opportunity to trade against what they regard as mispricing. If all investors are risk
averse, the equilibrium outcome reflects a weighted average among these beliefs.9
3 The Accrual Anomaly and Post-Earnings Announce-

ment Drift
The next subsection describes the basic structure of cash flow, earnings, and accruals
over time. Subsection 3.2 establishes that there is post-earnings announcement drift.
Subsection 3.3 shows that the same setting also generates overreaction to the accruals
component of earnings, and that cash flows positively predict subsequent abnormal
returns. Subsection 3.4 derives new empirical predictions about the circumstances in
which the accrual and cash flow anomalies will be stronger or weaker. Subsection 3.5
shows that limited attention also provides an explanation for the profit anomaly, the
predictability of returns based upon the level of earnings.
3.1 The Relation of Earnings, Accruals and Cash Flow over

Time
Suppose that at date 1 fraction f u of investors ignore current-period earnings e1 and
remain at their prior belief,10 that fraction f e of investors attend to earnings e1 but not to
accruals and cash flow separately, and that the remaining fraction f a ≡ 1−f u −f e attend
to both accruals and cash flow and therefore fully take into account the information in
earnings, since
e1 = c1 + a1 . (9)
9
Weighted average forms are found in previous models; see, e.g., Kandel and Pearson (1995), who
provides evidence supportive of prices reflecting average trader perceptions; and in the context of limited
attention, Hirshleifer and Teoh (2003).
10
It is not essential for the main conclusions of this paper that these investors completely ignore
earnings. They could attend to the direct effect but ignore the positive implications of higher immediate
earnings for future earnings. Taking this into account would slightly modify the algebra but would not
substantively affect the models qualitative predictions.
9
Then by equation (8), the date 1 stock price is
S1 = f u E[S2 ] + f e E[S2 |e1 ] + f a E[S2 |a1 , c1 ] − A var(S2 )x0 . (10)
For tractability, we assume multivariate normality of the stochastic variables. As a

result, date 2 earnings can be expressed as a linear function of the date 1 variables a1
and c1 and a noise term δ as
e2 = β0 + β1 c1 + β2 a1 + δ, (11)
where cov(δ, c1 ) = cov(δ, a1 ) = 0. Consistent with past empirical evidence (Sloan

(1996)), we assume that cash flow is a more positive predictor of future earnings than
accruals, β1 > β2 > 0.11 Since earnings e1 = a1 + c1 , equation (11) directly implies that
in a regression of future earnings e2 on current period earnings and accruals, there is a
negative coefficient on a1 . Similarly, in a regression of future earnings on current period
earnings and cash flow, there is a positive coefficient on cash flow.
Letting bars denote unconditional expectations, by (11) we have
ē2 = β0 + β1 c̄1 + β2 ā1 , (12)
so the deviation of earnings from its unconditional mean is
e2 − ē2 = β1 (c1 − c̄1 ) + β2 (a1 − ā1 ) + δ. (13)
The terminal realized value of the stock is the sum of the cash flows at the two periods.
Under clean surplus accounting, this is also equal to the sum of the earnings, so
S2 = c1 + c2 = e1 + e2
E[S2 ] = ē1 + ē2 = c̄1 + c̄2 . (14)
High earnings at date 1 is linearly associated with high earnings at date 2. The
strength of this relation is given by the regression coefficient, which by (9) and (11) is
cov(β1 c1 + β2 a1 + δ, c1 + a1 )
βe2 e1 =
Ve1

Vc + C Va + C
= β1 + β2 , (15)
Vc + Va + 2C Vc + Va + 2C
11
An extra unit of either cash flow or accruals at date 1 increases date 1 earnings by one dollar. Thus,
precisely because β1 > β2 > 0, expected firm value E[S2 |a1 , c1 ] = E[e1 + e2 |a1 , c1 ] increases more when
cash flow increases by one dollar than when accruals does.
10
where C ≡ cov(a1 , c1 ), and where V denotes the variance of a variable, with the abbre-
viations Va for Va1 and Vc for Vc1 .
Thus, βe2 e1 is a weighted average of β1 and β2 . Since β1 > β2 , it follows that
β1 > βe2 e1 > β2 so long as both weights are positive. Both weights are positive under
the assumption that each of higher accruals and higher cash flow is associated with
higher contemporaneous earnings.
cov(e1 , c1 ) = Vc + C > 0
cov(e1 , a1 ) = Va + C > 0. (16)
This is plausible; accruals and cash flows are components of earnings, and empirical
studies have documented that earnings is positively correlated with accruals and cash
flows (e.g., Dechow and Ge (2006), Pincus, Rajgopal, and Venkatachalam (2007)).
We also assume that accruals are positively related to the sum of date 1 and date 2
earnings,
cov(e1 + e2 , a1 ) = (1 + β2 )Va + (1 + β1 )C > 0. (17)
This assumption is intuitively obvious; it requires that accounting adjustments not be
completely meaningless, so that a higher accrual is on average associated with higher
long-run total firm value e1 + e2 . For example, as discussed above, earnings and accruals
are positively contemporaneously correlated, so a sufficient condition for this to hold is
that accruals be positively correlated with future earnings, cov(e2 , a1 ) > 0. Although
Sloan (1996) finds that the accrual component of earnings is less persistent than the
cash flow component, his estimates also indicate that high accruals are associated with
higher future earnings.12 Furthermore, condition (17) is also essentially equivalent (under
efficient markets) to the finding of Dechow (1994) that stock returns covary more strongly
with innovations in earnings than cash flows.13
Under these conditions, (15) indicates that high current-period cash flow is a more
favorable forecaster of future earnings than is high current-period earnings, which in
12
In a regression of one year-ahead earnings on accruals and cash flows, Sloan (1996) and Dechow
and Ge (2006) reports that the coefficient on both variables are significantly positive.
13
Since e1 + e2 is total firm value, the covariance in (17) is cov(e1 + e2 , e1 − c1 ) = cov(e1 + e2 , e1 ) −
cov(e1 + e2 , c1 ). By the law of iterated expectations, this last expression is equal to cov(E[e1 + e2 ], e1 ) −
cov(E[e1 +e2 ], c1 ), where the inner expectation is conditional on all publicly available date 1 information.
In an efficient market the inner expectation is just the stock price, so if cov(S1 , e1 ) − cov(S1 , c1 ) > 0
(which is basically the Dechow finding, since at date 0 any prior level of earnings, cash flows, or stock
price are constant) then (17) holds. In our model markets are not efficient, but as long as some investors
are attentive to earnings components, the general point still holds that, ceteris paribus, a tendency of
high accruals to covary positively with total firm value will tend to increase the covariance of stock
returns with earnings as compared to cash flow.
11
turn is a more favorable forecaster than high current-period accruals. It follows that the
relation between date 2 and date 1 earnings is stronger the more variable are cash flows
relative to accruals.
3.2 Post-Earnings Announcement Drift

We next examine the relation between the date 1 earnings surprise and expected fu-
ture abnormal stock returns. We define the earnings surprise as e1 − ē1 , where ē1 is
the prior expectation of date 1 earnings. Since ē1 is a constant, conditioning on the
earnings surprise is equivalent to conditioning on the date 1 earnings e1 . We begin by
calculating, conditional on earnings e1 , the expected future value of the stock E[S2 |e1 ].
For tractability, we examine price changes rather than percentage returns, as is stan-
dard in much of the literature on information in securities markets (see, e.g., Verrecchia
(2001) and Peng (2005)). Using standard properties of conditional expected values with
multivariate normal distributions,
E[S2 |e1 ] = e1 + E[e2 |e1 ]

= e1 + ē2 + (e1 − ē1 )βe2 e1 = E[S2 ] + (1 + βe2 e1 )(e1 − ē1 ). (18)
To calculate the conditional expected return given e1 , we also need E[S1 |e1 ]. Drift in
our model means that the expected change in the stock price conditional on the earnings
surprise increases with e1 , with zero effect when realized earnings is equal to its prior
expectation. We calculate the expected post-event return as
E[S2 − S1 |e1 ] = E[S2 |e1 ] − E[S1 |e1 ]. (19)
An iterated conditional expectation where one conditioning information set is coarser

than the other is equivalent to a single expectation conditional on the coarser information
set (e. g., Ash (1972), Theorem 6.5.10). Since e1 = a1 + c1 , the information provided by
e1 is coarser than that provided by (a1 , c1 ), so
E[E[S2 |a1 , c1 ]|e1 ] = E[S2 |e1 ]. (20)
E[S2 |e1 ] is given in equation (18). It follows from (10) and (18) that the expected return
after earnings announcement is
E[S2 − S1 |e1 ] = E[S2 |e1 ] − {f u E[S2 ] + (f e + f a )E[S2 |e1 ]}

= f u (E[S2 |e1 ] − E[S2 ])
= f u (1 + βe2 e1 )(e1 − ē1 ) (21)
12
We can define misvaluation in the current stock price as the difference between S1
and S1∗ , the price that would be set if all investors were attentive (f a = 1). From
(10) and (20), E[S1∗ |e1 ] = E[E[S2 |a1 , c1 ] − A var(S2 )x0 |e1 ] = E[S2 |e1 ]. Therefore, since
E[S1∗ − S1 |e1 ] = E[S2 − S1 |e1 ] there is over (under)-valuation if and only if the expected
price change is negative (positive).
From (10), the average immediate price reaction to the date 1 earnings announcement
conditional upon an earnings realization e1 is
E[S1 |e1 ] − E[S1 ] = (1 − f u )(E[S2 |e1 ] − E[S2 ])

= (1 − f u )(1 + βe2 e1 )(e1 − ē1 ). (22)
This proves:
Proposition 1 1. If fraction f u > 0 of investors neglect the information in current-

period earnings as well as cash flow and accruals, then more positive earnings
surprises are associated with greater undervaluation of the firm, and more nega-
tive surprises with greater overvaluation; and there is post-earnings announcement
drift.
2. The average immediate price reaction to the earnings surprise, the extent to which
the firm is undervalued (or less overvalued), and average post-event abnormal re-
turns increase with the earnings surprise e1 − ē1 .
3. The strength of the post-earnings announcement drift anomaly, and the sensitivity
of misvaluation and the average immediate price reaction to the earnings surprise,
increase with the persistence of earnings, βe2 e1 .
4. The higher the fraction of investors who neglect earnings information, f u , the
weaker is the average immediate reaction to a given earnings surprise, the stronger
is the relation of misvaluation to the earnings surprise, and the stronger is post-
earnings announcement drift.
As a special case, suppose that earnings follows a random walk, and consider a previous
date 0 at which time the firm earns e0 = ē1 . Then the surprise is the change in earnings
e1 − e0 . So the above predictions can be applied to one-year changes in earnings.
A recent body of research provides evidence which is generally supportive of the
persistence prediction of Part 3. Livnat (2003) provides evidence that higher earnings
persistence is associated with stronger drift, consistent with Part 3. Furthermore, since
13
revenues have greater persistence than expenses, drift should be especially strong if
the earnings surprise comes largely from a surprise in revenues (Jegadeesh and Livnat
(2006)). Jegadeesh and Livnat (2006) and Gu, Jain, and Ramnath (2005) find that
analyst forecasts also do not fully reflect differences in persistence between revenues
and expenses. Chen (2009) finds, consistent with the prediction in Part 3, that drift
is strongest among high persistence firms, but reports a reverse drift relation for firms
with very low persistence, a phenomenon our model does not explain.
Part 4 implies that the immediate price reaction is weaker and drift is stronger
when a greater fraction f u of investors are inattentive to earnings. Possible proxies for
inattention to earnings include the occurrence of earnings announcements on Fridays
(DellaVigna and Pollet (2009)), high number of earnings announcements competing for
attention (Hirshleifer, Lim, and Teoh (2009)), and announcement after trading hours
(Bagnoli, Clement, and Watts (2005)). For these proxies, Part 4 is consistent with the
evidence discussed in the introduction that there is weaker average immediate reaction to
earnings news and stronger drift when attention is weaker. For given size of the earnings
surprise, greater neglect of earnings in our model causes a weaker immediate reaction
to earnings news, and a greater long term reaction (drift). In addition, attention to
earnings is likely to increase with investor sophistication. If institutional holdings are
viewed as a proxy for investor sophistication, then this implication is consistent with the
evidence that firms whose shares are held heavily by individuals instead of institutions
have stronger drift (Bartov, Krinsky, and Radhakrishnan (2000)).
The empirical implications of Proposition 1 regarding under- and over-valuation can
be tested using contemporaneous misvaluation measures. For example, the residual
income model of Ohlson (1995) provides a contemporaneous measure of fundamental
firm value. As a result, the ratio of market price to the residual income model valua-
tion provides a measure of misvaluation (as applied, for example, by Lee, Myers, and
Swaminathan (1999) and Dong, Hirshleifer, Richardson, and Teoh (2006)).
3.3 The Accruals and Cash Flow Anomalies

We now examine whether accruals or cash flows are forecasters of future returns.14
Specifically, we examine whether, conditional on the level of accruals (or cash flows), the
14
Since earnings is the sum of cash flows and accruals, a bivariate regression of future returns on
earnings and on accruals is essentially equivalent to a bivariate regression of future returns on earnings
and on cash flows. However, the univariate regressions of returns on accruals or on cash flows are not
equivalent.
14
stock is mispriced, thereby implying subsequent abnormal returns. To do so, we calculate
the expectation of the date 2 value of the stock conditional on accruals, E[S2 |a1 ], and
of the date 1 stock price conditional on accruals, E[S1 |a1 ]. The difference between these
two values is the expected price change conditional on the level of accruals.
It follows from a property of conditional expectations (e.g., Ash (1972)) that
E[E[S2 |a1 , c1 ]|a1 ] = E[S2 |a1 ], (23)
as the information in a1 is coarser than that in (a1 , c1 ). So the expected price change
conditional on accruals a1 is
E[S2 − S1 |a1 ] = E[S2 |a1 ] − (f u E[S2 ] + f e E[E[S2 |e1 ]|a1 ] + f a E[S2 |a1 ])
= f u (E[S2 |a1 ] − E[S2 ]) + f e (E[S2 |a1 ] − E[E[S2 |e1 ]|a1 ]). (24)
From (13) and (14),
S2 = E[S2 ] + (1 + β1 )(c1 − c̄1 ) + (1 + β2 )(a1 − ā1 ) + δ. (25)

C
E[S2 |a1 ] = E[S2 ] + (1 + β1 ) (a1 − ā1 ) + (1 + β2 )(a1 − ā1 )
Va

C
= E[S2 ] + (a1 − ā1 ) (1 + β1 ) + (1 + β2 ) . (26)
Va
By (18) and multivariate normality,

C
E[E[S2 |e1 ]|a1 ] = E[S2 ] + (a1 − ā1 )(1 + βe2 e1 ) 1 + . (27)
Va
It follows that

u C e C
E[S2 − S1 |a1 ] = (a1 − ā1 ) f (1 + β1 ) + (1 + β2 ) + f (β1 − βe2 e1 ) + (β2 − βe2 e1 )
Va Va
C 2 − Va Vc

u C e
= (a1 − ā1 ) f (1 + β1 ) + (1 + β2 ) + f (β1 − β2 ) . (28)
Va Va (Va + Vc + 2C)
The second equality follows from equation (15).

On the right hand side of the last equality, the first term within the brackets reflects
the misvaluations of the fraction f u of investors who ignore earnings entirely. This
leads to direct underreaction to the higher date 1 earnings associated with higher date 1
accruals a1 , and underreaction to the implications of a higher accrual for future earnings.
15
Since these investors ignore the implications of higher accruals and resulting earnings,
they underreact. So if f e = 0, the future return is increasing with the deviation of
accruals from their mean.
The other term reflects the fraction f e of investors who attend to earnings but not
to how earnings is divided between accruals and cash flows. The expected error made
by these investors given current-period accruals is the difference between the correct
forecast given current-period accruals, and the forecast of future earnings based on the
effect of current-period accruals on current-period earnings. If |corr(a1 , c1 )| =6 1, the f e
term in (28) is negative since β1 > β2 and C 2 − Va Vc = Va Vc (corr2 (a1 , c1 ) − 1) < 0.
The model is symmetric with respect to c1 and a1 , except for the assumption that
β1 > β2 in (11). Thus, replacing a1 with c1 , c1 with a1 , β2 with β1 , and β1 with β2 in
(28), we obtain the expected return conditional on the date 1 cash flow,
−C 2 + Va Vc

u C e
E[S2 −S1 |c1 ] = (c1 −c̄1 ) f (1 + β1 ) + (1 + β2 ) + f (β1 − β2 )
Vc Vc (Va + Vc + 2C)
(29)
The f e term in (29) contributes to underreaction to cash flow since β1 > β2 and −C 2 +
Va Vc ≥ 0. The f u term also contributes to underreaction to cash flow since
(1 + β1 )Vc + (1 + β2 )C > (1 + β2 )(Vc + C) > 0, (30)
where the first inequality follows from β1 > β2 and the second from (16). Therefore,
overall there is underreaction to cash flow.
The above analysis is summarized in the following proposition.
Proposition 2 Suppose that at date 1 fraction f u of investors do not attend to any of

earnings e1 , cash flow c1 and accruals a1 ; that fraction f e attend to earnings but not
to its decomposition between cash flow and accruals; and that the remaining fraction
f a = 1 − f u − f e attend to all publicly available information. Then:
1. A firm with date 1 cash flows that are above (below) their unconditional mean is
undervalued (overvalued), and subsequently on average earns positive (negative)
abnormal returns.
2. If f u is sufficiently small relative to f e , a firm with date 1 accruals that are above
(below) their unconditional mean is overvalued (undervalued) and subsequently on
average earns negative (positive) abnormal returns.
16
Part 1 indicates that under our assumption that cash flow is a more favorable incre-
mental predictor of future earnings than is accruals (β1 > β2 in equation (11)), there is
under-reaction to cash flow. As discussed after footnote 11, this assumption is equiva-
lent to the assumption that after controlling for current-period earnings, accruals are a
negative incremental predictor of future earnings.
Part 2 indicates that if enough attention is paid to earnings, there is overreaction to
the accruals component of earnings. One case in which the condition for Part 2 applies
is f u = 0 (all investors attend to earnings). The ability of accruals to forecast returns in
this case reflects the fact, as discussed at the end of Subsection 3.1, that β1 > βe2 e1 > β2 .
In other words, high current-period cash flow is a more favorable forecaster of future
earnings than is high current-period earnings, which is a more favorable forecaster than
high current-period accruals. Those investors who focus on earnings without attention
to its components do not take into account that for a given level of earnings, the true
expectation of future earnings is higher when cash flow is high than when it is low. In
consequence, such investors undervalue firms with high cash flow and overvalue firms
with low cash flow. Such misvaluation is subsequently corrected, causing abnormal
returns.
Similarly, those investors who focus on earnings without attending to its components
do not take into account that for a given level of earnings, the true expectation of future
earnings is higher when accruals are low than when they are high. In consequence, such
investors overvalue firms with high accruals and undervalue firms with low accruals,
leading to subsequent abnormal returns.
When f u > 0, so that some investors neglect earnings, there is general underreaction
to earnings. Since cash flow is a more favorable predictor of earnings than accruals,
f u > 0 further implies underreaction to cash flow relative to accruals. This reinforces
the underreaction to cash flows, which provides the intuition for the cash flow anomaly
asserted in Part 1. Even though investors overreact to accruals relative to cash flow, if f u
is sufficiently large relative to f e , there is underreaction even to the accruals component
of earnings. This explains why the Part 2 conclusion that high accruals are associated
with low returns requires that the fraction of investors who attend only to earnings (and
not its components) be sufficiently large relative to the fraction of investors who neglect
earnings entirely.
Thus, the analysis is consistent with the accrual anomaly, but the condition under
which it applies is different from that proposed by Sloan (1996), that accruals be a
less favorable predictor than cash flows of future earnings (β1 > β2 ). Here β1 > β2
17
is a necessary but not sufficient condition for the accrual anomaly to apply. Thus,
an empirical implication of Proposition 2 is that the accrual anomaly can vanish or
even reverse even for sets of firms for which cash flow is a more positive predictor than
accruals of future earnings, if the difference β1 − β2 is not too large and/or f e is not
sufficiently large compared to f u . A further empirical implication is that the positive
relation of cash flows to subsequent returns should be more robust across different firms,
trading venues, and time periods than the negative relation of accruals to subsequent
returns. Specifically, the accrual anomaly could reverse for firms that have greater
neglect of earnings (higher f u ). Consistent with this implication, Pincus, Rajgopal, and
Venkatachalam (2007) find that the cash flow anomaly is reliably present in a much
wider set of countries (12 out of 20) than the accrual anomaly (3, including the US).
Proposition 1 indicates that a proxy for f u that can be used for further empirical
testing is the strength of the firm’s post-earnings-announcement drift. Alternatively,
other proxies for the sensitivity of a firm’s misvaluation to its earnings surprises could
be used based upon contemporaneous misvaluation proxies. Either type of proxy for f u
can be used to test Part 2 of Proposition 2 as well.
3.4 The Relative Strength of Accruals- and Cash Flow-Based

Return Predictability
Our analysis provides insight regarding the strength of the cash flow and accruals anoma-
lies. Let ba be the slope coefficient in the relation between accruals surprises a1 − ā1
and subsequent abnormal stock returns, and let bc be the slope coefficient in the relation
between cash flow surprises c1 − c̄1 and subsequent abnormal stock returns. Then by
equations (28) and (29),
C 2 − Va Vc

u C
ba = f (1 + β1 ) + (1 + β2 ) + f e (β1 − β2 )
Va Va (Va + Vc + 2C)
−C 2 + Va Vc

C
bc = f u (1 + β1 ) + (1 + β2 ) + f e (β1 − β2 ) . (31)
Vc Vc (Va + Vc + 2C)
3.4.1 Effects of Variations in Attention on the Accruals- and Cash Flow-

Anomalies
Since the f u terms are positive in both cash flow and accruals equations in (31), while
the f e term is positive in the cash flow equation and negative in the accruals equation,
we have:
18
Proposition 3
1. The strength of the relation between cash flow and subsequent abnormal returns,
bc , is increasing in f u and f e .
2. If there is an accrual anomaly (ba < 0), the strength of the relation between accruals
and subsequent abnormal returns, |ba | = −ba , is decreasing in f u and increasing
in f e .
3. A shift in investor probability mass from attending only to earnings to neglecting

both earnings and its components (increasing f u and decreasing f e by the same
amount) intensifies the cash flow anomaly.
Part 1 reflects the fact that neglect of earnings and neglect of earning components both
reinforce the cash flow anomaly. A shift in investor probability mass from attending to
both earnings and its components to either neglecting earnings components (increasing
f e ) or to neglecting earnings as well as its components (increasing f u ) intensifies the
cash flow anomaly. An untested empirical implication of Part 1 is that the cash flow
anomaly will be stronger when attention declines. Proxies for attention or inattention
from the literature such as trading volume, the number of distracting news events, and
Friday announcements could be used to test this implication.
Intuitively, if the fraction of investors that attends to earnings but neglects accruals
and cash flow, f e , increases (at the expense of fully attentive investors), then this ne-
glect favors underreaction to cash flows and overreaction to accruals. Empirically, the
complexity or length of the firm’s annual report is a proxy for the incremental cost of
attending to earnings components (where the earnings level itself can be attended to
without delving into these details). It is therefore a possible proxy for variation in f e ,
holding f u constant. If the fraction of investors that neglects earnings, f u , increases,
the underreaction to cash flows is reinforced, whereas the overreaction to accruals is
weakened. As mentioned in the discussion following Proposition 2, the strength of post-
earnings announcement drift can be used as an empirical proxy for f u for a stock or set
of stocks.
Another attention proxy is the share ownership of institutional versus individual
investors. If institutional investors are attentive to accruals, cash flows, and earnings,
then high institutional ownership and low individual ownership should be associated with
low f u (neglect of both earnings and accruals) and f e (neglect of earnings). Low f u and
low f e both weaken the cash flow anomaly. Furthermore, if institutional ownership is
19
high enough to drive both f u and f e toward zero (so that few investors neglect the
split of earnings between cash flow and accruals), the accrual anomaly should become
arbitrarily weak. Empirically, Collins, Gong, and Hribar (2003) find that the accrual
anomaly is stronger in stocks with lower ownership by active institutional investors.
With regard to Part 3, a shift in investor probability mass from attending only to
earnings to neglecting earnings as well has two opposing effects on the cash flow anomaly,
since both f e and f u terms contribute to underreaction to cash flow. However, decreasing
f e and increasing f u by the same amount ∆ increases bc by
(Vc + C)[β1 (Vc + C) + β2 (Va + C) + (Va + Vc + 2C)]

∆ > 0. (32)
Vc (Va + Vc + 2C)
When cash flow is high, for example, investors who attend only to earnings (fraction
f e ) neglect the cash flow but draw a somewhat positive inference from the (on average)
high earnings. However, investors who do not attend to earnings (fraction f u ) do not
draw any inference from the cash flow or the earnings. Therefore, decreasing f e and
increasing f u by the same amount strengthens the cash flow anomaly.
3.4.2 Effects of Earnings Quality on Accrual and Cash Flow Anomalies
It has often been alleged that earnings management reduces the quality of earnings, in
the sense that earnings is a less accurate indicator of long-run firm performance. In our
setting such a reduction in earnings quality associated with accruals would be reflected
in a low β2 in equation (11), so that current-period level of accruals becomes a much
less favorable predictor of future earnings than current-period cash flow.
We now consider the implications of lower earnings quality in this sense for the
strengths of the accrual and cash flow anomalies. Differentiating ba in (31) with respect
to β2 yields
Va Vc − C 2

∂ba u e
=f +f >0 (33)
∂β2 Va (Va + Vc + 2C)
where the final inequality holds because Va Vc ≥ C 2 . This derivative indicates that
if there is an accrual anomaly (ba < 0), then when earnings quality increases (accruals
becomes a more favorable incremental predictor of future earnings), the accrual anomaly
becomes weaker (the negative coefficient increases, moving it closer to zero). If there is
no accrual anomaly or a reverse accruals effect (ba ≥ 0), then the effect becomes even
more reversed.
20
Differentiating bc in (31) with respect to β2 yields
C 2 − Va Vc

∂bc u C e
=f +f (34)
∂β2 Vc Vc (Va + Vc + 2C)
Since C 2 ≤ Va Vc , the above equation indicates that the cash flow anomaly is weakened
by an increase in earnings quality if C < 0.
Proposition 4 Consider an increase in accruals quality that increases β2 , i.e., makes

the incremental forecasting power of current-period accruals for future earnings closer to
that of current-period cash flows. Then an increase in earnings quality:
1. Weakens the accrual anomaly; and
2. Weakens the cash flow anomaly if the covariance of accruals with cash flows is
negative.
The β2 parameter can be estimated by running the regression in (11). Therefore the
prediction about the relation of accruals quality to the accrual anomaly is empirically
testable.
Intuitively, in Part 1 the accrual anomaly is driven by the low quality of the accru-
als component of earnings, so if this component becomes a more favorable forecaster of
earnings, a strong investor reaction to accruals becomes a less severe mistake. This is re-
inforced by a subtler effect. When earnings quality increases owing to an increase in β2 ,
the persistence of earnings, βe2 e1 , increases (see equation (15)). Investor neglect of the
implications of current-period earnings for future earnings (as reflected in f u ) therefore
causes greater underreaction to earnings as the persistence of earnings increases (Propo-
sition 1, Part 3). This greater general underreaction further weakens the overreaction
to accruals.
In Part 2, the intuition for the effect of a change in accruals quality on the cash flow
anomaly reflects the same two effects. On the one hand, higher accruals quality eases
the misperceptions associated with the neglect of accruals and cash flow information.
This is reflect in the negative f e term in (34), indicating a weakening of the cash flow
anomaly.
More subtly, if cash flow covaries negatively with accruals, higher cash flow on average
implies lower accruals, and lower accruals on average implies lower current earnings e1
and lower total firm value e1 + e2 . This is in the opposite direction of the direct effect of
cash flow on firm value. An increase in β2 strengthens the association between accruals
21
and firm value e1 + e2 . Therefore, given neglect of current earnings, it further weakens
underreaction to cash flow. Past empirical evidence (e.g., Sloan (1996)) shows that the
covariance between cash flow and accruals is negative. Thus Part 2 of Proposition 4
predicts that an increase in earnings quality weakens the cash flow anomaly.
Testing of Proposition 4 requires controlling for other exogenous parameters such as
the variances of accruals and cash flows. This is important, for example, in evaluating
differences in earnings quality that derive from differing earnings management practices,
since a firm that manages earnings heavily may have greater variability in accruals. We
next examine the effects on anomalies of varying volatilities and correlations as well.
3.4.3 Effects of Accruals and Cash Flow Volatilities and Correlations on

Accruals- and Cash Flow- Anomalies
The f e term, which reflects investor inattention to the division of earnings between cash
flow and accruals, is the sole source of mispricing when f u = 0. We define b0a and b0c as
the values of the slope coefficients that come from neglect of earnings components, not
from neglect of earnings itself (i.e., the f u term),
C 2 − Va Vc

0 e
ba = f (β1 − β2 )
Va (Va + Vc + 2C)
−C 2 + Va Vc

0 e
bc = f (β1 − β2 ) . (35)
Vc (Va + Vc + 2C)
It follows that the relative size of the slope coefficients in the accruals regression and in
the cash flow regression is determined by the ratio of the variances of accruals and of
cash flows. 0
ba 0
= − ba = V c . (36)
b0 b0c Va
c
For example, if f u = 0 and Vc = Va , then b0a = −b0c , so that the accruals and cash flow
anomalies are equally strong.
So far in this discussion we have assumed that f u = 0, which eliminates post-earnings
announcement drift by Proposition 1. More generally, when f u > 0 in (31), the slope
coefficients ba and bc are larger than the corresponding b0a and b0c . Since b0c > 0, it follows
22
that if f u > 0 and there is an accrual anomaly (ba < 0),
h i
C
ba
u
−f (1 + β1 ) Va + (1 + β2 ) − b0a
− = h i
bc f u (1 + β ) + (1 + β ) C + b0
1 2 Vc c
b0a
< − h i
f u (1 + β1 ) + (1 + β2 ) VCc + b0c
b0a Vc
< − 0
= , (37)
bc Va
where the first inequality follows from (17) and the second from (30). Thus, the relative
strength of the cash flow effect is greater than what is implied by the variance ratio. For
example, if cash flow and accruals are equally variable, then (36) indicates an equally
strong cash flow and accrual effect. But if some investors ignore earnings, so that f u > 0,
by (37) the cash flow effect is stronger than the accruals effect. Thus, although the
empirical literature has focused more on accruals than cash flow, our analysis predicts
that the cash flow effect can be stronger.
This analysis is summarized in the following proposition.
Proposition 5
1. If investors always attend to earnings, so that f u = 0, then the ratio of the absolute
slopes in the univariate regressions of subsequent returns on accruals and on cash
flows, −b0a /b0c , is equal to the ratio of the variance of cash flow to the variance of
accruals, Vc /Va .
2. If some investors neglect earnings, so that f u > 0, and if there is an accrual

anomaly (ba < 0), then the ratio of the absolute slopes in the univariate regressions
of subsequent returns on accruals and on cash flows, −ba /bc , is less than the ratio
of the variance of cash flow to the variance of accruals, Vc /Va .
Intuitively, consider an investor who focuses on current-period earnings in forecasting

future earnings. For simplicity, suppose that the covariance of current-period accruals
and current-period cash flow is zero. High accruals increase current-period earnings,
making the investor more optimistic about future earnings. The investor on average
becomes too optimistic, because he forecasts high future cash flow based on the un-
conditional relation between current-period earnings and future earnings. Thus, the
investor’s overoptimism will be greater to the extent that an extra unit of earnings is
23
on average associated with higher future earnings more strongly than is an extra unit of
accruals.
When accruals are highly variable relative to cash flow, most variation in earnings
comes from variations in accruals. In this case, the forecasts of investors with limited
attention who condition on earnings are almost equivalent to fully attentive forecasts
based on accruals. High accruals bring about little over-optimism, so the slope b0a ap-
proaches zero. In contrast, when the variance of accruals is low relative to the variance
of cash flow, the forecasts of investors with limited attention who condition on a given
deviation of earnings from mean earnings are similar to the forecasts that would be made
based on a comparable deviation of cash flow from its mean. If in fact it is the level of
accruals, not cash flow, that is high, then this misattribution brings about a great deal
of overoptimism.
A higher value of ba means that it is less negative, a weaker accruals effect. So Part
2 indicates that the cash flow effect can be stronger than the accruals effect even if the
relative variability is equal.
One reason why a firm’s accruals might be highly variable is if it engages in extensive
earnings management. If so, then accruals may be a less favorable predictor of future
earnings (lower β2 ). It is therefore striking that the prediction of Proposition 5 is inde-
pendent of the forecasting powers of cash flow or accruals, β1 or β2 , for future earnings.15
The independence of the prediction of Proposition 5 from β1 and β2 simplifies empirical
testing.
By Proposition 5, a higher variance of accruals relative to cash flow implies a weaker
accruals effect. With regard to Part 1, if the accruals or cash flow effects are empirically
evaluated using hedge profits based upon fractile sorts, the spread in the independent
variables is affected by their variances. Under normality, among a set of ex ante identical
firms, a higher variance of accruals implies a higher mean high-low fractile spread in
accruals. Since the relative weakness in the slope is proportional to the relative variances,
whereas the fractile spread increases only as the square root of the variances, there is
partial cancellation. Overall, Proposition 5 indicates that for fractile spreads, among a
set of ex ante identical firms that obtain different realizations of accruals and cash flows,
the ratio of the hedge profits based upon accruals versus those based upon cash flow will
be inversely proportional to the ratio of the standard deviations (instead of variances)
15
Intuitively, the prediction in (36) is about the relative sizes of these anomalies. If β2 β1 , so
that the neglect of accruals makes a big difference for value, the accrual anomaly will be stronger (as
indicated by equation (33) in the derivation of Proposition 4). However, in such a case the cash flow
anomaly also tends to be stronger (as indicated by the f e term in equation (34)).
24
of accruals and of cash flows.
We next evaluate the effects of variances on each of the slope coefficients separately.
Proposition 6 If investors are fully attentive to earnings (f u = 0), but some do not
attend to accruals and cash flow separately (f e > 0), then the slope coefficient boa
is increasing, and the slope coefficient boc is decreasing, with ρ. In other words, as ρ
increases, both the accrual and cash flow anomalies become weaker.
The proof is in the Appendix. Empirically, the parameter ρ can be estimated using
accrual and cash flow data.
The intuition is that both accruals and cash flow effects derive from investors ne-
glecting the differing implications for long-run earnings of current-period cash flow versus
accruals. When accruals and cash flow are highly correlated with each other, each is
highly correlated with earnings, so that ignoring the distinction between different earn-
ings components is on average of little consequence.
If f u > 0 so that some investors neglect earnings, not just its components, higher ρ
further weakens the accruals effect (increases the negative slope b0a ):
" r #
Vc
ba = f u (1 + β1 )ρ + (1 + β2 ) + b0a , (38)
Va
so r
∂ba u Vc ∂boa
= f (1 + β1 ) + . (39)
∂ρ Va ∂ρ
Since the first term is positive, it follows that ∂ba /∂ρ > 0. The following proposition
summarizes this finding:
Proposition 7 The slope coefficient of future returns on accruals ba is increasing with
the correlation ρ between cash flows and accruals.
Intuitively, the first term reflects the fact that when the correlation between accruals
and cash flow is higher, high accruals tend to be more positively (or less negatively)
associated with high cash flow. Since the market underreacts to earnings (f u > 0),
there is underreaction to the higher accruals, which tends to oppose the pure accruals
effect (make ba less negative).
The sign of ∂bc /∂ρ is ambiguous. As shown earlier, the f e term of bc , boc , is decreasing
with the correlation ρ between accruals and cash flow. On the other hand, neglect of
earnings (f u > 0) intensifies the cash flow when ρ is higher, as high cash flow is more
positively associated with high accruals, both of which are positive predictors of date 2
earnings. Thus, the net effect of a higher ρ on bc depends on parameter values.
25
3.5 The Profit Anomaly and Post-Earnings Announcement Drift
Balakrishnan, Bartov, and Faurel (2010) provide evidence that the level of (as dis-
tinguished from the surprise in) earnings predicts future stock returns, and that this
effect is not subsumed by post-earnings announcement drift. There is also evidence that
stocks with high earnings on average earn higher returns (Chen, Novy-Marx, and Zhang
(2010)). In this subsection we show that investor inattention can explain the profit
anomaly, the return predictability based on the level of earnings, and that, consistent
with existing evidence, the effect is incremental to the post earnings announcement drift.
To illustrate the key intuition, we simplify the model by assuming that there are only
two types of investors, those who attend to earnings alone and those who do not. In other
words, we set the fraction who attend to earnings components, f a , to zero. We focus
here on the issue of return predictability based upon earnings or on earnings surprises,
not on earnings components. At some point prior to the date 1 earnings announcement,
both groups of investors form their expectations f0 of the upcoming earnings e1 based
upon available date 0 information. We can view f0 as either an analyst forecast, or
the previous level of earnings. After the date 1 earnings announcement, a fraction λ
of investors are inattentive and stick to their original beliefs, and a fraction 1 − λ of
investors use earnings information to update their beliefs. Here λ = f u from before; we
rename it here to avoid confusion with our terminology for the analyst forecast, f0 .
As before, we assume that the date 2 stock value is the sum of the date 1 earnings
e1 and the date 2 earnings e2 ,
S2 = e1 + e2 , (40)
where
e2 = ē2 + βe (e1 − ē1 ) + δe . (41)
The date 1 earnings can be decomposed into the forecast f0 and additional informa-
tion ε,
e1 = f0 + ε, (42)
where f0 ∼ N (f¯0 , Vf ) and cov(f0 , ε) = 0. We assume that forecasts are on average
unbiased (ē1 = f¯0 ).16 Date 0 earnings forecasts of e1 are made prior to the arrival of
e1 , so we assume that they are less informative than e1 itself about date 2 earnings. So
comparing βf in the predictive regression
e2 = ē2 + βf (f0 − f¯0 ) + δf , (43)
16
In reality analyst forecasts are biased, but unbiasedness is a simple benchmark and is not crucial
for our results.
26
with βe in equation (41), it follows that βe > βf ≥ 0. Furthermore, the dominance of
e1 over f0 as a predictor of future earnings implies that a bivariate regression of e2 on
e1 and f0 reduces to a univariate regression on e1 . So the expectations of attentive and
inattentive investors are
E[S2 |e1 , f0 ] = E[S2 |e1 ] = E[S2 ] + (1 + βe )(e1 − ē1 )

E[S2 |f0 ] = E[S2 ] + (1 + βf )(f0 − f¯0 ). (44)
As before (see (10)), the date 1 stock price is a weighted average of the beliefs of
attentive and inattentive investors. Recalling that λ denotes the fraction of investors
who do not attend to earnings, the date1 stock price can be written as
S1 = E[S2 ] + (1 − λ)(1 + βe )(e1 − ē1 ) + λ(1 + βf )(f0 − f¯0 ) − A var(S2 )x0 , (45)
and the change in stock price is
S2 − S1 = λ(1 + βe )(e1 − ē1 ) − λ(1 + βf )(f0 − f¯0 ) + A var(S2 )x0 + δe . (46)
In this setting, it is not hard to derive the profit anomaly, the finding that the level of
earnings is a positive predictor of future returns. However, given the well-known finding
of post earnings announcement drift, it is more interesting to derive that profit is a
predictor of future returns even after controlling for the earnings surprise. We therefore
run a ‘horse race’ between the profit anomaly and post earnings announcement drift
by regressing the stock price change on both the level of date 1 earnings e1 , and the
earnings surprise e1 − f0 :
S2 − S1 = b0 + b1 e1 + b2 (e1 − f0 ) + . (47)
The coefficient on the level of earnings, b1 , captures the profit anomaly, and the coefficient
on the earnings surprise, b2 , captures post earnings announcement drift. The regression
coefficients b1 and b2 are
b1 = λ(βe − βf )
b2 = λ(1 + βf ). (48)
Since βe > βf ≥ 0, b1 > 0 and b2 > 0. Therefore there are both a profit anomaly and
post-earnings announcement drift, and neither subsumes the other.
The results imply that both anomalies stem from investor inattention to earnings
information (λ). The effect of attention toward earnings news can be viewed as con-
taining two parts. First is a shift in the mean belief about the current level of earnings
27
e1 by the amount of the surprise (ε = e1 − f0 ). Second is greater certainty about the
current level of earnings (e1 for sure instead of f0 on average), which causes the use of
a different coefficient when investors forecast future earnings based on the information
they have (use of βe instead of βf ). When there is inattention, the mean shift causes a
misperception (and subsequent return predictability) induced by the earnings surprise,
i.e., post-earnings announcement drift. The second effect, a failure to update sufficiently
strongly for any given level of date 1 expected earnings, induces mispricing in relation to
the level of earnings.17 Therefore, the earnings level predicts returns (the profit anomaly)
even after controlling for the earnings surprise.
A further untested empirical implication is that the profit anomaly is stronger when
the current level of earnings is a much better predictor of future earnings than are prior
earnings expectations such as analyst forecasts and prior earnings (higher βe − βf ). The
following proposition summarizes these results.
Proposition 8 1. If fraction λ > 0 of investors ignore the information in current-

period earnings and hold onto their beliefs based on prior earnings expectations,
both the level of earnings and earnings surprise (earnings minus prior earnings
expectations) predict future stock returns.
2. There is a stronger profit anomaly when current earnings is a much better predictor
of future earnings than prior earnings expectations.
4 Trading Profits and Equilibrium Inattention

It could be argued that inattentive investors should withdraw from the market instead of
trading; and that if they do trade, they will on average lose money, and in the long run,
tend to vanish. However, in standard models of securities markets, individuals do find
it optimal to trade despite having informational disadvantages relative to some subsets
of other traders. Furthermore, attending to more information is costly, so those who
devote more cognitive resources to an information signal (such as a given firm’s earnings,
accruals or cash flow) need not do better overall. Attending to a given signal allows
individuals to value the firm more accurately, at the cost of withdrawing attentional
17
Holding earnings surprise ε constant, a unit increase in earnings level (e1 = f0 + ε) is equivalent to
a unit increase in f0 . This increase in earnings level increases the expected stock price by 1 + βf for
inattentive investors, which is smaller than the increase in the expectation of attentive investors, 1 + βe .
So there is underreaction to variations in the earnings level above and beyond the underreaction to the
earnings surprise.
28
resources from some other activity. For example, attention demands time, which has
a monetary opportunity cost. Since there is both a benefit and a cost to attending to
a given public signal, in a long-run equilibrium in which wealths of investors shift over
time, it does not follow that fully attentive investors dominate.
In this section we show that if attention is costly, there can be an equilibrium in
which inattentive investors find it optimal to trade; and in which inattentive and at-
tentive investors on average achieve the same expected utility, and therefore coexist.
We first show that investors who do not attend to all publicly available information
can nevertheless earn positive expected trading profits. Next, when individuals decide
to attend by balancing the cost of attending against the expected utility benefits from
making better-informed decisions, we show that there can exist an equilibrium where a
positive fraction of investors decide not to attend to some public information. Since the
attentive and inattentive achieve equal ex ante welfare, there is no reason to expect the
inattentive to vanish in the long run.
4.1 Expected Trading Profits

Investors who neglect the information contained in earnings or its components make
inferior trades, which raises the question of whether such behavior can survive in equi-
librium. We now show that inattentive investors can still earn positive expected profits
owing to noise trading. We consider investors who make rational plans when they al-
locate attention ex ante, foreseeing the fact that if they choose not to attend to an
information item then their subsequent beliefs will be biased. We first calculate the true
expected trading profits to investors as a function of whether they attend to information
signals.
Using the formula for the optimal security position given by (4), the expected profit
of an investor who ignores earnings and its components in forming expectations is

u E[S2 ] − S1
E[x (S2 − S1 )] = E (S2 − S1 ) . (49)
Avar(S2 )
For an investor who attends to earnings information only, her expected profit is

e E[S2 |e1 ] − S1
E[x (S2 − S1 )] = E (S2 − S1 ) . (50)
Avar(S2 )
Proposition 9 When there is a large amount of noise trading (Vx sufficiently large),
inattentive investors earn positive expected profits.
29
The proof is in the Appendix. We find that uninformed investors (those who ignore
earnings) can earn positive expected profits owing to noise trading. Both noise trading
and the presence of uninformed investors positively contribute to the expected trading
profits of investors who attend to earnings but ignore its components.
4.2 Expected Utility and Characterization of Equilibrium

We now evaluate the expected utility of each type of investor. Given the mean-variance
utility function in equation (1), the consumption (2), and the demand for the risky
security in equation (4), the expected utility of investor group i is as follows.
(E i [S2 ] − S1 )2

i i
E[U (C2 )] = E (W − k ) + . (51)
2A var(S2 )
Assume that the cost k i of attention is equal to zero for uninformed investors (k u = 0)
and that the cost of attending to earnings only is less than that of attending to cash
flow and accruals separately (k e < k a ).
From multivariate normality, E i [S2 ] − S1 is normally distributed with mean zero
since E[S1 ] = E[S2 ] = E[E i [S2 ]]. Thus (E i [S2 ] − S1 )2 follows a chi-square distribution.
Therefore, the expected utility of each group of investors is
var(S1 )
E[U u (C2 )] = W +
2A var(S2 )
var(E[S2 |e1 ] − S1 )
E[U e (C2 )] = W − k e +
2A var(S2 )
var(E[S2 |c1 , a1 ] − S1 )
E[U a (C2 )] = W − k a + . (52)
2A var(S2 )
In an equilibrium where the fraction of investors in each category is non-zero, the
ability of investors to pay to enter higher attention categories will cause expected utility
to be equated across all three categories:
var(S1 ) var(E[S2 |e1 ] − S1 ) var(E[S2 |c1 , a1 ] − S1 )
= −k e + = −k a + . (53)
2A var(S2 ) 2Avar(S2 ) 2Avar(S2 )
A numerical example of such an equilibrium is provided by the case Vc = Va = Vδ = Vx =
1, A = 1, cov(a1 , c1 ) = −0.4, β1 = 0.5, β2 = 0.3, f u = 0.6, f e = f a = 0.2, k e = 0.0696,
and k a = 0.0721.
Proposition 10 When attention is costly and is allocated endogenously, under some pa-
rameter values there are equilibrium fractions of investors who choose to neglect earnings
and its components, and earn the same expected utility as fully attentive investors.
30
Intuitively, owing to the cost of attention as reflected in k i , investors who allocate
greater or lesser attention to earnings or its components can coexist in the long run
since more attentive investors incur higher opportunity costs of attention. These oppor-
tunity costs can be viewed as the benefit from allocating cognitive resources to other
decision domains, such as personal life or other investment categories. Previous research
that studies the optimization decision for allocating attention (Hirshleifer, Lim, and
Teoh (2008), Gabaix and Laibson (2005), Peng (2005), and Iliev and Welch (2010)) has
identified the importance of such opportunity costs of allocating attention to any given
domain. Proposition 10 shows that owing to the tradeoff between making well-informed
decisions based upon earnings information versus in other domains (as reflected in the
cost of attention function), a lack of attention to earnings can persist in the long run.
5 Do Investors Fully Compensate for Limited At-

tention?
A key assumption of our model is that individuals with limited attention trade based
upon their beliefs. As a result, limited attention affects the equilibrium price. Casual
observation suggests that investors often do make trades based on beliefs that do not
fully reflect publicly available information. However, an individual who understands
that he is neglecting a relevant public information item in forming his beliefs is free to
retreat into autarky, thereby deferring completely to the market price. Such withdrawal
into passivity could make sense if an individual believes that the market value is highly
accurate. However, in reality, inattentive investors are not necessarily sophisticated
enough to realize that they should be passive.
For both psychological and economic reasons, we do not expect that individuals
with limited attention would or even should always withdraw into passivity. Evidence
from both psychology and market behavior indicates that individuals often fail to adjust
appropriately for the fact that they have left some information unprocessed.
Such double neglect makes sense when processing power is limited. Attention and
mental processing are needed to adjust for the fact that information items that are not
being attended to in detail may affect the reliability of the judgments being formed. An
extra cognitive step is required, after forming a valuation of the firm, to recognize that
the market may be using useful information that was not a part of the information used
by the individual. Indeed, the cognitive cost of calculating how to adjust for the fact
that a relevant information item has been neglected can be as great or greater than the
31
cognitive cost of simply processing the information item. So in many cases, ignoring the
information item and failing to adjust for the fact that the item has been neglected go
hand in hand.
Evidence that people both neglect signals and do not adjust for the fact that they
are neglecting them is provided by studies that show that the form of presentation of
information affects individuals judgments and decisions (see, e.g., Slovic (1972), Payne,
Bettman, and Johnson (1993), and the review of Libby, Bloomfield, and Nelson (2002)).
Experimental studies have found that different presentations of equivalent information
about a firm affect the valuations and trades of investors and experienced financial
analysts.18 In principle, if an investor understood that owing to limited attention certain
formats were hard to process, the investor could self-debias by, for example, mentally
rearranging the format of presentation. However, such rearrangement itself requires
mental processing.
Furthermore, experimental research has found that the presentation of one-sided
arguments and evidence to subjects (call ‘jurors’) asked to judge a legal dispute were
biased in favor of the side they heard (Brenner, Koehler, and Tversky (1996)). According
to the authors, “The results indicate that people do not compensate sufficiently for
missing information even when it is painfully obvious that the information available to
them is incomplete.
Why don’t individuals fully adjust beliefs about their own precisions to take into
account the set of cues they are neglecting? Because thinking about how the neglect
of a cue creates bias or reduces precision requires an extra layer of cognitive process-
ing. Just as cognitive resource constraints cause a cue to be neglected, they often also
cause the individual to fail to take the extra step of assessing the consequences of that
neglect. Even if on average the individual is correct, in those cases in which the cues
he neglects are especially important, he will tend to overestimate the precision of his
beliefs; and when the cues he neglects are minor, he will underestimate his precision.
Such miscalibration encourages individuals who have neglected important cues to trade
18
Presentation effects have been found in the context of recognition versus disclosure of pension
liabilities (Harper, Mister, and Strawser (1987)), classification of the same hybrid financial instrument
as debt, equity or mezzanine financing in the balance sheet (Hopkins (1996)), the previewing of negative
earnings news with an adverse qualitative preannouncement (Libby and Tan (1999)), the use of the
purchase method of accounting for business combinations (Hopkins, Houston, and Peters (2000)) and
the inclusion of other comprehensive income items in the income statement rather than in the statement
of changes in shareholders’ equity (Hirst and Hopkins (1998)); Dietrich et al. (2001) find that disclosure
of information that is redundant with financial statements affects prices in an experimental setting, and
that equivalent disclosures with different formats affect prices differently.
32
and influence price.
Our model shares with informal behavioral explanations for anomalies the assump-
tion that investors who neglect public signals such as current-period earnings are im-
portant for price setting. For example, the seasonal-random-walk explanation for post-
earnings-announcement drift of Bernard and Thomas (1989) assumes that investors who
focus on year-ago earnings neglect the latest earnings surprise. There are a number of
reasons why an individual who neglects important information such as the implications
of current-period earnings would still trade actively. An investor who has a perspective
about the firm’s long-term business strategy and competitive environment may trade
based upon his valuation target without updating his forecasts of future earnings in
response to every earnings report.19
There is evidence that some individual investors are net providers of liquidity to the
market, absorbing the demand by institutions for trading immediacy.20 If institutions
(perhaps for agency reasons) sometimes make uninformed trades, a simple contrarian
trading strategy will in general be profitable. Indeed, the evidence indicates that con-
trarian trading allows U.S. individual investors to earn positive excess returns in the
month after their trades (Kaniel, Saar, and Titman (2008)).
A naive contrarian strategy of trading in opposition to market price movements with-
out regard to their source will on average induce trading against earnings announce-
ments.21 If institutions are willing to pay for trading immediacy, a naive contrarian
strategy can be profitable on average. However, such a strategy will on average be un-
profitable after an earnings announcement, because the price move is being triggered by
actual news rather than by another investor’s demand for trading immediacy. Thus, lim-
19
The tendency to hold a fixed valuation in mind may be reinforced by the practice of analysts of
announcing ‘target’ prices below which the stock is recommended as a good buy. An investor who
follows such a recommendation without adjusting the target to reflect further news about earnings
fits the analysis. Plausible-sounding media sound bites can reinforce the tendency of investors with
limited attention to trade as contrarians. There is much editorializing in the business media against
‘obsession’ with the short-term, and in favor of ‘buying on the dips.’ An investor can excuse a failure
to update valuations frequently as ‘focusing on the long-term’ rather than ‘myopically’ focusing on
quarterly earnings. A naive application of sound bites with high availability in the mass media is itself
a possible consequence of limited attention.
20
For example, in the U.S. there is evidence that individuals as a group trade as contrarians to the
previous week’s stock return (Kaniel, Saar, and Titman (2008)). A similar finding has been documented
among Finnish and Korean individual traders (Grinblatt and Keloharju (2000), Choe, Kho, and Stulz
(1999)).
21
For example, a limit order is one means by which an investor can implement a naive contrarian
strategy. Since limit orders are triggered by moves in market price, placing such an order allows the
investor to trade against market price moves, providing liquidity to the market, without continuously
monitoring prices.
33
ited attention on the part of investors traders who are following a generally-reasonable
contrarian strategy can induce unprofitable contrarian trading in response to earnings
announcements.
A further reason why an investor with limited attention would actively trade as a
contrarian to earnings news is that analysts on average do not fully adjust their earnings
forecasts in response to earnings announcements.22 Owing to limited attention, some
investors may rely on analyst earnings forecasts without performing the additional cog-
nitive processing needed to adjust for this state-contingent bias in analyst forecasts. The
beliefs of such investors will therefore underreact to earnings surprises, just as analyst
forecasts do.23 Consistent with this interpretation, there is evidence that firms that are
followed by analysts whose forecasts are more responsive to earnings announcements
have less post-earnings-announcement drift (Zhang (2008)).
Furthermore, the intuition from standard securities market models suggests that
even an investor who is aware of his own limited attention and rationally adjusts for
it should trade based upon his expectations rather than withdrawing into autarky. In
Section 4, we show that investors who ignore earnings can profit owing to the presence of
noise/liquidity traders. Standard models of information and securities markets such as
Grossman and Stiglitz (1976) provide the insight that, owing to liquidity or noise trad-
ing, prices aggregate information imperfectly, and in equilibrium contain noise-induced
mispricing. As a result, even an informationally disadvantaged individual should trade
based upon his beliefs rather than deferring completely to market price.24 In a setting
with limited attention, an isomorphic situation arises in which a set of investors has
a kind of pseudo- private information. Attending to a public signal that some other
investors neglect is analogous to observing a private signal. Neglecting a signal that
other individuals attend to is akin to being uninformed about that signal. However, in
standard models of information and securities markets, individuals with informational
22
This phenomenon is well-documented (e.g., Abarbanell and Bernard (1992) and Zhang (2008)), and
has theoretical motivation. Models of analyst reputation predict this phenomenon because an analyst
who has a prior forecast tends to hold too strongly to that forecast in response to a public signal in order
to maintain a reputation for having highly accurate private information. A general model of analyst
neglect of relevant information is provided by Trueman (1994).
23
A similar argument applies to investors who neglect accruals. Such investors may form beliefs based
upon analysts’ earnings forecasts, which underutilize the information contained in accruals (Teoh and
Wong (2002)).
24
In forming his beliefs, an investor combines any private signals he may possess (none, for an unin-
formed trader), together with the information implicit in market price. The weight on his own signals
and prior is positive because market price is noisy. The noise in market price derives both from liquidity
shocks and, if there are multiple private signals, from confounding between signals.
34
advantages and disadvantages all trade based upon their beliefs, and in so doing profit
at the expense of liquidity traders.
Indeed, securities market models that are ostensibly about private information are
often interpreted in ways that are more consistent with different individuals processing
publicly available information differently. Applied discussions based on these models do
not usually interpret private information as being limited to inside information (e.g.,
information obtained by rummaging through a firm’s trash, eavesdropping on cell phone
conversations, or persuading employees to leak information). Instead, investors become
privately informed through some unspecified process—presumably involving analysis of
publicly available signals such as financial statements and media reports. This broader
interpretation of Grossman and Stiglitz (1976) implicitly involves trade based upon
processing versus neglecting publicly available information.
In order to develop our implications in the simplest and most parsimonious possible
way, we assume that investors with limited attention do not incorporate market price
into their beliefs. In reality investors with limited attention probably do sometimes
fail to process the information about future earnings implicit in market price. However,
qualitatively identical results to those in our model could be derived in a setting in which
investors with limited attention draw rational inferences from market price, and in which
liquidity trading makes prices noisy. In such a setting liquidity trading causes investors
rationally to place less weight upon market price in updating beliefs. Thus, such a
setting would endogenize the conclusion that individuals with limited attention trade
actively based upon their beliefs instead of deferring completely to market price. Such
an analysis would have more algebraic details, but conceptually would be essentially
equivalent to our model.
There is other evidence that limited attention affects capital markets; indeed, Daniel,
Hirshleifer, and Teoh (2002) argue that limited attention may underlie a wide range of
anomalous patterns in securities market trading and prices.25 Many short-horizon event
25
In an experimental setting, Gillette et al. (1999) document investor misreactions to public infor-
mation arrival. Perhaps the most striking indication of limited attention in public markets is that
stock prices react to news that is already public information (Huberman and Regev (2001), and Ho
and Michaely (1988)), and even to confusions in ticker symbols between stocks (Rashes (2001)). More
broadly, Hong, Torous, and Valkanov (2007) report evidence that industry stock returns lead aggregate
market returns, potentially consistent with gradual diffusion of information about fundamentals across
markets. Hou and Moskowitz (2005) provide a measure of investor neglect of a stock, the lag in the
relation between the return on the overall market and the stock’s return. They find that stocks with
long delay (which can be viewed as low-attention stocks) have stronger post-earnings announcement
drift.
35
studies confirm that stock markets react immediately to relevant news. Long-horizon
event studies provide evidence suggesting that there is underreaction to various kinds of
public news events (see, e.g., the review of Hirshleifer (2001)). However, there has been
a great deal of debate as to the appropriate methodology for testing market efficiency
using long-run abnormal returns. There is also evidence suggesting that investors’ and
analysts’ assessments are influenced by the format and salience with which public signals
are presented (see the discussion in Section 5, and Schrand and Walther (2000)).
Although this paper uses a pure limited attention approach, psychological studies
also indicate that individuals tend to be overconfident about the precision of their be-
liefs. Overconfidence can reinforce the tendency for individuals who fail to process an
information item to also fail to adjust for this neglect. An individual who overconfidently
thinks that he has already taken into account the most important information would
underestimate the urgency of working hard to adjust for his neglect of other relevant
signals.
It can be argued that arbitrageurs such as hedge funds will eliminate almost all of
the mispricing created by limited attention. However, a literature in behavioral finance
and accounting has argued that arbitrage is limited by risk-bearing capacity and market
frictions; see, e.g., Shleifer and Vishny (1997), Hirshleifer (2001), and Lee (2001). We
would argue that an important constraint on arbitrage is the aggregate attentional ca-
pacity in the market (see, e.g., Peng (2005)). Attention can be leveraged by such means
as computers and financial intermediation, but even large institutions face tradeoffs in
allocating their attentional resources.
6 Conclusion
This paper offers a model of stock market misreactions to earnings-related information
based upon limited investor attention. It is motivated by evidence of stock return
predictability based upon earnings surprises and the level of earnings, accruals, and cash
flows, including the striking fact that there are both under-reactions and over-reactions
to different kinds of earnings-related information. To understand the sources of these
return anomalies, it is important to be parsimonious in assumptions about psychological
biases, to avoid overfitting the data. We therefore explore the consequences of a single
psychological constraint, limited attention, which we use to derive a rich set of untested
empirical implications.
We assume that some investors neglect information contained in the latest earnings
36
surprise, and that some investors further neglect the information contained in accruals
and cash flow. In equilibrium, there is underreaction to earnings surprises, because some
investors do not attend to the newly-arriving earnings news. Cash flows positively and
accruals negatively predict future stock returns, because some investors do not impound
the information contained in the division of earnings between cash flow and accruals.
Since cash flow is more favorable than accruals as a forecaster of future earnings, high
accruals are associated with overvaluation, and high cash flow with undervaluation.
The model does not in general predict that either of the cash flow or the accruals
effects on future returns will completely subsume the other. We also find that the
level of earnings predicts future stock returns when investors are inattentive toward
earnings news. This predictability arises when inattentive investors stick to their beliefs
based on the prior expectation of short-term earnings (e.g., analyst forecasts), instead
of updating and improving the precision of their forecasts based on the realization of
short-term earnings. Finally, we show that when processing information is costly, in
equilibrium some investors may actively trade yet choose not to attend to some public
information. This may explain why inattentive investors can form incorrect expectations
that influence price in the long run.
The model provides a rich set of new empirical implications. When some investors
neglect earnings, and others attend to earnings but neglect accruals, price underreacts
to earnings, but overreacts to accruals relative to cash flow. In consequence, there is
stronger underreaction to cash flow than to earnings. Furthermore, if enough attention
is paid to earnings, there is overreaction to accruals. A lower quality of accruals as
an earnings forecaster (induced, for example, by earnings management) strengthens
the accrual anomaly, but has an ambiguous effect on the cash flow anomaly. The more
variable are accruals relative to cash flows, the stronger is the cash flow anomaly relative
to the accrual anomaly. The ratio of the cash flow effect to the accruals effect is stronger
than the ratio of accruals variance to cash flow variance. Higher correlation between cash
flows and accruals tends to weaken the accrual anomaly. In addition, owing to neglect of
earnings news, the profit anomaly becomes stronger when there is less attention toward
earnings news and expected earnings (such as analyst forecasts of short-term earnings)
becomes a less accurate predictor of future earnings compared to actual short-term
earnings.
Another appealing set of empirical implications is provided by events that shift atten-
tion to or away from the firm. For example, a greater number of distracting events such
as earnings announcements by other firms is predicted to intensify both post-earnings
37
announcement drift and the cash flow anomaly. The implications of shifts of attention
toward or away from a firm for the accrual anomaly is less clear-cut. Neglect of earn-
ings components (cash flow versus accruals) strengthens the accrual anomaly, whereas
neglect of the earnings innovation itself weakens the accrual anomaly.
Our reconciliation of the drift and accruals effects is potentially consistent with some
of the informal intuitions about investor ‘naiveté’ offered in the empirical literature. It
is of course reassuring that such insights can be captured within an equilibrium model.
However, formal analysis does not entirely confirm casual intuition. For example, in a
classic paper, Sloan (1996) argues that the accrual anomaly will be present if accruals
are a weaker forecaster than cash flows of future earnings, whereas we show that this is
a necessary but not sufficient condition. More importantly, our main contribution is to
develop a unified framework based upon a well-established psychological constraint that
offers a rich set of untested empirical predictions about earnings, cash flow, accruals,
and stock market prices.
Our model is, of course, very stylized. A natural further direction of extension is
to consider finer components of accruals and cash flow. An analysis similar to that
developed here would show that overvaluation will be increasing with the level of an
earnings component if that component is a relatively strong incremental forecaster of
future earnings, and will be decreasing with that component if it is a weak incremental
forecaster of future earnings. Thus, our approach is consistent with the evidence on
earnings components and returns of Richardson et al. (2005) and Dechow and Ge (2006).
Furthermore, it would be simple to apply such a generalized analysis to normal versus
abnormal levels of accruals (where ‘normal’ is evaluated relative to an industry- or other
benchmark), in order to develop predictions about how managerial discretion affects
misvaluation as studied empirically in Teoh, Welch and Wong (1998b, 1998a) and others.
Also, by adding another time period, the relation between the forecasting power of
variables for short-term versus long-term earnings with misvaluation could be considered.
The framework can be applied to investment-related anomalies as well. These and other
possible extensions suggest that the modeling approach offered here potentially has a
wide range of applicability to circumstances in which market misvaluation derives from
investor neglect of publicly availably financial information.
38
Appendix
Proof of Proposition 6: By (35),
C 2 − Va Vc
boa = f e (β1 − β2 )
Va (Va + Vc + 2C)
ρ2 − 1
= f e (β1 − β2 ) q . (54)
Va Va
Vc
+ 1 + 2ρ Vc
Similarly,
−C 2 + Va Vc
boc = f e (β1 − β2 )
Vc (Va + Vc + 2C)
1 − ρ2
= f e (β1 − β2 ) q . (55)
Vc Vc
Va
+ 1 + 2ρ Va
Differentiating boa in (54) with respect to ρ:

q q
2ρ( VVac + 1 + 2ρ VVac ) − 2(ρ2 − 1) VVac
∂(boa )/∂ρ = f e (β1 − β2 ) q 2 . (56)
Va Va
Vc
+ 1 + 2ρ Vc
Since β1 > β2 , It follows that ∂(boa )/∂ρ is positive if and only if the term in the numerator
is positive, i.e.,
r " r r !# r r ! r !
Va 2 Va Vc Va Va Vc
2 1+ρ +ρ + = 2 ρ+ ρ+
Vc Vc Va Vc Vc Va
2(C + Va )(C + Vc )
= > 0. (57)
Vc
√
The second equality follows from the fact that ρ = C/ Va Vc , and the inequality
holds under our assumptions in (16) that both accruals and cash flow are positively
correlated with contemporaneous earnings.
Differentiating boc in (55) with respect to ρ, similar reasoning shows that
q q q
Vc Va
Va
ρ + Vc ρ + VVac
o e
∂(bc )/∂ρ = −2f (β1 − β2 ) q 2 < 0.
Vc Vc
Va
+ 1 + 2ρ Va
39
k
Proof of Proposition 9: It follows from equation (25) that
E[S2 |c1 , a1 ] = E[S2 ] + (1 + β1 )(c1 − c̄1 ) + (1 + β2 )(a1 − ā1 ). (58)
Substituting E[S2 |e1 ] and E[S2 |c1 , a1 ] in (10) with (18) and (58), date 1 stock price can
be written as
S1 = E[S2 ] + [f a (1 + β1 ) + f e (1 + βe2 e1 )](c1 − c̄1 )

+ [f a (1 + β2 ) + f e (1 + βe2 e1 )](a1 − ā1 ) − A var(S2 )x0 . (59)
From (59) and (25), the price change S2 − S1 is
S2 − S1 = [(f u + f e )(1 + β1 ) − f e (1 + βe2 e1 )](c1 − c̄1 )

+ [(f u + f e )(1 + β2 ) − f e (1 + βe2 e1 )](a1 − ā1 ) + δ + A var(S2 )x0 . (60)
Since E[S1 ] = E[S2 ], the expected profit of an inattentive investor is

E[S2 ] − S1 cov(−S1 , S2 − S1 )
E (S2 − S1 ) = . (61)
A var(S2 ) A var(S2 )
Using S1 and S2 − S1 given by (59) and (60) and simplifying some terms using the
definition of βe2 e1 in (15), the covariance term can be written as follows.
cov(−S1 , S2 − S1 ) = −f u f e (1 + βe2 e1 )2 (Va + Vc + 2C) − f u f a var(E[S2 |c1 , a1 ])

f a f e (β1 − β2 )2 (Vc Va − C 2 )
− + A2 (var(S2 ))2 Vx . (62)
(Va + Vc + 2C)
Since Va +Vc +2C = Ve > 0 and Vc Va ≥ C 2 , uninformed investors earn negative expected
profits when there is no noise trading, i.e., Vx = 0. However, the expected profit of an
uninformed investor is positive when
f u f e (1 + βe2 e1 )2 (Ve )2 + f u f a var(E[S2 |c1 , a1 ])Ve + f a f e (β1 − β2 )2 (Vc Va − C 2 )

Vx > .
A2 (var(S2 ))2 Ve
(63)
The expected trading profit of an investor attending only to earnings is

E[S2 |e1 ] − S1 cov(E[S2 |e1 ] − S1 , S2 − S1 )
E (S2 − S1 ) = . (64)
A var(S2 ) A var(S2 )
40
The equality follows from the fact that E[E[S2 |e1 ]] = E[S1 ] = E[S2 ]. From (59) and
(18),
E[S2 |e1 ] − S1 = [(f u + f a )(1 + βe2 e1 ) − f a (1 + β1 )](c1 − c̄1 )

+ [(f u + f a )(1 + βe2 e1 ) − f a (1 + β2 )](a1 − ā1 ) + A var(S2 )x0 . (65)
From (60) and (65),
f a (f u + f e )(β1 − β2 )2 (Vc Va − C 2 )
cov(E[S2 |e1 ] − S1 , S2 − S1 ) = (f u )2 (1 + βe2 e1 )2 Ve −
Ve
+ A2 (var(S2 ))2 Vx . (66)
Investors attending only to earnings can earn positive expected profits owing to unin-
formed investors (the first term) and noise trading (the last term). The expected profit
of an investor who attends to earnings is positive if and only if
−(f u )2 (1 + βe2 e1 )2 (Ve )2 + f a (f u + f e )(β1 − β2 )2 (Vc Va − C 2 )

Vx > . (67)
A2 (var(S2 ))2 Ve
Thus, investors attending only to earnings can earn positive expected profits if there is
a large amount of noise trading (Vx satisfying the above inequality).
41
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November 17, 2010

Limited Investor Attention

We provide a model in which a single psychological constraint, limited investor atten-

We provide a model in which a single psychological constraint, limited investor atten-

2 The Economic Setting

Thus, an individual in attention group i solves

As a preliminary building block, we verify in our setting a standard finding about

Substituting for xi from (4), and solving for S1 gives

weight λi / i λi on each information set. By (7), ceteris paribus λi is increasing in f i .

3 The Accrual Anomaly and Post-Earnings Announce-

3.1 The Relation of Earnings, Accruals and Cash Flow over

S1 = f u E[S2 ] + f e E[S2 |e1 ] + f a E[S2 |a1 , c1 ] − A var(S2 )x0 . (10)

For tractability, we assume multivariate normality of the stochastic variables. As a

where cov(δ, c1 ) = cov(δ, a1 ) = 0. Consistent with past empirical evidence (Sloan

ē2 = β0 + β1 c̄1 + β2 ā1 , (12)

so the deviation of earnings from its unconditional mean is

e2 − ē2 = β1 (c1 − c̄1 ) + β2 (a1 − ā1 ) + δ. (13)

3.2 Post-Earnings Announcement Drift

E[S2 |e1 ] = e1 + E[e2 |e1 ]

E[S2 − S1 |e1 ] = E[S2 |e1 ] − E[S1 |e1 ]. (19)

An iterated conditional expectation where one conditioning information set is coarser

E[E[S2 |a1 , c1 ]|e1 ] = E[S2 |e1 ]. (20)

E[S2 − S1 |e1 ] = E[S2 |e1 ] − {f u E[S2 ] + (f e + f a )E[S2 |e1 ]}

E[S1 |e1 ] − E[S1 ] = (1 − f u )(E[S2 |e1 ] − E[S2 ])

Proposition 1 1. If fraction f u > 0 of investors neglect the information in current-

3.3 The Accruals and Cash Flow Anomalies

E[E[S2 |a1 , c1 ]|a1 ] = E[S2 |a1 ], (23)

From (13) and (14),

S2 = E[S2 ] + (1 + β1 )(c1 − c̄1 ) + (1 + β2 )(a1 − ā1 ) + δ. (25)

By (18) and multivariate normality,

The second equality follows from equation (15).

(1 + β1 )Vc + (1 + β2 )C > (1 + β2 )(Vc + C) > 0, (30)

Proposition 2 Suppose that at date 1 fraction f u of investors do not attend to any of

3.4 The Relative Strength of Accruals- and Cash Flow-Based

3.4.1 Effects of Variations in Attention on the Accruals- and Cash Flow-

3. A shift in investor probability mass from attending only to earnings to neglecting

(Vc + C)[β1 (Vc + C) + β2 (Va + C) + (Va + Vc + 2C)]

3.4.2 Effects of Earnings Quality on Accrual and Cash Flow Anomalies

Proposition 4 Consider an increase in accruals quality that increases β2 , i.e., makes

1. Weakens the accrual anomaly; and

3.4.3 Effects of Accruals and Cash Flow Volatilities and Correlations on

2. If some investors neglect earnings, so that f u > 0, and if there is an accrual

Intuitively, consider an investor who focuses on current-period earnings in forecasting

E[S2 |e1 , f0 ] = E[S2 |e1 ] = E[S2 ] + (1 + βe )(e1 − ē1 )

and the change in stock price is

S2 − S1 = λ(1 + βe )(e1 − ē1 ) − λ(1 + βf )(f0 − f¯0 ) + A var(S2 )x0 + δe . (46)

Proposition 8 1. If fraction λ > 0 of investors ignore the information in current-

4 Trading Profits and Equilibrium Inattention

4.1 Expected Trading Profits

4.2 Expected Utility and Characterization of Equilibrium

5 Do Investors Fully Compensate for Limited At-

Differentiating boa in (54) with respect to ρ:

Proof of Proposition 9: It follows from equation (25) that

E[S2 |c1 , a1 ] = E[S2 ] + (1 + β1 )(c1 − c̄1 ) + (1 + β2 )(a1 − ā1 ). (58)

S1 = E[S2 ] + [f a (1 + β1 ) + f e (1 + βe2 e1 )](c1 − c̄1 )

From (59) and (25), the price change S2 − S1 is

S2 − S1 = [(f u + f e )(1 + β1 ) − f e (1 + βe2 e1 )](c1 − c̄1 )

Since E[S1 ] = E[S2 ], the expected profit of an inattentive investor is