Accruals, growth, accounting distortions and stock returns: The case of FRS3 in the UK

• We examine the accrual anomaly in the UK, conditional on the introduction of FRS3.
• Accruals due to accounting distortions do not predict future returns following FRS3.
• Accruals due to growth continue to predict future returns in the post-FRS3 period.
• The accrual anomaly is still present in the UK, even after the adoption of FRS3.

We investigate the accrual anomaly, conditional on the mandatory adoption of Financial Reporting Standard No. 3: Reporting Financial Performance (FRS3) by UK firms. We show that return predictability associated with accruals attributable to accounting distortions is largely attenuated and not statistically significant at conventional levels, after the introduction of FRS3. In contrary, the predictive ability of accruals attributable to growth for future returns is not substantially affected and remains strong in magnitude from the pre-FRS3 to the post-FRS3 periods. As a consequence, total accruals continue to predict returns following FRS3. Overall, our findings are broadly consistent with increased accounting disclosure and investor protection eliminating inefficiencies and promoting accurate share prices in the capital market.