The literature on accounting anomalies and fundamental analysis provides important insights into the behavior of stock prices and the relation between accounting numbers and firm value. My review discusses five key topics from this literature: (1) discriminating between risk and mispricing explanations for return anomalies; (2) estimating the implied cost of capital; (3) inferring investors’ perceptions of the earnings process; (4) understanding the importance of trading costs and firm size; and (5) improving the construction of characteristic-based trading strategies. My discussion highlights important challenges facing the literature and offers suggestions for improving empirical tests.

Higher accruals are associated with lower subsequent earnings. We show this phenomenon can be explained by the way sales, profits, and working capital respond to changes in a firm's product markets. Empirically, high accruals predict high subsequent sales growth but a long-lasting drop in both profits and profitability. Accruals also predict an increase in future competition, suggesting that accruals are correlated with abnormally high—and, in equilibrium, transitory—true profitability that attracts new entrants to the industry. Overall, the predictive power of accruals is better explained by product-market effects than by measurement error in accruals or diminishing returns from investment.