Discussion of “Accruals, Cash Flows and Equity Values”

Abstract

Accruals are at the very heart of accounting and are the subject of constant debate among investment professionals. Some academics and practitioners advocate ‘backing out’ accruals in evaluating corporate performance, encouraging investors to focus on cash flows rather than earnings. Yet most investors still clearly embrace the earnings number with its accruals intact, as evidenced by Wall Street’s continued fixation on quarterly EPS results. The paper by Beaver, Barth, Hand and Landsman (1999, BBHL hereafter) therefore clearly focuses on an important and contentious topic. The major conclusion reached by BBHL is that investors should condition on both the cash flow and accrual components of earnings when forecasting fundamentals and determining firm value. Using a valuation framework developed in Ohlson (1999), the authors also show that stock prices act as if investors at least partially incorporate information in the accrual and cash flows components of earnings. My main concern with the paper of BBHL is that its incremental contribution does not become clear. Relative to previous research, BBHL’s use of the Ohlson valuation framework enables them to more explicitly articulate the links between current cash flows and accruals, future fundamentals and firm value. However, at the end of the day, our understanding of the properties of cash flows and accruals and the extent to which these properties are reflected in stock prices is not enhanced much beyond previous research. I expand on my concerns below, and finish with a call for more research in this area, along with some general suggestions concerning the focus of such research.