Earnings Management, IFRS Adoption, and the Correlation between Accruals and Cash Flows: Evidence from Korea

Abstract

A fundamental role of accrual accounting is to smooth out transitory fluctuations in operating cash flows, suggesting a contemporaneous negative correlation between accruals and cash flows. While prior research (e.g., Bushman et al. 2016) documents a decline in the negative accruals-cash flow correlation over time and examines several factors (e.g., cash flow shocks, non-timing-related accruals, poor matching between revenues and expenses, and intangible intensity) that can explain the temporal pattern, we identify earnings management and IFRS adoption as additional relevant factors. Using a sample of Korean listed firms for the period from 1983 to 2017, we provide the following results. First, we find that the negative correlation between accruals and cash flows has declined over time in Korea. This decline is significantly associated with increases in non-timing-related accruals and poor matching between revenues and expenses. Second, and more importantly, we find that the negative accrual-cash flow correlation strengthens with an increase in the absolute and positive values of discretionary accruals. This suggests that, on average, Korean firms manage accruals upward in response to poor cash flow outcomes. Third, we find that the decrease in accrual management over the three years following IFRS adoption (as reported in prior research) can incrementally explain the decline in the negative accrual-cash flow relation. Overall, this study enhances our understanding of temporal changes in the contemporaneous negative correlation between accruals and cash flows by identifying earnings management and IFRS adoption as additional relevant factors.