The Accruals-Cash Flow Relation and the Evaluation of Accrual Accounting

Abstract

Considerable research has evaluated the role of accruals in determining earnings, with an accrual-cash flow relation at the center of the investigation. However, much of the research is based on misconceptions. First, accruals are identified as the items that reconcile earnings to cash flows in the cash flow statement. But these are not the accruals applied in determining earnings; rather, they are changes in balance-sheet items, the relevant accruals reduced by the cash flow. Second, accruals are characterized as an adjustment to cash flows, to reduce volatility of cash flows. Consequently, a negative correlation between accruals and cash flow—the accruals-cash flow relation—has been taken as the criterion for quality accruals. However, the accruals that determine earnings are independent of those cash flows, not a reaction to them. The two misconceptions combine to introduce confusion. With the accruals measure employed in the existing research, the comparison to cash flows is spurious, for accruals (so-called) include cash flows. The paper presents a corrective analysis and conducts empirical tests that confirms that analysis and reexamines hypotheses tested in previous research.