Predicting Accruals Based on Cash-Flow Properties

Our goal is to understand the extent to which cash-flow properties explain accruals. Using the Dechow et al. (1998) model, we derive a negative relation between accruals and cash-flow changes and show that the strength of the relation is linked to negative serial correlation in cash-flow changes. Dechow et al. also suggest that the strength of the relation between accruals and revenue changes relates to operating-cycle length. Prior accrual models have not incorporated these theoretical relations. We show that incorporating cash-flow changes, serial correlation in cash-flow changes, and operating-cycle length increases explanatory power of all accrual models considered (i.e., Jones; Ball and Shivakumar; McNichols; and Jeter and Shivakumar). We find that incorporating these variables in accrual models also improves specification and power, aids detection of earnings management in AAER firms, and produces a nondiscretionary-accrual estimate that better predicts future cash flows and earnings. These results suggest the importance of considering the economic role of accruals when predicting accruals