THE INCREMENTAL INFORMATION CONTENT OF ACCRUAL VERSUS CASH FLOWS

Abstract

Current financial reporting practices have traditionally emphasized measures of accrual earnings. On the other hand, the link between future cash flows and firm value is well accepted by financial economists, and recently there has been increased interest in measures of cash flow. This paper provides evidence on the role of accrual (i.e., earnings and working capital from operations [WCFO]) and cash flow measures in an explanatory model of security prices. This issue is first examined by testing for an association between unexpected security returns and unexpected cash flows, after controlling for the relation between unexpected returns and unexpected earnings. We also examine the obverse issue by testing for an association between unexpected security returns and unexpected earnings, after controlling for the relation between unexpected returns and unexpected cash flows. We test these relations in two contexts: in results pooled over the entire ten-year time period studied and in year-byyear cross-sectional regressions. Results for our complete sample are generally consistent with: (1) cash flow data having incremental information content relative to that contained in earnings; (2) cash flow data having incremental information content in addition to that contained in earnings and WCFO; and (3) accrual data (i.e., earnings and WCFO) jointly and separately having incremental information content in addition to that contained in cash flow data. However, the results do not support the hypothesis that WCFO has incremental information content relative to that contained in earnings. T HE onset of higher interest rates and more frequent business failures in the 1970s was accompanied by increased concern over the usefulness of accrual accounting numbers relative to cash flow data. Recently, the Financial Accounting Standards Board (FASB) [1986] has addressed this concern by proposing that the Statement of Changes in Financial Position (SCFP) be replaced by a Cash Flow Statement. The increased emphasis on the more primitive concept of cash flows is a departure from the current institutional environment in which accrual accounting preThe authors wish to thank Vic Bernard, Andrew Christie, George Foster, Lauren Kelly, Dana Klemme, Paul Malatesta, Eric Noreen, Pete Wilson, two anonymous reviewers, and participants in the 1981 and 1984 Robert M. Bowen is Associate Professor of Accounting, University of Washington, David Burgstahler is Associate Professor of Accounting, University of Washington, and Lane A. Daley is AssociateProfessorofAccounting, University of Minnesota. Manuscript received July 1986. Revisions received March 1987 and May 1987. Accepted May 1987.

Keywords

Related Publications