ABSTRACT An important stream of literature spanning decades has drawn conflicting inferences regarding whether accrual accounting serves the purposes prescribed by the Conceptual Framework by conveying information about future cash flows. We help reconcile this literature by demonstrating that tests of the relative abilities of current earnings and cash flows to explain future cash flows require careful interpretation. Tests of relative predictive ability can lead to the inference that accrual accounting does not achieve the aims of the Conceptual Framework precisely because accruals do covary with future cash flows. This phenomenon arises from the statistical regularity that cash flows and accruals covary unconditionally with future cash flows in opposite directions. We show that this opposing covariances phenomenon does not affect the inferences drawn in tests of earnings’ (1) incremental predictive ability or (2) relative ability to explain contemporaneous returns. After accounting for this phenomenon, the conclusion is clear and consistent: accrual accounting does indeed contribute to the purposes laid out in the Conceptual Framework. We suggest that future research studying how accrual accounting affects cash flow prediction should exercise care in designing tests and forming conclusions.
Jaggi et al. (Tue,) studied this question.