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The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors


Ilia D. Dichev


Emory University - Goizueta Business School

Patricia M. Dechow


University of California, Berkeley - Haas School of Business

July 2001


Abstract:     
This paper suggests a new measure of one aspect of the quality of accruals and earnings. The major benefit of accruals is to reduce timing and mismatching problems in the underlying cash flows. However, accruals accomplish this benefit at the cost of making assumptions and estimates about future cash flows, which implies that accruals include errors of estimation or noise. Since estimation noise reduces the beneficial role of accruals, this study suggests that the quality of accruals and earnings is decreasing in the magnitude of estimation noise in accruals. More specifically, we develop a simple model of working capital accruals where accruals correct the timing problems in cash flows at the cost of including errors in estimation. Based on the model, we derive an empirical measure of accrual quality as the residual from firm-specific regressions of changes in working capital on past, present, and future operating cash flow realizations. The study concludes with two empirical applications that illustrate the usefulness of our measure of accrual quality. First, we explore the relation of accrual quality to economic fundamentals. We find that accrual quality is negatively related to the magnitude of total accruals, length of the operating cycle, and the standard deviation of sales, cash flows, and earnings, while it is positively related to firm size. Second, we show a strong positive relation between accrual quality and earnings persistence.

Number of Pages in PDF File: 44

Keywords: Quality; Accruals; Earnings; Persistence; Estimation; Errors

JEL Classification: M41

working papers series


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Date posted: July 20, 2001  

Suggested Citation

Dichev, Ilia D. and Dechow, Patricia M., The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors (July 2001). Available at SSRN: http://ssrn.com/abstract=277231 or http://dx.doi.org/10.2139/ssrn.277231

Contact Information

Ilia D. Dichev (Contact Author)
Emory University - Goizueta Business School ( email )
1300 Clifton Road
Atlanta, GA 30322-2722
United States
Patricia M. Dechow
University of California, Berkeley - Haas School of Business ( email )
545 Student Services Building
Berkeley, CA 94720
United States
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