Evidence on the Relative Usefulness of Accruals and Cash Flows: The Case of Depreciation

Abstract:     
Investment professionals often suggest that current accounting earnings can be improved upon as an indicator of share values by substituting capital expenditures for reported depreciation. To provide evidence on the effect of this substitution, we compare the ability of earnings measures based on accrual- and cash-basis accounting for property and equipment to explain the cross-sectional distribution of stock prices for a large sample of manufacturing firms. We find that earnings based on expensing current capital expenditures explains a much smaller fraction of the variation in share prices than earnings based on reported depreciation. This result holds even for stable firms with a relatively smooth year-to-year pattern of capital expenditures.

Number of Pages in PDF File: 37

JEL Classification: M41, G12

working papers series