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

44 Pages Posted: 20 Jul 2001  

Ilia D. Dichev

Emory University - Department of Accounting

Patricia M. Dechow

University of Southern California - Leventhal School of Accounting; University of California, Berkeley - Accounting Group

Date Written: 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.

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

JEL Classification: M41

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: https://ssrn.com/abstract=277231 or http://dx.doi.org/10.2139/ssrn.277231

Ilia D. Dichev (Contact Author)

Emory University - Department of Accounting ( email )

1300 Clifton Road
Atlanta, GA 30322-2722
United States

Patricia M. Dechow

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

University of California, Berkeley - Accounting Group ( email )

Haas School of Business
Berkeley, CA 94720
United States

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