Surrogate Measures of Operating Cash Flows and Accruals: Problems and Solutions

Abstract

We examine the implications of measurement error in surrogate measures of operating cash flows. We decompose the measurement error into two components—the inclusion error and the non-articulation error. We find that the measurement error is large in magnitude and primarily driven by the improper inclusion of accruals in surrogate cash flow measures (i.e., the inclusion error). Furthermore, we find the non-articulation error has little effect on the inclusion error. We demonstrate that the measurement error in surrogate cash flow measures produces biased coefficients and incorrect inferences in common research settings. We also provide a simple correction that eliminates the inclusion error and show that the correction reduces biases and improves inferences. Importantly, our decomposition and correction can be used by future researchers to identify, understand, and take steps to mitigate the measurement error and the resulting biases that are introduced when using surrogate measures of operating cash flows.

Keywords: Balance Sheet Method, Surrogate Cash Flow Measures, Surrogate Accruals Measures

JEL Classification: M40, M41