The Differential Persistence of Accruals and Cash Flows for Future Operating Income Versus Future Return on Assets

Abstract

Prior research shows that a higher proportion of accrued relative to cash earnings is associated with lower earnings performance in the subsequent period (Sloan 1996). The result has been widely interpreted as indicative of higher levels of operating accruals relative to cash flows from operations signaling (opportunistic) earnings management. We note, however, that earnings performance in prior studies (e.g., Sloan 1996) is typically defined as one-year-ahead operating income divided by one-year-ahead average total assets. Consequently, and not unimportant to our study or prior studies, the deflation of operating income transforms operating income into return on assets (i.e., an income measure into a profitability measure).

We find that accruals have a greater impact than cash flows on one-year-ahead average total assets, the denominator of return on assets. We also find that, although accruals are less persistent than operating cash flows for one-year-ahead return on assets, accruals and cash flows have equivalent associations with one-year-ahead operating income. We conclude that the lower persistence of accruals relative to cash flows should not be interpreted as evidence of earnings management, but instead, as evidence that accruals are more highly correlated with one-year-ahead average total assets than are cash flows.

Keywords: accrued earnings, growth, return on assets, earnings management, financial statement analysis

JEL Classification: M41, M43, G12