On the Relation between Accruals and Cash Flows

Abstract

Research on financial reporting identifies two important roles of accruals. First, accruals smooth fluctuations in operating cash flows. Second, accruals allow recognition of losses in an asymmetric timely manner. While these two roles of accruals imply quite different relations between individual accrual components and operating cash flow news, prior research often focuses on the properties of aggregate accruals. We investigate the role of individual accrual components and identify asymmetry in the relation of investment with operating cash flow news as a confounding factor in prior research. We show that this factor operates through the depreciation and amortization (D&A) component of aggregate accruals. While D&A is not subject to conditional conservatism, we find that asymmetry in the relation of D&A accruals with operating cash flow news accounts for as much as 50% of prior evidence of asymmetric timeliness in aggregate accruals. Our granular approach to identifying the roles of individual accrual components sheds new light on variation in asymmetric timeliness with firm characteristics as well as the role of changing firm characteristics in explaining prior evidence of a declining time trend in smoothing.

Keywords: Accruals, Cash Flows, Smoothing, Asymmetric Timeliness, Investment

JEL Classification: M40, M41, G30, G31