The Relation between Earnings and Cash Flows

Posted: 6 Sep 2006

See all articles by Patricia Dechow

Patricia Dechow

USC Marshall School of Business

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Ross L. Watts

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Abstract

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firm's series. The implications and predictions are tested on a 1337 firm sample over 1963-1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

Keywords: Accruals, cash flows, earnings, correlations

JEL Classification: M41, G20

Suggested Citation

Dechow, Patricia and Kothari, S.P. and Watts, Ross L., The Relation between Earnings and Cash Flows. Journal of Accounting & Economics, Vol. 25, 1998, Available at SSRN: https://ssrn.com/abstract=928702

Patricia Dechow

USC Marshall School of Business ( email )

Los Angeles, CA 90089-0441
United States

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

Ross L. Watts (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States

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