Review of Accounting Studies, 8, 221243, 2003 # 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.

The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Protability
PATRICIA M. FAIRFIELD Georgetown University, The Robert Emmett McDonough School of Business, Washington, DC 20057 SCOTT WHISENANT The University of Houston, C. T. Bauer College of Business TERI LOMBARDI YOHN* yohnt@msb.edu Georgetown University, The Robert Emmett McDonough School of Business, Washington, DC 20057 Abstract. Prior research provides evidence that a higher proportion of accrued relative to cash earnings is associated with lower earnings performance in the subsequent scal year. The result has been widely interpreted as indicative of higher levels of operating accruals relative to cash ows foreshadowing a subsequent earnings reversal, and thus signaling earnings management. We note, however, that earnings performance in prior studies is typically dened as one-year-ahead operating income divided by one-yearahead invested capital, or a measure of protability. We nd that accruals are more highly associated than cash ows with invested capital in the denominator of the protability measure. In contrast, accruals and cash ows have no differential relation to one-year-ahead operating income. The evidence is not consistent with accruals having a reversal effect on earnings. This suggests that the lower persistence of accruals versus cash ows may not be due to earnings management but may rather be due to the effect of growth on future protability. Keywords: accrued earnings, growth, return on assets, earnings management, nancial statement analysis JEL Classication: M41

Sloan (1996) documents differential persistence in the components of current protability for explaining future protability. He shows that operating accruals are less persistent than operating cash ows for one-year-ahead earnings performance. More recent research extends this nding to total accruals, suggesting that protability attributable to either operating or nonoperating accruals is less sustainable in the subsequent period than is protability attributable to operating cash ows (Barth et al., 1999; Collins and Hribar, 2000; Xie, 2001). Much of the literature has interpreted these ndings as indicative of higher levels of accruals relative to cash ows foreshadowing a subsequent earnings reversal (Penman and Zhang, 2001; Richardson et al., 2001), and thus signaling earnings management. Although Sloan (1996) does not claim that accruals are used for earnings management, the motivation for examining accruals and cash ows
*Corresponding author.

222

FAIRFIELD, WHISENANT AND YOHN

includes a comment by Bernstein (1993) that accruals involve higher degrees of subjectivity than what enters the determination of cash ows from operations. Barth et al. (1999) state that because accruals are more affected by the estimation procedures of GAAP and, therefore, managerial discretion, we expect accruals and cash ows to have different abnormal earnings forecastability. Kothari (2001) states that discretionary accruals and earnings management are used synonymously in the literature. We note, however, that most tests of the differential persistence of accruals and cash ows use dependent and explanatory variables scaled by a measure of contemporaneous invested capital. Thus the dependent variable is one-year-ahead operating income divided by one-year-ahead invested capital, or a measure of protability. We note that one-year-ahead protability is affected by not only income in the numerator (income effect), but also by growth in invested capital (growth effect) in the denominator of the ratio. Accordingly, we question whether the differential persistence of current operating accruals and cash ows is due to their differential relations to growth in invested capital, rather than to the reversal of current operating accruals into one-year-ahead earnings. Our investigation is motivated by the nding in Faireld et al. (2003) that, after controlling for current protability, growth in non-current net operating assets and operating accruals equivalently depress one-year-ahead protability. We argue that a nding of lower persistence of accruals relative to cash ows for one-year-ahead operating income would provide persuasive evidence of earnings management. On the other hand, evidence that accruals are related to growth in invested capital in the denominator of protability would suggest another explanation for the lower persistence of accruals for future protability: it is more likely attributable to the effect of growth on future protability than to earnings management. We investigate whether the differential persistence of accruals and cash ows for one-year-ahead return on net operating assets (RNOA) results from differential associations with one-year-ahead operating income or with growth in net operating assets, or both. We nd that operating accruals exhibit a stronger association with growth in net operating assets than do operating cash ows. In contrast, operating accruals are no less persistent than operating cash ows for explaining one-yearahead operating income. These results are not consistent with the interpretation that accruals reverse and subsequently lead to lower one-year-ahead operating income. Thus, our results suggest that the differential persistence of accruals versus cash ows may not be due to earnings management.1 The results are more consistent with the interpretation that operating accruals capture growth in net operating assets and that growth tends to cause protability to converge to normal protability levels (e.g., the effect of conservative accounting or diminishing/increasing marginal returns to investments). Our ndings demonstrate that the choice of deator can have an important impact on empirical research. Researchers often use the term earnings (or income) when measures of protability are being investigated (Richardson et al., 2001; Penman and Zhang, 2001; Xie, 2001; Collins and Hribar, 2000). We agree that protability appropriately measures income relative to the capital used to generate the income;

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

223

therefore, we do not suggest that measures of return on invested capital are not value-relevant variables. Rather, we argue that researchers should be cautious in interpreting results for protability measures as also pertaining to earnings. Prior research has documented a market mispricing of accruals (Sloan, 1996; Xie, 2001; Faireld et al., 2003). Our results suggest that the documented market mispricing of accruals may not be due to investors inability to detect earnings management, but rather to investors inability to extrapolate growth rates (Tarpley, 2000) or to consider the effects of diminishing marginal returns or conservative accounting on new investments (Faireld et al., 2003). These interpretations are also consistent with the ndings in Desai et al. (2002) that the accrual anomaly may be a special case of the value-glamor anomaly documented in the nance literature (Lakonishok et al., 1994). The next section provides the development of the research questions regarding the information content of accrued earnings and cash earnings for one-year-ahead operating income and net operating assets. Section 2 provides a description of the variables used in the analysis. Section 3 provides evidence on the association between cash ows and accruals with growth in net operating assets. Section 4 provides evidence on the relation between cash ows and accruals and one-year-ahead protability and operating income. Section 5 presents results of additional analyses, while Section 6 presents our conclusions.

1. Development of Research Questions There is a large body of literature that provides evidence of earnings management of specic accruals (McNichols and Wilson, 1988; Petroni, 1992; Beaver and McNichols, 1998), and managements discretion over earnings to achieve earnings targets (Burgstahler and Dichev, 1997). Sloan (1996) has been interpreted as providing evidence on the use of accruals for earnings management. However, we question whether the evidence on differential persistence of accruals versus cash ows for future protability captures the use of accruals for earnings management. We argue that an equally plausible interpretation of the evidence is that accruals and cash ows are differentially related to growth. While both cash ows and accruals in year t potentially increase assets in year t, we expect a dollar of operating accruals and operating cash ows to have disproportionate relations to invested capital at the end of year t. Operating accruals are dened as growth in operating working capital less depreciation and amortization expense and, like other forms of investment, increase net operating assets. Firms with growth in working capital are likely to have growth in net operating assets. In contrast, cash ows from operations may or may not be reinvested in the rm. The rm might elect to use the cash to retire debt or to pay dividends, and thus operating cash ows may not be reected in net operating assets at the end of the year. Accordingly, we expect operating accruals in year t to have a disproportionate impact on growth in net operating assets in year t relative to operating cash ows.2 We predict that accruals, relative to cash ows, in year t are more highly associated with growth in net operating assets in year t.

224

FAIRFIELD, WHISENANT AND YOHN

In the literature on the differential persistence of accruals and cash ows, the dependent and explanatory variables (i.e., future and current income, respectively) are typically scaled by their contemporaneous measures of invested capital (Sloan, 1996; Xie, 2001; Richardson et al., 2001; Faireld et al., 2003). The research design has the effect of transforming a regression of earnings in scal year t 1 onto accruals and cash ows in scal year t into a regression of protability in scal year t 1 onto accruals and cash ows in scal year t.3 Thus, the empirical evidence showing lower persistence of operating accruals relative to cash ows in year t may capture the differential relations of accruals relative to cash ows for operating income in year t 1 (the numerator of the dependent variable), invested capital at the end of year t (the denominator of the dependent variable), or both. We predict that the lower persistence of operating accruals relative to cash ows is due to their differential relations to growth in invested capital in the denominator of the protability measure. Thus, we predict that the lower persistence of current operating accruals relative to cash ows for explaining future operating income is not evident when all variables are scaled by the same measure of invested capital.

2. Variable Denitions and Model Specication The nancial data are taken from the annual database of Standard & Poors 2001 COMPUSTAT Industrial and Research les. Our sample consists of rms with required one-year-ahead, current, and lagged values of nancial statement and stock price data during the 30-year period 1964 to 1993.4 The purpose of using this sample period and formation method is to replicate the sample in Sloan (1996), thus better ensuring that sample differences do not limit comparisons of our ndings to those in Sloan. The following data lters are applied to 79,679 NYSE and AMEX rm-year observations during the 30-year period 1964 to 1993. Firms in the nancial services, insurance, and real estate industries (DNUM 60006999) are removed since those rms typically do not have the required data to estimate operating accruals (12,859 rm-years). We successively eliminate observations due to missing, combined, or estimated values of working capital or depreciation accounts in either the current or prior scal year (21,851 rm-years), scal year changes in either the current or prior scal year (346 rm-years), or insufcient returns data (7696 rm-years).5 Finally, we delete observations with less than $1 million in net operating assets (scaling variable reported) to control for the potential inuence of observations with relatively low values of the deating variable (1844 rm-years). The nal sample includes 35,083 rm-years with sufcient stock price data and nancial data to estimate the nancial statement variables. Effective for scal years after July 1988, Statement Financial Accounting Standard No. 95 requires a report of a statement of cash ows (SCF). The operating section of SCF allows one to obtain an estimate of operating and nonoperating accruals (Whisenant and Yohn, 2002; Givoly and Hayn, 2000). However, the SCF is not available for most of our sample period. Therefore, as in Sloan (1996), we use the balance sheet approach to

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

225

estimate the accruals and cash ows components of operating income.6 The balance sheet method relies on the articulation between changes in working capital and accruals.7

2.1.

Measurement of Variables

The dependent variables used in the analysis are one-year-ahead RNOA and oneyear-ahead operating income (OPINC). One-year-ahead RNOA is dened as operating income in year t 1 deated by net operating assets at the end of year t.8 Thus, RNOAt1 is dened as (although not shown, cross sectional rm subscripts throughout the study should be assumed): RNOAt1 where Operating Incomet1 operating income after depreciation and amortization expense in year t 1COMPUSTAT item 178; and NOAt operating assets (excluding cash) minus operating liabilities at the end of year t; or ARt INVt OTHERCAt PPEt INTANGt OTHERLTAt APt OTHERCLt OTHERLTLt ; where AR accounts receivable COMPUSTAT item 2; INV inventories COMPUSTAT item 3; OTHERCA other current assets COMPUSTAT item 68; PPE net property; plant; and equipment COMPUSTAT item 8; INTANG intangibles COMPUSTAT item 33; OTHERLTA other long-term assets COMPUSTAT item 69; AP accounts payable COMPUSTAT item 70; OTHERCL other current liabilities COMPUSTAT item 72; and OTHERLTL other long-term liabilities COMPUSTAT item 75: OPINCt1 is similar to RNOAt1 , but instead of deating operating income by net operating assets in year t, we deate by net operating assets in year t 1. OPINCt1 is, therefore, not affected by growth in net operating assets in year t. For OPINCt1 , we scale operating income to control for heteroscedasticity; therefore, we scale operating income by the deator that is used to scale the explanatory variables. Operating Incomet1 ; NOAt

226

FAIRFIELD, WHISENANT AND YOHN

We differentiate operating income deated by lagged net operating assets, OPINC, from operating income deated by contemporaneous net operating assets, RNOA.9 OPINCt1 is dened as: OPINCt1 Operating Incomet1 : NOAt1

The explanatory variables in the model are current operating cash ows and operating accruals. Using the balance sheet method to estimate operating accruals, accruals is dened as the net change in operating working capital accounts other than tax liabilities minus current period depreciation and amortization expense.10 Therefore, we dene operating accruals in year t as: Operating Accrualst GrWCt DEPAMt ; where: GrWCt DARt DINVt DCAOt DAPt DCLOt ; and DAR one-year change in AR; DINV one-year change in INV; DOCA one-year change in OTHERCA; DAP one-year change in AP; DCLO one-year change in OTHERCL, and DEPAM depreciation and amortization expense (COMPUSTAT item 14: Operating cash ows in year t is estimated by subtracting the estimate of operating accruals from operating income as follows: Operating Cash Flowst Operating Incomet Operating Accrualst : ACCt is dened as operating accruals in year t deated by net operating assets at the end of year t 1, and CFOt is dened as operating cash ows in year t deated by net operating assets at the end of year t 1.

2.2.

Model Specication

We predict that the empirical evidence showing lower persistence of operating accruals relative to cash ows in year t is at least in part due to their differential relations to the measure of invested capital used in protability in year t 1. Thus, we predict that accruals, relative to cash ows, in year t are more highly associated

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

227

with growth in net operating assets in year t using the following model: GrNOAt g0 g1 CFOt g2 ACCt Vt ; or, alternatively, NOAt Operating Cash Flowst Operating Accrualst g0 g1 g2 NOAt1 NOAt1 NOAt1 vt : 1a 1

That is, we predict that in equation (1) we will nd evidence that g1 6 g2 . To determine if the differential persistence of accruals versus cash ows in entirely due to the effect of growth on the denominator of the protability measure, we run the following models: RNOAt1 a0 a1 CFOt a2 ACCt et1 ; or, alternatively, Operating Incomet1 Operating Cash Flowst a0 a1 a2 NOAt NOAt1 6 and OPINCt1 b0 b1 CFOt b2 ACCt ut1 ; or, alternatively, Operating Incomet1 Operating Cash Flowst b 0 b1 b2 NOAt1 NOAt1 6 Operating Accrualst ut1 : NOAt1 3a 3 Operating Accrualst et1 ; NOAt1 2a 2

Equation (2) represents a regression of future protability onto components of current protability. The literature has consistently documented the differential persistence (i.e., a1 > a2); however, we conjecture that the lower persistence of accrued operating income relative to operating cash ows is due solely to their differential relations to growth in net operating assets. Therefore, we predict the lower persistence of current operating accruals relative to cash ows does not relate to operating income scaled by net operating assets in year t1. That is, we predict that in equation (3), we will not nd evidence to reject b1 b2.

228

FAIRFIELD, WHISENANT AND YOHN

2.3.

Descriptive Statistics

Table 1 provides descriptive statistics on the variables. Panel A reports the unscaled variables: operating income in years t 1 and t and net operating assets at the end of years t and t 1. We note that operating income is larger in year t 1 than in year t. In addition, net operating assets are larger at the end of year t than at the end of year t 1. The statistics suggest that growth occurs in both earnings and net operating assets for our sample, where growth rates are approximately 6.5% based on reported means. Panel B provides descriptive statistics on the deated variables: one-year-ahead RNOA, one-year-ahead OPINC, current CFO, and current ACC. The mean (median) one-year-ahead RNOA for the rms in the sample is 19.4% (16.1%). The mean (median) one-year-ahead OPINC is about 3.5% (1.6%) points higher, at 22.9%
Table 1. Descriptive statistics. Panel A: Levels of components of one-year-ahead and current protability Variable Growth Rate Mean Operating Incomet1 Operating Incomet NOAt NOAt1 6.69% 6.48% $118.75 $111.30 $760.24 $713.98

Std. Dev. $462.17 $446.82 $3038.00 $2957.00 Std. Dev. 0.215 0.273 0.327 0.238 0.214 0.118

Median $15.99 $14.65 $100.72 $90.48 Median 0.161 0.177 0.199 0.040 0.021 0.060

Panel B: Deated measures of one-year-ahead and current operating income Variable Variable Denition Mean RNOAt1 OPINCt1 CFOt ACCt GrWCt DEPRt Operating Incomet1/NOAt Operating Incomet1/NOAt1 Operating Cash Flowst/NOAt1 Operating Accrualst/NOAt1 Working Capitalt/NOAt1 Depr & Amort Expt/NOAt1 0.194 0.229 0.221 0.019 0.053 0.073

Number of observations 35,083 rm-years between 1964 and 1993. Operating Income annual operating income after depreciation and amortization (COMPUSTAT # 178). NOA net operating assets at the end of scal-year. RNOAt1 return on assets at scal year t 1, dened as operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t. OPINCt1 annual operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t 1. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1. GrWCt growth in working capital at scal year t dened as DARt DINVt DCAOt DAPt DCLOt , where DAR one-year change in accounts receivables, DINV one-year change in inventory, DOCA one-year change in other current assets, DAP one-year change in accounts payable, and DCLO one-year change in other current liabilities, divided by NOA at scal year t 1. DEPRt depreciation and amortization expense at scal year t, divided by NOA at scal year t 1.

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

229

(17.7%). As explained earlier, the difference between RNOAt1 and OPINCt1 is only in the denominator, where OPINCt1 is deated by net operating assets in year t1 (compared with RNOAt1 being deated by net operating assets in year t). Comparisons of the two yield the expected RNOAt1 < OPINCt1 due to growth in the denominator in year t. The mean (median) current CFO is 22.1% (19.9%), and, as documented in prior studies, the mean (median) current ACC is 1.9% ( 4.0%), suggesting that accruals, on average, decrease income. However, further tabulated statistics on ACC, where ACC equals growth in working capital plus depreciation (GrWC DEPR), show that, on average, growth in working capital is incomeincreasing. The mean (median) current GrWC is 5.3% (2.1%). Table 2 reports correlation coefcients for the variables, and offers insights into the differences between protability analysis and income analysis. For example, growth in net operating assets exhibits a higher correlation with accruals than with cash ows. In addition, the correlation between ACC and one-year-ahead OPINC is higher than the correlation between ACC and one-year-ahead RNOA. These simple correlations suggest that the results regarding the differential relations between ACC and CFO and one-year-ahead RNOA might not apply to one-year-ahead operating income.11

Table 2. Correlation matrices. (Spearman coefcients in the upper triangle; Pearson coefcients in the lower triangle). Correlation coefcients of variablesa Variables RNOAt1 RNOAt1 OPINCt1 GrNOAt CFOt ACCt 1.00 0.82* 0.06* 0.59* 0.03

OPINCt1 0.96* 1.00 0.33* 0.60* 0.20*

GrNOAt 0.17* 0.35* 1.00 0.02* 0.52*

CFOt 0.59* 0.53* 0.08* 1.00 0.45*

ACCt 0.12* 0.22* 0.58* 0.44* 1.00

Number of observations 35,083 rm-years between 1964 and 1993. a The correlation coefcients are the averages of the 30 annual correlation coefcients obtained from 1964 to 1993. The signicance levels are based on the means and standard deviations of the 30 correlation coefcients obtained in the annual correlation analyzes. *Denotes Spearman (upper triangle) or Pearson (lower triangle) correlation coefcients are signicantly different from zero, p-value < 1% level. RNOAt1 return on assets at scal year t 1, dened as operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t. OPINCt1 annual operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t 1. GrNOAt net operating assets at the end of scal-year t, divided by net operating assets at the end of scal-year t 1. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1.

230

FAIRFIELD, WHISENANT AND YOHN

3. Evidence on the Association Between Cash Flows and Accruals and Net Operating Assets We predict that the well-documented differential persistence of the components of current protability for explaining future protability is, at least in part, attributable to the differential relations between operating cash ows and accruals in year t and growth in net operating assets in year t. In this section, we examine whether ACC and CFO have differential relations to growth in net operating assets in year t. The dependent variable is net operating assets in year t, deated by net operating assets in year t 1. In this analysis, we scale the dependent and explanatory variables by NOAt1 to control for heteroscedasticity. The results are reported in Table 3. The difference in the coefcients on CFO and ACC is surprisingly largethe coefcient on CFO is 0.38 while the coefcient on ACC is 1.41. Panel B provides results of tests for differences in the coefcients on CFO and ACC. The results show that the coefcient on CFO is signicantly smaller than the coefcient on ACC (p-value < 0.01, two-tailed test). We conclude that operating accruals in year t are more highly associated with growth in net operating assets in year t than are operating cash ows in year t.

4. Evidence on the Differential Persistence of Current Accruals and Cash Flow to One-Year-Ahead Protability Versus One-Year-Ahead Operating Income In Table 4 we present the results of regressing both RNOAt1 and OPINCt1 onto the components of current operating income: operating cash ows and accruals. For the RNOAt1 regression we obtain results consistent with prior research (Sloan, 1996; Xie, 2001; Faireld et al., 2003) that accruals are less persistent than cash ows for explaining one-year-ahead RNOA. The estimated coefcient on accrued earnings is 0.57, signicantly smaller than the estimated coefcient on cash ows from operations of 0.72 (p-value < 0.01, two-tailed test). In the equation (3) panel we present the regressions using OPINCt 1 as the dependent variable. The results conrm our predictions that there is no differential persistence of accruals versus cash ows, after controlling for the effect of the deator on the dependent variable. The coefcients on CFO (0.93) and ACC (0.97) do not differ signicantly (p-value 0.14, two-tailed test) for one-year-ahead OPINC. This suggests that accruals do not signal reversals in one-year-ahead operating income. In sum, we fail to detect a reversal effect associated with accruals. The empirical evidence indicates that the well-documented lower persistence of accruals relative to cash ows is not attributable to a negative association between accruals and oneyear-ahead operating income. Instead, operating accruals have a higher correlation than cash ows with one-year-ahead net operating assets. Thus, ACC and CFO exhibit differential relations with RNOA because the denominator of RNOA captures the differential implications of ACC and CFO in year t for growth in net operating assets in year t.

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

231

Table 3. Results from regressions of one-year-ahead net operating assets on operating cash ows and accruals. Equation (1): GrNOAt g0 g1 CFOt g2 ACCt vt where: GrNOAt NOAt =NOAt1 CFOt Operating Cash Flowst =NOAt1 ACCt Operating Accrualst =NOAt1 Panel A: Estimation results a,
b

Equation (1): Variables Intercept CFOt ACCt Adjusted R2 Estimated Coefcients 1.108 0.378 1.407 0.390 t-Statistic (66.62)*** (4.38)*** (23.11)***

Panel B: Tests of differences in persistence of operating cash ows and accruals Test: g1 g2 t-statistic (p-value) 17.11*** (< 0.001)

Number of observations 35,083 rm-years between 1964 and 1993. a The coefcients and explained variation are the averages of the 30 annual estimates obtained from 1964 to 1993. b The t-statistics are based on the means and standard deviations of the 30 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively. NOA net operating assets at the end of scal-year. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1.

5. Supplemental Analysis 5.1. Tests of Two-Year-Ahead Protability and Operating Income

It is possible that the reversal of accruals is not immediate, but may impact operating income over a longer horizon. In Table 5 we present the results of regressing RNOAt2 and OPINCt2 onto the components of current operating

232

FAIRFIELD, WHISENANT AND YOHN

Table 4. Results from regressions of one-year-ahead RNOA and OPINC on operating cash ows and accruals. Equation (2): RNOAt1 a0 a1 CFOt a2 ACCt et1 Equation (3): OPINCt1 b0 b1 CFOt b2 ACCt ut1 where: RNOAt1 Operating Incomet1 =NOAt OPINCt1 Operating Incomet1 =NOAt1 CFOt Operating Cash Flowst =NOAt1 ACCt Operating Accrualst =NOAt1 Panel A: Estimation results on each equationa,
b

Equation (2): Estimated Coefcients 0.045 0.723 0.569 0.549

Equation (3): Estimated Coefcients 0.041 0.927 0.966 0.627

Variables Intercept CFOt ACCt Adjusted R2

t-Statistic (6.87)*** (23.51)*** (24.58)***

t-Statistic (6.58)*** (32.73)*** (31.60)***

Panel B: Tests of differences in persistence of operating cash ows and accruals Test: a1 a2 t-statistic (p-value) 6.98*** (< 0.001) Test: b1 b2 t-statistic (p-value) 1.51 (0.14)

Number of observations 35,083 rm-years between 1964 and 1993. a The coefcients and explained variation are the averages of the 30 annual estimates obtained form 1964 to 1993. b The t-values are based on the means and standard deviations of the 30 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively. RNOAt 1 return on assets at scal year t 1, dened as operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t. OPINCt 1 annual operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t 1. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1.

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

233

Table 5. Results from regressions of two-year-ahead RNOA and operating income on operating cash ows and accruals. Equation (4): RNOAt2 a0 a1 CFOt a2 ACCt et2 Equation (5): OPINCt2 b0 b1 CFOt b2 ACCt ut2 where: RNOAt2 Operating Incomet2 =NOAt1 OPINCt2 Operating Incomet2 =NOAt1 CFOt Operating Cash Flowst =NOAt1 ACCt Operating Accrualst =NOAt1 Panel A: Estimation results on each equationa,
b

Equation (4): Estimated Coefcients 0.069 0.565 0.404 0.282 Estimated Coefcients 0.070 0.920 1.014 0.386

Equation (5):

Variables Intercept CFOt ACCt Adjusted R2

t-Statistic 11.27*** 17.58*** 15.68***

t-Statistic (10.49)*** (26.77)*** (19.95)***

Panel B: Tests of differences in persistence of operating cash ows and accruals Test: a1 a2 t-statistic (p-value) Test: b1 b2 t-statistic (p-value)

5.06 (< 0.001)***

2.59 (0.01)

Number of observations 35,083 rm-years between 1964 and 1993. a The coefcients and explained variation are the averages of the 30 annual estimates obtained from 1964 to 1993. b The t-values are based on the means and standard deviations of the 30 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively. RNOAt2 return on assets at scal year t 2, dened as operating income after depreciation and amortization at scal year t 1, divided by NOA at scal year t 1. OPINCt2 annual operating income after depreciation and amortization at scal year t 2, divided by NOA at scal year t 1. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1.

234

FAIRFIELD, WHISENANT AND YOHN

income: operating cash ows and accruals. RNOAt2 is dened as operating income at t 2 divided by net operating assets in year t 1, while OPINCt2 is dened as operating income at t 2 divided by net operating assets in year t 1. For the RNOA regression, we again observe differential persistence between accruals and cash ows. The estimated coefcient on accrued earnings is 0.40, which is signicantly smaller (p-value < 0.01, two-tailed) than the estimated coefcient on cash ows from operations of 0.57. In contrast, the regression of OPINCt2 on accruals and cash ows in year t shows that accruals are actually more persistent than cash ows for two-year-ahead operating income. The coefcient on ACC of 1.01 is signicantly higher (p-value < 0.01, two-tailed) than the coefcient on CFO of 0.92. Thus we nd that accruals signal higher, not lower, operating income in year t 2 compared to cash ows.12 This evidence is not consistent with a reversal effect of accruals in year t 2, adding to the evidence that the lower persistence of accruals for future RNOA is not due to their effect on future operating income.

5.2.

Inclusion of Future Special Items in Operating Income

It is also possible that the reversal of accruals is characterized by rms as a nonrecurring item in the following year, and coded by COMPUSTAT as a special item. These special items are not included in our denition of OPINC, and therefore our tests would not capture such reversals. In Table 6 we present results for tests of whether cash ows and accruals have differential persistence for operating income inclusive of special items. We include only those rms reporting special items in year t 1.13 Again we nd that cash ows and accruals have equivalent implications for future operating income that, in this case, includes special items. The coefcients on cash ows (0.84) and accruals (0.89) do not differ signicantly, suggesting that accruals are not reversed in the form of charges characterized by management as unusual or non-recurring items.

5.3.

Discretionary Accruals

Prior research (Xie, 2001) has examined Jones (1991) model discretionary accruals and has documented that the lower persistence of accruals relative to cash ows for one-year-ahead protability is driven by discretionary accruals. We test whether discretionary operating accruals are less persistent than operating cash ows for oneyear-ahead operating income. Specically, we use the Jones (1991) model to disaggregate operating accruals into nondiscretionary accruals and discretionary accruals. We then regress one-year-ahead RNOA and one-year-ahead OPINC on operating cash ows, nondiscretionary accruals, and discretionary accruals. The results are reported in Table 7. We nd, as in Xie (2001), that only discretionary accruals are less persistent than cash ows for one-year-ahead RNOA. However, we nd that neither discretionary accruals nor nondiscretionary accruals is less

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

235

Table 6. Results from regressions of one-year-ahead operating income plus special items on operating cash ows and accruals for rms reporting special items in year t 1. Equation (6): OPINCSPt1 g0 g1 CFOt g2 ACCt vt1 where: OPINCSPt1 Operating Income plus Special Itemst1 =NOAt1 CFOt Operating Cash Flowst =NOAt1 ACCt Operating Accrualst =NOAt1 Panel A: Estimation resultsa,
b

Equation (6): Variables Intercept CFOt ACCt Adjusted R2 Estimated Coefcients 0.039 0.842 0.895 0.457 t-Statistic 4.49*** 17.13*** 17.13***

Panel B: Tests of differences in persistence of operating cash ows and accruals Test: g1 g2 t-statistic (p-value) 1.62 (0.12)

Number of observations 7534 rm-years with special items in year t 1 between 1964 and 1993. a The coefcients and explained variation are the averages of the 30 annual estimates obtained from 1964 to 1993. b The t-values are based on the means and standard deviations of the 30 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively. OPINCSPt1 annual operating income after depreciation and amortization plus special items at scal year t 1, divided by NOA at scal year t 1. CFOt cash ows from operations at scal year t where cash ows are dened as operating income after depreciation and amortization minus operating accruals at scal year t, divided by NOA at scal year t 1. ACCt operating accruals at scal year t estimated from the balance sheet method, divided by NOA at scal year t 1.

persistent than cash ows for one-year-ahead operating income. The coefcient on nondiscretionary accruals is 0.99, and the coefcient on discretionary accruals is 0.97. Neither of these coefcients differs signicantly from the coefcient of 0.96 on CFO. Thus, we conclude that the lower persistence of discretionary accruals documented in the prior literature is driven by their differential relation to growth in net operating assets in the denominator of RNOA.

236

FAIRFIELD, WHISENANT AND YOHN

Table 7. Results from regressions of one-year-ahead RNOA and OPINC on operating cash ows, nondiscretionary accruals, and discretionary accruals. Equation (7): RNOAt1 a0 a1 CFOt a2 NDACCt a3 DISACCt et1 Equation (8): OPINCt1 b0 b1 CFOt b2 NDACCt b3 DISACCt ut1 where: RNOAt1 Operating Incomet1 =NOAt OPINCt1 Operating Incomet1 =NOAt1 CFOt Operating Cash Flowst =NOAt1 NDACCt Nondiscretionary Operating Accrualst =NOAt1 DISACCt Discretionary Operating Accrualst =NOAt1 Panel A: Estimation results on each equationa,
b

Equation (7): Estimated Coefcients 0.047 0.723 0.683 0.555 0.525

Equation (8): Estimated Coefcients 0.035 0.958 0.987 0.966 0.638

Variables Intercept CFOt NDACCt DISACCt Adjusted R2

t-Statistic (8.54)*** (28.19)*** (24.53)*** (24.86)***

t-Statistic (9.53)*** (52.98)*** (28.18)*** (39.15)***

Panel B: Tests of differences in persistence of operating cash ows and accruals Test: a1 a2 t-statistic (p-value) Test: a1 a3 t-statistic (p-value) Test: b1 b2 t-statistic (p-value) Test: b1 b3 t-statistic (p-value)

1.32 (0.20) 8.52 (< 0.001)

0.90 (0.37) 0.41 (0.68)

Number of observations 35,083 rm-years between 1964 and 1993. NDACC and DISACC are calculated using the Jones (1991) model on operating accruals. The remaining variables are dened in Table 1. a The coefcients and explained variation are the averages of the 30 annual estimates obtained from 1964 to 1993. b The t-values are based on the means and standard deviations of the 30 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively.

Table 8. Results from regressions of one-year-ahead operating income on the accrual and cash ow components of current operating income for ten portfolios of rms formed annually based on the magnitude of growth in net operating assets.

Equation (3) : Portfolio Ranking by Growth in NOAt GrNOAt NOAt =NOAt1 Deciles Low 0.77 2 0.94 3 1.00 4 1.03 5 1.06 6 1.10 7 1.14 8 1.19 9 1.29 High 1.77

OPINCt1 b0 b1 CFOt b2 ACCt ut1

Mean GrNOAt

Full Sample 0.13

Panel A: Estimation resultsa 0.022 0.787 0.620 0.595 0.022 0.921 0.782 0.623 0.020 0.994 0.952 0.663 0.004 1.054 0.973 0.715 0.004 1.069 1.032 0.736 0.015 0.990 0.932 0.706 0.013 1.021 0.970 0.717 0.005 1.059 1.042 0.728 0.018 1.034 1.030 0.671 0.014 1.084 1.122 0.621

Intercept CFOt ACCt Adjusted R2

0.021 1.036 1.059 0.683

Panel B: Tests of differences in persistence of cash ow and accrual components of operating incomeb t-value (p-value) 4.81*** (< 0.01) 2.29** (0.033) 0.76 (0.456) 1.51 (0.147) 0.86 (0.397) 0.96 (0.347) 1.03 (0.311) t-value (p-value) t-value (p-value) t-value (p-value) t-value (p-value) t-value (p-value) t-value (p-value) t-value (p-value) 0.62 (0.541) t-value (p-value) 0.11 (0.914) t-value (p-value) 0.73 (0.471)

Coefcient Comparisons

t-value (p-value)

Test: b1 b2

0.023 (0.573)

Panel C: Means (standard deviations) of ACC and CFO for full sample and within growth deciles

ACCt =NOAt1

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

CFOt =NOAt1

0.02 (0.33) 0.22 (0.25)

0.19 (0.18) 0.28 (0.29)

0.11 (0.08) 0.24 (0.19)

0.07 (0.06) 0.22 (0.15)

0.06 (0.06) 0.22 (0.14)

0.04 (0.06) 0.22 (0.15)

0.03 (0.07) 0.23 (0.17)

0.02 (0.08) 0.23 (0.17)

0.01 (0.10) 0.23 (0.20)

0.04 (0.16) 0.22 (0.29)

0.15 (0.36) 0.21 (0.50)

Number of observations 28,472 rm-years between 1972 and 1993. All coefcient estimates of RNOA are signicantly different from zero at less than the one percent level. a The coefcients and explained variation are the averages of the 22 annual estimates obtained from 1972 to 1993. We exclude observations for rm-years 1964 to 1971 because the sample sizes are too small to yield reliable parameter estimates after sorting into growth deciles (i.e., less than 30 observations per regression). b The t-values are based on the means and standard deviations of the 22 parameter estimates obtained in the annual regressions. ***, **, and * denotes signicance at less than 1%, 5%, and 10% levels (two-tailed test), respectively.

237

238

FAIRFIELD, WHISENANT AND YOHN

5.4.

Regressions on Portfolios Ranked by Growth in Net Operating Assets

In Table 8 we investigate whether accruals and cash ows are differentially persistent for subsets of the data formed on the basis of growth in net operating assets. This test is performed to assess whether the results are robust to an alternative method of controlling for growth in net operating assets and to provide more insights into the circumstances in which differential persistence may occur. Panel A of the table reports regressions of OPINCt1 on CFOt and ACCt . In Panel B we report the test statistics for the equality of the coefcients on CFOt and ACCt . We note that the two lowest growth deciles do exhibit higher persistence of cash ows than accruals. Panel C reports the mean and standard deviation of ACC and CFO for the full sample of rms and for rms within growth deciles. From Panel C we observe that although forming portfolios by GrNOAt mitigates some of the variation in accruals and cash ows within portfolios, forming portfolios does not eliminate the variation. In particular there is still considerable variation in accruals within the highest and lowest growth deciles, so we cannot attribute the results to the absence of variation in accruals. The differential persistence of accruals and cash ows in the two lowest growth deciles may suggest an interesting avenue for future research. These lowest two deciles report negative growth in net operating assets while the other eight deciles exhibit positive growth. In addition, we note that the rms in these deciles report income decreasing accruals. In untabulated analyses, we nd that these rms exhibit negative growth in working capital while the rms in the other deciles exhibit positive growth in working capital. In addition, rms in the lowest deciles report a higher level of cash ows to net operating assets on average than rms in the other deciles. Finally, we note that the coefcients on both ACC and CFO are lower than their coefcients in the other deciles. A more detailed analysis to determine potential reasons for the differential persistence for these rms might be an interesting avenue for future research. Nonetheless, if the differential persistence is due to earnings management, it only occurs for the bottom 20% of the sample rms based on GrNOAt .

5.5.

Alternative Measures of Investment

Prior researchers have used different measures of the asset base used to generate the income. Sloan (1996), Collins and Hribar (2000), and Faireld et al. (2003) scale by average total assets; Xie (2001) scales by beginning total assets; and Richardson et al. (2001) and Penman and Zhang (2002) scale by beginning net operating assets. We examined whether our results regarding the differential persistence of accruals and cash ows for future return on assets and future operating income are robust to the asset base used as a deator. Specically, we performed our analyses using average total assets, beginning total assets, and average net operating assets as the scalar (these results are available from the authors). We nd that the results reported in the tables are robust to these alternative scalars. Specically, for each of the deators, we

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

239

nd that accruals are less persistent than cash ows for operating income scaled by the contemporaneous deator but are no less persistent than cash ows for operating income scaled by the lagged deator. We conclude that our results are robust to alternative deators used in prior research.

5.6.

Including the Scalar as an Explanatory Variable

In the OPINC analyses reported in the tables, we scale the dependent and explanatory variables by net operating assets in year t 1 to control for heteroscedasticity. Barth and Kallapur (1996) suggest that including a scale proxy as an explanatory variable and using Whites (1980) standard errors is more effective than deation in regression analysis to control for heteroscedasticity and coefcient bias. To test the robustness of our results to including the scalar as an explanatory variable, we performed our analyses using this alternative methodology. We nd that accruals are no less persistent than cash ows for one-year-ahead operating income when net operating assets at t 1 is included as an explanatory variable rather than used as a deator, and Whites standard errors are used. We conclude that the results for operating income are robust to this alternative methodology.14

6. Conclusions Prior research (Sloan, 1996; Xie, 2001; Faireld et al., 2003) nds differential persistence in operating cash ows and accruals for one-year-ahead protability. We show that the specication of the dependent variable is critical to the interpretation of the results. We nd no difference in the persistence of accruals and cash ows when the dependent variable in the regression is operating income in year t 1 divided by net operating assets in year t 1 rather than net operating assets in year t. The results suggest that the differential persistence of accruals versus cash ows is attributable to their differential associations with net operating assets in the denominator of one-year-ahead protability. In contrast, accruals are not less persistent then cash ows for one-year-ahead operating income. This suggests that there is no evidence of accruals having a reversal effect on future operating income. We note that to be consistent with prior research we examine only operating accruals in this study. Our results should not be interpreted as evidence on the behavior of total accruals. An analysis of operating and nonoperating accruals should be carefully designed to control for the differential persistence in earnings components (Faireld et al., 1996; Whisenant and Yohn, 2002; Givoly and Hayn, 2000). Prior research has documented a market mispricing of accruals. Our results suggest that this mispricing is more likely attributable to investors inability to extrapolate growth rates or to consider the effects of diminishing marginal returns or conservative accounting on new investments than to investors inability to detect

240

FAIRFIELD, WHISENANT AND YOHN

earnings management. The question of how the market mispricing of accruals relates to growth appears to be an interesting avenue for future research. We conclude that the evidence does not demonstrate a primary role for current operating accruals deated by invested capital in providing differential information in explaining one-year-ahead operating income. The results also suggest that researchers should use caution in concluding that the ratio of accruals to net operating assets necessarily signals earnings management. The differential persistence of accruals and cash ows documented in prior research is attributable to the differential implications of accruals relative to cash ows for net operating assets in the denominator of protability. Distinguishing between true economic growth and earnings management as drivers of balance sheet changes remains a challenging area for future research.

Acknowledgments We appreciate the comments of Ilia Dichev, Charles Lee, Richard Sloan, Srinivasan Sankaraguruswamy, Dennis Chambers, Sudipta Basu, Paul Hribar, Michael Mosebach, Ken Cavalluzzo, Dan Collins, Bill Baber, Son-Hyon Kang, Bala Dahran, Agnes Cheng, Stephen Zeff, and Tom Stober. We would especially like to thank Stephen Penman, James Ohlson, and Prem Jain for their contributions. This study has also benetted from the comments of workshop participants at Emory University, Texas Christian University, The University of Houston, Rice University, George Washington University, The University of Arkansas, Hong Kong University of Science and Technology, the 2001 American Accounting Association annual meetings, New York University, the 2002 Stanford University Accounting Summer Camp, and the 2002 Review of Accounting Studies conference. This research was supported in part by a Steers Faculty Research Fellowship awarded by the McDonough School of Business.

Notes
1. We do not conclude that accruals are not used for earnings management. Rather, we argue that the ratio of operating accruals to invested capital may not be a useful measure to capture earnings management. Similarly to McNichols (2000), we argue that more extensive modeling of specic accruals or more contextual analyses are likely to provide more insight into earnings management. For example, see Penman and Zhang (2002), Richardson et al. (2001), and Jansen and Yohn (2002). 2. We note that the higher correlation between operating accruals and growth in net operating assets will not obtain by construction. Firms with high operating accruals might dispose of other operating assets, or rms with low operating accruals might acquire net operating assets by issuing debt or capital. Also, rms with high levels of operating cash ows might reinvest the cash in operating assets, while rms with low or negative operating cash ows might dispose of non-current operating assets to provide more liquidity. However, on average we believe we will observe a stronger association between operating accruals and growth in net operating assets than operating cash ows and growth in net operating assets.

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

241

3. Sloan (1996) and Collins and Hribar (2000) scale by contemporaneous average total assets; Xie (2001) scales by contemporaneous beginning total assets; Richardson et al. (2001), and Penman and Zhang (2002) scale by contemporaneous beginning net operating assets; and Barth et al. (1999) examine abnormal earnings, which is calculated using contemporaneous beginning book value. The transformation of income measures to protability measures is similar whether average assets, beginning assets, average net operating assets, or beginning net operating assets are used as measures of invested capital. 4. Sloan (1996) employs nancial data for the 30 years from 1962 to 1991. However, we drop 1962 and 1963 from our sample since the required data reduces the sample size for those years to below reasonable sample sizes (less than twenty observations) on which to run annual cross-sectional regressions. Therefore, we add two additional years, 1992 and 1993, to our sample period which yields a 30-year sample period as in Sloan (1996). The conclusions of this study are unchanged if observations from 1992 and 1993 are removed. 5. We use the footnoting system in COMPUSTAT that supplies supplemental information to nancial data. For example, some companies report unclassied balance sheets in either the current or prior scal year. For these companies, COMPUSTAT estimates components of working capital (footnoting item # 27), and in some cases, depreciation (footnoting item # 5) which results in elimination of 3239 rm-years. Data on scal year changes or partial year nancial statements are obtained from COMPUSTAT scal year code (FYR) or footnoting data (item # 1). We eliminate those observations that either could not be found on CRSP or had insufcient returns data on CRSP to be consistent with the sample formation in Sloan (1996). Our results are robust to inclusion of those rms eliminated due to missing or insufcient CRSP data, but otherwise having the required nancial statement data. 6. This method excludes accruals attributable to income-statement elements below operating income. Other studies using SFAS No. 95 data (e.g., Barth et al., 1999; Collins and Hribar, 2000; Xie, 2001) dene accruals as income before extraordinary items and discontinued operations minus cash ows from operations taken from the statement of cash ows to provide evidence on the differential persistence of total accruals and cash ows from operations. Faireld et al. (1996) nd that incomestatement items lower on the income statement have less predictive ability for future return on equity. Whisenant and Yohn (2002) provide evidence that the differential persistence of total accruals relative to cash ows, using statement of cash ow data, is attributable to the lower persistence of nonoperating transactions relative to operating transactions. 7. Studies document nonarticulation problems with the balance sheet approach to estimating the accrual component of earnings (Drtina and Largay, 1985; Bahnson et al., 1996; Hribar and Collins, 2002). For example, Hribar and Collins (2002) document that merger and acquisition activities, foreign currency translations, and divestitures introduce signicant measurement error into accruals estimated using the balance sheet method. Our inferences are unaffected if we eliminate the approximately 13,000 rmyears in our sample noted using the Hribar and Collins (2002) method of isolating non-articulation events. Additionally, we test the sensitivity of our results to two other potential non-articulation events: changes in accounting methods for the calculation of operating income (e.g., changes in cost ow method for cost of goods sold) and increases in goodwill for rms not excluded using the Hribar and Collins (2002) method of identifying merger and acquisition activities. This eliminated 2550 and 826 rm-years, respectively. Although our results are robust to deletion of each of these sets of nonarticulation rm-years, we report results without deleting these additional rm-years to enhance comparability with Sloan (1996) and to provide larger sample sizes for our year-by-year regressions. 8. Sloan (1996) and Faireld et al. (2003) measure protability as operating income scaled by contemporaneous average total assets. We deate by beginning-of-year net operating assets instead of contemporaneous average total assets for two reasons. First, since our income measure is operating income, we use net operating assets as the denominator to ensure that operating income is measured relative to the invested capital used to generate the operating income. Second, we use beginning-ofyear net operating assets in our measure of protability so that only observable growth in net operating assets is included in the denominator of RNOA. The use of net operating assets at the beginning of the scal year is consistent with recent research (e.g., Penman and Zhang, 2002; Richardson et al., 2001). Tests of robustness using other deators are discussed in Section 5.

242

FAIRFIELD, WHISENANT AND YOHN

9. We label the variable OPINC even though it is deated by NOAt1 since the explanatory variables are deated by the same variable. 10. Taxes payable and deferred taxes are removed since operating income excludes tax expense. The income measure also excludes interest expense suggesting that interest payable should also be excluded. Interest accruals arising from differences between periodic interest payments and recorded interest expense are recorded in the net book value of debt and are, therefore, excluded from the estimate of accruals. However, interest accruals arising due to timing differences at scal year-end are reported in COMPUSTAT in either debt in current liabilities, or current liabilities-other. When reported in debt in current liabilities, they are appropriately excluded from accruals. When reported in current liabilities-other, the interest accrual is incorrectly included in accruals. Our results are robust to the exclusion of other current liabilities excluding accrued expenses in the estimate of accruals. 11. We also calculated the correlations after deleting observations in which the numerator of the variable is more than 300% of the denominator. The results are similar to those reported, although the Pearson correlations are more similar to the Spearman correlations when these observations are deleted. We also ran all the regression analyzes after deleting these observations. The results are similar to those reported in the tables. In addition, we ran the analyses after deleting the top and bottom one percent of the observations for each variable. Again, the results are similar to those reported in the tables. 12. We also ran a regression with ACCt1 and CFOt1 (scaled by NOAt1 ) included as explanatory variables in the model in addition to ACCt and CFOt . These results show that ACCt is signicantly more persistent than CFOt and there is no signicant difference in the persistence of ACCt1 and CFOt1 for operating income in year t 2. 13. When all rms are included in the analysis, the results are comparable to those reported in Table 4. 14. Barth and Kallapur (1996) also suggest including an intercept and an explanatory variable equal to 1 divided by the scalar in the regression model. Our results are robust to this alternative specication.

References
Bahnson, P., P. Miller and B. Budge. (1996). Nonarticulation in Cash Flow Statements and Implications for Education, Research, and Practice. Accounting Horizons 10, 115. Barth, M., W. Beaver, J. Hand and W. Landsman (1999). Accruals, Cash Flows, and Equity Values. Review of Accounting Studies 4, 205229. Barth, M., D. Cram and K. Nelson. (2001). Accruals and the Prediction of Future Cash Flows. The Accounting Review 76, 2758. Barth, M. and S. Kallapur. (1996). The Effects of Cross-sectional Scale Differences on Regression Results in Empirical Accounting Research. Contemporary Accounting Research 13, 527567. Beaver, W. and M. McNichols. (1998). The Characteristics and Valuation of Loss Reserves of Property Casualty Insurers. Review of Accounting Studies 3, 7395. Bernstein, L. (1993). Financial Statement Analysis. 5th ed. Homewood, IL: Irwin. Burgstahler, D. and I. Dichev. (1997). Earnings Management to Avoid Earnings Decreases and Losses. Journal of Accounting and Economics 24, 99126. Collins, D. and P. Hribar. (2000). Earnings-based and Accrual-based Market Anomalies: One Effect or Two? Journal of Accounting and Economics 29, 101123. Desai, H., S. Rajopal and M. Venkatachalam. (2002). Value-glamour and Accruals Mispricing: One Anomaly or Two? Working Paper, Southern Methodist University. Drtina, R. and J. Largay. (1985). Pitfalls in Calculating Cash Flows from Operations. The Accounting Review 60, 314326. Erickson, M. and S. Wang. (1999). Earnings Management by Acquiring Firms in Stock for Stock Mergers. Journal of Accounting and Economics 27, 149176. Faireld, P., R. Sweeney and T. Yohn. (1996). Accounting Classication and the Predictive Content of Earnings. The Accounting Review 71, 337355.

THE DIFFERENTIAL PERSISTENCE OF ACCRUALS AND CASH FLOWS

243

Faireld, P., S. Whisenant and T. Yohn. (2003). Accrued Earnings and Growth: Implications for Future Protability and Market Mispricing. The Accounting Review 78, 353371. Faireld, P. and T. Yohn. (2001). Using Asset Turnover and Prot Margin to Forecast Changes in Protability. Review of Accounting Studies 6, 371386. Givoly, D. and C. Hayn. (2000). The Changing Time-series Properties of Earnings, Cash Flows and Accruals: Has Financial Reporting Become More Conservative? Journal of Accounting and Economics 29, 287320. Hribar, P. and D. Collins. (2002). Errors in Estimating Accruals: Implications for Empirical Research. Journal of Accounting Research 40, 105134. Jansen, I. and T. Yohn. (2002). Using Changes in Asset Turnover as a Signal of Potential Earnings Management. Working Paper, Georgetown University. Jones, J. (1991). Earnings Management During Import Relief Investigations. Journal of Accounting Research 29, 193228. Kothari, S. P. (2001). Capital Markets Research in Accounting. Journal of Accounting and Economics 31, 105232. Lakonishok, J., A. Shleifer and R. Vishny. (1994). Contrarian Investment, Extrapolation, and Risk. Journal of Finance 49, 15411578. McNichols, M. (2000). Research Design Issue in Earnings Management Studies. Journal of Accounting and Public Policy 19, 313345. McNichols, M. and P. Wilson. (1988). Evidence of Earnings Management from the Provision for Bad Debts. Journal of Accounting Research 26, 131. Penman, S. and X. Zhang. (2002). Modeling Sustainable Earnings and P/E Ratios Using Financial Statement Information. Working Paper, Columbia University. Petroni, K. (1992). Optimistic Reporting in the Property-casualty Insurance Industry. Journal of Accounting and Economics 15, 485508. Richardson, S., R. Sloan, M. Soliman and I. Tuna. (2001). Information in Accruals about the Quality of Earnings. Working Paper, University of Michigan. Sloan, R. (1996). Do Stock Prices Fully Reect Information in Accruals and Cash Flows about Future Earnings? The Accounting Review 71, 289315. Tarpley, R. (2000). Protability of Information Contained in the Accrual Component of Earnings. Working Paper, George Washington University. Whisenant, S. and T. Yohn. (2002). Do Measurement Errors in Accruals and Cash Flows Explain the Differential Persistence of Income Components? Working Paper, Georgetown University. White, H. (1980). A Heteroskedasticity-consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity. Econometrica 48, 817838. Xie, H. (2001). The Mispricing of Abnormal Accruals. The Accounting Review 76, 357373.