On the Relationship between Accruals and Cash Flows: Earnings as a Confounding Variable.

• In Event: Strategic Disclosures 1

Abstract

Bushman, Lerman, and Zhang (2016) present remarkable evidence contradicting the long held-notion that accruals and cash flows are negatively correlated, reporting that the overall correlation and explanatory power have largely disappeared in recent years. We postulate that the absence of a consistent negative correlation is due the lack of consideration that there exists a “confounding” variable (Elwert and Winship 2014), namely, earnings. We demonstrate that, once we control for earnings by conditioning the accrual-cash flow regressions based on earnings on a portfolio basis, the negative correlation and explanatory power resurface in a strong and consistent manner. We present a framework that helps understand the accrual-cash flow relationship in the context of basic accounting principles on income recognition. This framework also helps connect the phenomenon of increasing earnings volatility and correlation between earnings and cash flows to deteriorating explanatory power of the accrual-cash flow models over the past five decades.

Authors

• Sok-Hyon Kang, George Washington University

• HYUN JONG NA, George Washington University

• Seunghee Yang, Seoul National University