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JOURNALOF ELSEVIER Journal of Accounting and Economics 18 (1994) 3-42 Accounting Accounting &Economics earnings and cash flows as measures firm performance The role of accounting accruals Patricia of M. Dechow Wharton School, University of Pennsylvania, Philadelphia, PA 19104-6365, USA (Received October 1992; final version received September 1993) Abstract This paper investigates circumstances under which accruals are predicted to improve earnings’ ability to measure firm performance, as reflected in stock returns. The importance of accruals is hypothesized to increase (i) the shorter the performance measurement interval, (ii) the greater the volatility of the firm’s working capital requirements and investment and financing activities, and (iii) the longer the firm’s operating cycle. Under each of these circumstances, cash flows are predicted to suffer more severely from timing and matching problems that reduce their ability to reflect firm performance. The results of empirical tests are consistent with these predictions. Key words: Capital markets; Accruals; Operating Summary measures of performance JEL classification: cycle; Timing and matching problems; C52; G14; M41 I am grateful for the encouragement and guidance from Ross Watts, Ray Ball, S.P. Kothari, Jay Shanken and Jerry Zimmerman (the editor). This paper has benefited from Sudipta Basu, Fischer Black, Michele Daley, Neil Fargher, Stephen Fisher, Bob Holthausen, Krishna Palepu, Terry Shevlin, Amy Sweeney, and Peter Wilson. I am also grateful to Dan Collins (the referee) and Richard Sloan for many insightful comments and to Philip Kearns for his help on nonnested model selection techniques. The paper has benefited from workshop participants at University of Chicago, Columbia University, Harvard University, Massachusetts Institute of Technology, University of Michigan, Northwestern University, University of Rochester, Wharton School of the University of Pennsylvania, and Yale University. 0165-4101/94/$07.00 0 SSDI 016541019400356 1994 Elsevier Science B.V. All rights reserved A 4 P.M. Dechow / Journal of Accounting and Economics 18 (1994) 3-42 1. Introduction Earnings are the summary measure of firm performance produced under the accrual basis of accounting. Earnings are important since they are used as a summary measure of firm performance by a wide range of users. For example, they are used in executive compensation plans, in debt covenants, in the prospectuses of firms seeking to go public, and by investors and creditors. The objective of this paper is to better understand the role of accruals in producing earnings as one of the key outputs of the accounting process. Specifically, the paper examines how accruals improve earnings’ ability to reflect firm performance and the circumstances in which accruals are important in performing this role. The view adopted in this paper is that the primary role of accruals is to overcome problems with measuring firm performance when firms are in continuous operation. Information asymmetries between management and other contracting parties create a demand for an internally generated measure of firm performance to be reported over finite intervals. This measure can be used to contract and recontract as well as to evaluate and reward management. The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. Therefore, one performance measure that could be used is net cash receipts (realized cash flows). However, over finite intervals, reporting realized cash flows is not necessarily informative. This is because realized cash flows have timing and matching problems that cause them to be a ‘noisy’ measure of firm performance. To mitigate these problems, generally accepted accounting principles have evolved to enhance performance measurement by using accruals to alter the timing of cash flows recognition in earnings. Two important accounting principles that guide the production of earnings are the revenue recognition principle and the matching principle. The revenue recognition principle requires revenues to be recognized when a firm has performed all, or a substantial portion, of services to be provided and cash receipt is reasonably certain. The matching principle requires cash outlays associated directly with revenues to be expensed in the period in which the firm recognizes the revenue. By having such principles, the accrual process is hypothesized to mitigate timing and matching problems inherent in cash flows so that earnings more closely reflects firm performance. The view that accruals will improve the ability of earnings to measure firm performance is expressed by the FASB. For example, Statement of Financial Accounting Concepts No. 1, paragraph 44 states: ‘Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than does information about current cash receipts and payments.’ P.M. Dechow / Journal of Accounting and Economics 18 (1994) 3-42 5 However, the use of accruals introduces a new set of problems.’ Management typically have some discretion over the recognition of accruals. This discretion can be used by management to signal their private information or to opportunistically manipulate earnings. Signaling is expected to improve the ability of earnings to measure firm performance since management presumably have superior information about their firm’s cash generating ability (Holthausen and Leftwich, 1983, Watts and Zimmerman, 1986, Holthausen, 1990, and Healy and Palepu, 1993). Therefore, a credible signal will reduce information asymmetry and result in more efficient contracting. However, to the extent that management use their discretion to opportunistically manipulate accruals, earnings will become a less reliable measure of firm performance and cash flows could be preferable. This alternative view of accrual accounting is often expressed in the popular press: ‘Many financial analysts regard operating cash flow as a better gauge of corporate financial performance than net income, since it is less subject to distortion from differing accounting practices’ (Chemical Week, May 8, 1991, p. 28). ‘A growing number of portfolio managers and analysts insist that cash flows is a more meaningful measure of a company’s value than reported earnings’ (Institutional Investor, August 1988, p. 55). Therefore, it is an empirical question as to whether the net effect of accruals is to improve or reduce the ability of earnings to measure firm performance. The concern that management will use their information advantage to opportunistically manipulate accruals is consistent with the allowable set of accruals being limited by accounting conventions (Watts and Zimmerman, 1986). Accounting conventions, such as objectivity, verifiability and the use of the historical cost valuation model, limit the flexibility of management to manipulate revenue and expense recognition. In the absence of problems with information asymmetries, such conventions would be dysfunctional since they place a constraint on earnings’ ability to reflect firm performance. However, since management manipulation is not always detectable (at least over short measurement intervals), contracting parties desire a performance measure that is reliable (and verifiable by auditors) so that there are bounds on the manipulation that can occur. The accrual process is therefore the result of a trade-off between relevance and reliability (Ball, 1989; Watts and Zimmerman, 1986, p. 206; Statement of Financial Accounting Concepts No. 2, paragraph 90). This suggests that earnings will also suffer from timing and matching problems over short time intervals but to a lesser extent than realized cash flows. ‘The term accrual is used in a general sense and includes both accruals and deferrals. 6 P.M. Dechow / Journal of Accounting and Economics 18 (1994) 3-42 In this paper, the empirical tests use stock price performance as the benchmark against which to compare realized cash flows and earnings. Stock prices are viewed as encompassing the information in realized cash flows and earnings concerning firm performance. The paper makes predictions concerning problems with realized cash flows and how earnings overcomes these problems through the use of accruals. Therefore, the focus of the tests is to assess the ability of each measure to reflect firm performance in their realized form (as opposed to their innovative or unexpected form). Existing research has generally focused on determining whether the unexpected component of earnings or cash flows can incrementally explain abnormal stock returns (Bowen, Burgstahler, and Daley, 1987; Livnat and Zarowin, 1990). The results are generally consistent with both cash flows and earnings providing incremental information vis-a-vis one another. However, these tests do not directly address the question of which measure is a relatively superior summary measure of firm performance given the choice of one. This is of interest since it is rare to observe the use of both earnings and cash flows in contracts. For example, the Sibson & Company’s (1991) survey indicates that earnings are almost universally used in executive compensation contracts. Few firms use both earnings and cash flows to assess management performance. The purpose of this paper is to examine why earnings is the most frequently used summary measure of firm performance. Research by Rayburn (1986), Wilson (1986, 1987) and Bernard and Stober (1989) examines whether unexpected cash flows and accruals are significant in a regression where abnormal stock returns are the dependent variable. The results of Rayburn and Wilson are consistent with both components having incremental information, while Bernard and Stober find little evidence of either component having incremental information. As the focus of these studies is to test for information content, they do not directly assess whether reported earnings is a superior summary measure to realized cash flows. To do this, it is necessary to demonstrate that setting the coefficient on reported accruals and realized cash flows to be equal results in a better specified model than constraining the coefficient on reported accruals to zero. The evidence to date is ambiguous (Jennings, 1990).2 This study builds on existing research by (i) formally establishing that earnings is a superior summary measure of firm performance, (ii) demonstrating the role of accruals in mitigating temporary matching problems in cash flows, and (iii) identifying the determinants of timing and matching problems in cash flows, thus highlighting the circumstances under which accruals play a more important role in measuring firm performance. ‘Earnings is the aggregate of cash flows and accruals (i.e., earnings = cash flows + accruals). Therefore, earnings places equal weights on both components. If cash flows have incremental information over earnings, then this implies that the coefficients on accruals and cash flows are not equal (and vice versa). Biddle and Seow (1992) discuss in detail incremental information content versus relative explanatory power. P.M. Dechow 1 Journal of Accounting and Economics 18 (1994) 3-42 I The paper predicts that for firms in steady state (i.e., firms with cash requirements for working capital, investments, and financing that are relatively stable), cash flows have few timing and matching problems and are a relatively useful measure of firm performance. However, for firms operating in volatile environments with large changes in their working capital and investment and financing activities, cash flows will have more severe timing and matching problems. Thus, cash flows’ ability to reflect firm performance will decline as the firms’ working capital requirements and investment and financing activities increase. Accruals are predicted to mitigate timing and matching problems in cash flows. As a consequence, earnings are predicted to better reflect firm performance than cash flows, in firms with more volatile operating, investment and financing activities. The paper also predicts that cash flows and earnings will be equally useful in industries with short operating cycles. However, in industries with long operating cycles, cash flows are predicted to be a relatively poor measure of firm performance. The results are consistent with these predictions. Finally, the paper provides evidence on the relative importance of various accrual components. In particular, working capital accruals are demonstrated to be more important for mitigating timing and matching problems in cash flows than long-term operating accruals. Meanwhile, the class of special item accruals that are made primarily in response to previous over- or understatements of accruals are shown to reduce the ability of earnings to reflect firm performance. The next section develops the research hypotheses and discusses the use of stock returns as the benchmark measure of firm performance. Section 3 provides details on sample selection and variable measurement. Section 4 presents the results of the empirical tests, and Section 5 concludes. 2. Testable predictions The existence of information asymmetries between the firm’s managers and outside parties contracting with the firm creates a demand for a summary measure of firm performance. This measure can be used to evaluate management and as a source of information to investors and creditors on the firm’s cash generating ability. The problem faced by contracting parties is that although management is the most informed party to report on the firm’s performance, they are also evaluated and rewarded based on the firm’s performance. Therefore, in the absence of objective procedures to determine performance, external parties have difficulty assessing the reliability of signals produced by management. On the one hand, contracting parties could demand that managers report realized cash flows. These can be objectively measured but are influenced by the timing of cash receipts and disbursements. For example, management would be penalized for purchasing inventory (above beginning inventory levels) even if 8 P.M. Dechow / Journal of Accounting and Economics I8 (1994) 3-42 this was a positive net present value decision. On the other hand, management could attempt to determine the firm’s expected future cash flows. This, however, would provide management with so much reporting flexibility that any signal produced would be difficult to verify and would result in an unreliable measure of firm performance. The accrual process can be viewed as trading off these two problems when producing earnings. The accrual process provides rules on the timing of cash flow recognition in earnings so that earnings will more closely reflect firm performance than realized cash flows. However, accruals are also required to be objective and verifiable. For example, expenditures can only be capitalized when there is objective and verifiable evidence that the cash flows will be realized. Requiring objectivity and verifiability limits management’s discretion. This will reduce the usefulness of reported earnings in circumstances where management has private information concerning firm performance and could reveal this information through reported earnings. However, this will also reduce the possibility that management can provide false information for a private gain. If existing accruals are the outcome of efficient contracting, then accruals, on average, will improve the ability of earnings to measure firm performance relative to realized cash flows. Alternatively, if the dominant effect of accruals is to provide management with flexibility to manipulate earnings, then realized cash flows will provide a relatively more useful summary measure of firm performance over short measurement intervals. 2.1. Measurement interval predictions This study compares the ability of earnings relative to net cash flows and cash from operations to reflect firm performance. Net cash flows will fluctuate with cash inflows and outflows associated with the firm’s investment and financing activities as well as the firm’s operating activities. Net cash flows have no accrual adjustments and are hypothesized to suffer severely from timing and matching problems (see Appendix 1). Cash from operations reflects the net cash flows generated by the firm’s operating activities. This measure includes accruals that are ‘long-term’ in nature (i.e., do not reverse within one year) and mitigate timing and matching problems associated with the firm’s investment and financing activities. However, cash from operations exclude accruals associated with changes in firms’ working capital requirements. Earnings contain accruals that mitigate the timing and matching problems associated with firms’ operating, investment, and financing cash flows. Therefore, earnings are predicted, on average, to be a more useful measure of firm performance than either cash flow measure. This generates the first prediction: Hypothesis 1. There is a stronger contemporaneous association between stock returns and earnings than between stock returns and realized cashjows over short measurement intervals. 9 P.M. Dechow 1 Journal of Accounting and Economics I8 (1994) 3-42 A short measurement interval is defined increasing the time interval over which years). Over longer intervals, cash flows matching problems and so the importance over longer intervals, earnings and realized as measures of firm performance (assuming the direction of convergence: Hypothesis 2. The contemporaneous as one quarter or one year. Consider performance is measured (e.g., four will suffer from fewer timing and of accruals diminishes. Therefore, cash flows are expected to converge clean surplus). Hypothesis 2 predicts association of stock returns with realized association of stock returns interval is increased. cash Jlows improves relative to the contemporaneous with earnings as the measurement The alternative hypothesis is that due to the manipulation of accruals, cash flows are superior to earnings over short intervals. Under the alternative hypothesis, earnings will improve relative to cash flows over longer measurement intervals. Note, however, that the ability of earnings to reflect firm performance is also expected to improve over longer measurement intervals (Easton, Harris, and Ohlson, 1992; Warfield and Wild, 1992). Generally accepted accounting principles trade off relevance and reliability so that accruals do not completely mitigate all short-term timing and matching problems in realized cash flows. An empirical investigation of Hypothesis 2 can provide insights into the economic importance of accruals. Evidence that cash flows’ ability to reflect firm performance is poor over intervals that are commonly used to report firm performance and converge to that of earnings only over long measurement intervals, would confirm the economic importance of accruals. 2.2. Cross-sectional predictions Consider the following simplified example of a firm with only one accrual, accounts receivable. [For a more comprehensive model of accruals the reader is referred to Jones (1991).] Let = cash collected in accounting period t; = revenues generated from sales made during accounting period t; of accounting period t - 1 sales for which cash is not colleccp = proportion ted until the next accounting period t; cp is assumed constant for each accounting period and all cash is collected by t. C, S, Now C,=(l-cp)S,+cpS,-1. (1) 10 P.M. Dechow / Journal of Accounting and Economics 18 (1994) 3-42 Thus, earnings will differ from realized cash flows in each period to the extent that (i) credit sales are excluded from realized cash flows and (ii) realized cash flows include collections from the previous period’s credit sales. Eq. (1) can provide insights into determinants of cross-sectional variation in the usefulness of accruals. If a steady-state firm is defined as one that is neither growing nor declining (i.e., neither increasing nor reducing sales), then this implies that S, = S,_ 1. Substituting S, for S,_ 1 in Eq. (1) reveals that C, = S,. Therefore, in a steady-state firm there will be no difference between the numbers reported under a cash system or an accrual system and accruals are less important. Consider instead the case of a firm that has the same sales in period t - 1 to the steady-state firm but has an increase (or decrease) in sales in period t. In this case S, # S,_ 1 and: S, - C, = cpdS,, where AS, = (S, - S,_J. (2) Eq. (2) reveals that the magnitude of the difference between revenues and cash flows for any period will be greater (i) the larger cp(i.e., the proportion of sales on credit) and (ii) the larger the magnitude of the change in revenues (AS,). Alternatively stated, the difference between earnings and cash flows is increasing in the absolute magnitude of the change in the balance of accounts receivable, cpdS, , over the period. This analysis highlights where accruals are expected to play an important role in measuring firm performance. The accrual process is most important for firms that have had large changes in the net balance of their noncash accounts. Consider for example, a ship building firm that obtains a lucrative construction contract. The construction takes several accounting periods and the payment by the customer occurs on completion of the contract. Under generally accepted accounting principles, revenue recognition for this contract is based on an engineer’s estimate of the degree of completion. If cash collection is reasonably certain, then the actual timing of the cash collection is not relevant for reporting purposes. Realized cash flows for the firm could easily be negative in the early periods because of purchases required for the construction contract. Revenues on the other hand (through an increase in accounts receivable) are positive, and the application of the matching principle will lead to positive earnings. Thus, earnings will better reflect the contract’s value and indicate that the firm has performed well in each of the periods. This highlights an important feature of the accrual process. If accruals reduce timing and matching problems in cash flows, then earnings are expected to reflect relatively more value-relevant events when earnings and cash flows differ by the greatest magnitude. While the analysis focuses on accounts receivable, it is readily generalizable to aggregate accruals (the net change in noncash accounts). When aggregate accruals are large in magnitude (either positive or negative) earnings will more closely reflect firm performance than realized cash flows. Eq. (2) suggests that cash flows are not a poor measure of firm performance for firms that are in P.M. De-chow / Journal of Accounting and Economics 18 (1994) 3-42 11 steady state. However, when firms undertake new investment and financing activities or experience large changes in their working capital requirements (when cpdS, is large in absolute magnitude), realized cash flows are expected to be a relatively poor measure of firm performance. Under such circumstances, realized cash flows suffer from timing and matching problems and are less able to reflect firm performance. Accruals are expected to reduce these problems in earnings. This leads to the following hypothesis: Hypothesis 3. The larger the absolute magnitude of aggregate accruals made by a jirm, the lower the contemporaneous association between stock returns and realized cash$ows relative to the association between stock returns and earnings. The fourth hypothesis predicts the type of firms for which the volatility of accruals will be large and hence realized cash flows will be a poor measure of firm performance. Eq. (2) reveals that the change in accounts receivable, cpdS,, is composed of two components, cp and AS,. Therefore, the magnitude of accruals is larger, the greater the change in the level of sales, AS,, and the larger the proportion of sales on credit, p. Generalizing from sales, S, can proxy for the level of operating activity and cp can proxy for the length of the operating cycle. The operating cycle measures the average time elapsing between the disbursement of cash to produce a product and the receipt of cash from the sale of the product. Firms with longer operating cycles are expected to have larger working capital requirements for a given level of operating activity. Therefore, in firms with longer operating cycle, a given change in the level of operating activity (AS,) is expected to translate into a larger change in the required level of working capital (cpdS,). Thus, the length of the operating cycle is predicted to be an underlying determinant of the volatility of working capital. Cash from operations excludes accruals relating to the firm’s operating activities. Hence the ability of cash from operations to measure firm performance is expected to decline as the length of the operating cycle increases. This leads to the following hypothesis: Hypothesis 4. The longer a jirm’s operating cycle, the more variable the jirm’s working capital requirements and the lower the contemporaneous association between stock returns and realized cash$ows. Working capital accruals are hypothesized to reduce the timing and matching problems inherent in cash from operations. Hence, the ability of earnings to reflect firm performance is not expected to be as sensitive to the length of the operating cycle. Finally, the paper investigates several components of accruals. Although, on average, accruals are predicted to improve earnings’ ability to reflect firm performance, certain components are hypothesized to be less important in 12 P.M. Dechow / Journal of Accounting and Economics 18 (1994) 3-42 performing this role. The first test compares short-term working capital accruals to long-term operating accruals. Working capital accruals such as accounts receivable and inventory have existed for centuries (Littleton, 1966). If accruals evolved to mitigate timing and matching problems in cash flows, then these accruals are predicted to mitigate the more severe timing and matching problems. In contrast, Watts (1977) and Watts and Zimmerman (1979) argue that more recent long-term operating accruals (such as depreciation) are influenced by the political process and so the motivation for their inclusion in earnings is less clear.3 Therefore, the association of cash from operations with stock returns is predicted to be less sensitive to the magnitude of long-term operating accruals. The second test investigates special items. Special items represent the cumulative effect of previous under- or overstatement of accruals. Prior to APB No. 30 these items were predominantly classified as ‘extraordinary’ since they are nonrecurring in nature and are not expected to be relevant for measuring current performance (e.g., Nichols, 1974; Barnea, Ronen, and Sadan 1975). However, management had discretion to determine what special items would be classified as ‘extraordinary’ and therefore excluded from earnings (from continuing operations). This discretion was perceived to be used by management to manipulate earnings.4 APB No. 30 reduced the discretion of management by requiring that special items flow through income from continuing operations so that ‘clean surplus’ is maintained and cumulative earnings is measured objectively. Therefore, special items are an accrual adjustment that is predicted to reduce earnings’ ability to reflect firm performance. 2.3. Stock returns as u benchmark measure of firm performance This paper assumes that stock markets are efficient in the sense that stock prices unbiasedly reflect all publicly available information concerning firms’ expected future cash flows. Therefore, stock price performance is used as a benchmark to assess whether earnings or realized cash flows better summarize this information. Earnings, realized cash flows, and stock prices are each scaled s Accrualsthat are the outcome of the political process will not necessarily reduce earnings’ ability to measure firm performance. Many transactions that result in these accruals did not occur prior to regulation. Therefore, the same procedures may have evolved in an unregulated environment and be consistent with the objectives of contracting parties (see also Ball, 1989). 4See for example, ‘Accounting Panel seen curbing the use of special items’, Wall Street Journal, March 15, 1973, p. 2, that notes ‘critics contend the proliferation of special items has confused investors and enabled corporate managements to gloss over bad business decisions. Too often, they charge, routine losses are allowed to pile up. Then, when finally written off as an ‘extraordinary’ loss, the write-off is inflated, sweeping all the ‘garbage’ off the books and setting up a healthy profit rebound.’