Changes in accrual properties and operating environment: Implications for cash flow predictability

• Published in: Journal of accounting & economics 2020-04, Vol.69 (2-3), p.101313, Article 101313
• Main Authors: Nallareddy, Suresh, Sethuraman, Mani, Venkatachalam, Mohan
• Format: Article
• Language: English
• ISSN: 0165-4101; 1879-1980
• DOI: 10.1016/j.jacceco.2020.101313

This paper reconciles conflicting evidence in prior literature on the relative ability of earnings and cash flows in predicting future cash flows. Further, we investigate the implications of temporal shifts in accrual properties and operating environment for cash flow predictability. Three key insights emerge. First, cash flows consistently outperform earnings in predicting future cash flows. Second, accruals and its components, including those capturing non-articulating events, have incremental (albeit small) predictive ability over cash flows. Third, earnings’ ability to predict future cash flows has increased over the period 1989–2015, due to changes in operating environment rather than accrual properties. •We reconcile the mixed evidence in prior literature on the relative ability of earnings and cash flows in predicting future cash flows. We document that the conflicting evidence is attributable to differences in the manner in which cash flows are measured.•Operating cash flows outperform earnings in predicting future operating cash flows every year over the last two decades, both in the US and internationally.•Accruals and its components, including those capturing non-articulating events, exhibit incremental predictive ability over current operating cash flows. Thus, our study sheds new light on interpreting prior research by Hribar and Collins (2002) on accrual measurement.•Earnings' ability to predict future operating cash flows is increasing over the period 1989–2015. However, this trend is attributable to the increasing predictive ability of operating cash flows rather than accruals.•Shortening operating cycles, decreasing levels of non-cash working capital, and increasing intensity of intangibles over time explain the increasing trend in cash flow predictability.