Another look at total accruals and cash flow from operations in academic research

The separation of earnings into its accrual and cash flow components for use as explanatory variables in multivariate regressions has been applied in market return, quality of earnings, income smoothing, and cash flow versus earnings informativeness studies. Also, earnings studies have regressed year t + 1 earnings performance on year t accruals and cash flows to determine the relative informativeness of the two variables. Informativeness in these studies is determined by the statistical significance and relative magnitude of the coefficients of the independent variables. Since inferences about informativeness are based on the relative magnitude of the coefficients, the inferences are affected by the efficiency of accruals and cash flows as independent variables in the regression models. Researchers, within the scope of this study, calculate accruals and cash flows as: Total Accruals (TA) = Net Income After-Tax (NIAT) minus Cash Flow from Operations after-tax (CFO_at). Thus the formula of interest for TA and CFO is: TA=NIAT -CFOat 1 and algebraically, NIAT=TA +CFOat 2 ; This study takes an “income perspective” of TA and CFO. The income perspective exploits the concept of economic performance—the increase or decrease in claims to assets—a requirement before an accrual or cash transaction generates NIAT. Since both TA and CFO have income affecting components and non-income affecting components, I decompose TA and CFO into their income affecting and non-income affecting components. The non-income affecting components are working capital related. Other studies use non-decomposed TA and CFO, with working capital included, as explanatory variables for their market return and earnings studies. The income perspective of TA and CFO, depicted in Figure 1 and Figure 2, separates my study from other studies.*; I find that removing the working capital components from TA and CFO (Figure 2) and only using the income impact of accruals (NIAT_acc) and the income impact of cash flows (NIAT_cf) is more informative of how the market values accruals and cash flows.; *Please refer to dissertation for diagrams.