The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors

TLDR

Accruals adjust cash‑flow recognition to better measure firm performance, yet they rely on assumptions and estimates of future cash flows. The paper proposes a new measure of working‑capital accrual quality and argues that accrual and earnings quality deteriorate as estimation error increases. The authors derive an empirical accrual‑quality metric as the residuals from firm‑specific regressions of changes in working capital on past, present, and future operating cash flows. The study finds that observable firm characteristics, such as volatility of accruals and earnings, can serve as instruments for accrual quality, and that higher accrual quality is associated with greater earnings persistence.

Abstract

This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. We argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. We derive an empirical measure of accrual quality as the residuals from firm-specific regressions of changes in working capital on past, present, and future operating cash flows. We document that observable firm characteristics can be used as instruments for accrual quality (e.g., volatility of accruals and volatility of earnings). Finally, we show that our measure of accrual quality is positively related to earnings persistence.