Intangible Investments, Scaling, and the Trend in the Accrual–Cash Flow Association

• Published date: 01 September 2022
• Author: JEREMIAH GREEN,HENOCK LOUIS,JALAL SANI
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/1475-679X.12414

DOI: 10.1111/1475-679X.12414

Journal of Accounting Research

Vol. 60 No. 4 September 2022

Printed in U.S.A.

Intangible Investments, Scaling, and

the Trend in the Accrual–Cash Flow

Association

JEREMIAH GREEN ,∗HENOCK LOUIS,†AND JALAL SANI‡

Received 9 June 2020; accepted 6 September 2021

ABSTRACT

We provide evidence that the documented weakening of the accrual–cash

flow association results not from a loss of accrual accounting usefulness per

se, but from the deviation from accrual accounting as it relates to intangi-

ble investments. More specifically, the weakening of the negative association

is driven by the combined effects of (1) increasing intangible investments,

(2) the practice of expensing rather than capitalizing intangible investments,

and (3) scaling accruals and cash flows by book value of assets, which are un-

derstated for intangible-intensive firms. Treating intangible expenditures as

capitalized investments and scaling accruals and cash flows by market value

of equity, which reflects the value of intangible investments, (1) substantially

∗Texas A&M University; †Penn State University; ‡University of Illinois

Accepted by Rodrigo Verdi. We thank an anonymous referee, an anonymous associate ed-

itor, Rachel Flam, Kurt Gee, Dan Givoly, John Hand, Brad Hepfer, Hannah Judd, Hal White,

workshop participants from the Chinese University of Hong Kong and Penn State, and PhD

students at Penn State for helpful discussions and comments. Jeremiah Green thanks Ernst &

Young for its generous financial support. All errors are our own. An online appendix to this

paper can be downloaded at http://research.chicagobooth.edu/arc/journal-of-accounting-

research/online-supplements.

Email: jgreen@mays.tamu.edu

1551

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

1552 j. green, h. louis, and j. sani

strengthens the negative association between accruals and cash flows and (2)

practically eliminates the apparent weakening trend in the association.

JEL codes: E22, G14, M40, M41, O3

Keywords: accruals; accrual accounting; accrual quality; cash flows; capital-

ization; earnings quality; intangible capital; intangible investments; scaling

by book value of assets

1. Introduction

We re-examine the notion that the association between cash flows and ac-

cruals has been weakening and has become essentially zero in recent years.

Prior studies postulate and document a negative association between the

two components of earnings (Dechow [1994], Dechow, Kothari, and Watts

[1998]). These studies suggest that the negative association arises from the

role of accrual accounting in smoothing the temporary timing differences

in operating cash flows to produce a summary measure of performance

(i.e., accruals-based earnings) that is less noisy than cash flows in predict-

ing a firm’s future expected cash flows. However, Bushman, Lerman, and

Zhang [2016] find that the association between assets-scaled accruals and

assets-scaled cash flows has been declining, with the association practically

disappearing in recent years.1

As noted by Bushman, Lerman and Zhang [2016], the decline in the

cash flows and accruals association could be evidence of a dramatic decline

in the smoothing (or timing) role of accruals. Accordingly, the disappear-

ance of the association could suggest that accruals-based financial report-

ing has become less useful in assessing the amount, timing, and uncertainty

of future expected cash flows, which is an important objective of financial

reporting, as stated by the Financial Accounting Standards Board (FASB

[1978, 2010]). The disappearance of the association could also call into

question the effectiveness of a variety of accrual and earnings quality mod-

els that rely on this association. For instance, Bushman, Lerman and Zhang

[2016, p. 45] “question the meaning of the estimation of residual accruals”

measured using the Dechow and Dichev [2002] model, which is commonly

used in accounting research. Specifically, they argue that, “[if] cash flows

explain little of the variation in accruals, then the residual is basically ac-

cruals and the variance of residual accruals is equivalent to the variance

of accruals, which does not seem to be a useful way to assess accounting

quality.”

We provide a nuanced interpretation of the trend in the accrual–

cash flow association and show that the concern about the usefulness of

1Bushman et al. [2016] conclude that “increases in non-timing-related accrual recognition,

as proxied by one-time and non-operating items and the frequency of loss firm-years, explain

the majority of the overall decline … [and that] temporal changes in the matching between

revenues and expenses, and the growth of intangible-intensive industries play only a limited

role in explaining the observed attenuation” (p. 41).

intangible investments and the accrual-cash flow 1553

accounting arising from the trend in the association is likely unwarranted.

We posit that the apparent weakening accrual–cash flow association does

not necessarily result from a loss of accruals accounting usefulness per se

but instead arises from a deviation from accrual accounting, as it relates to

intangible investments, and a specific design choice made by researchers.

Specifically, we identify three factors that interact to induce the decline

in the association between assets-scaled accruals and assets-scaled cash

flows: (1) the unprecedented increase in firm intangible intensity (Corrado

and Hulten [2010]); (2) the current accounting treatment of intangible

investments, which are expensed rather than being capitalized;2and (3)

deflating the net income components (accruals and cash flows) by assets,

as opposed to market value of equity—the corresponding balance sheet

summary number for net income that also reflects the value of intangible

investments. We argue that these factors could introduce enough noise in

the scaled accrual and cash flow measures to drive their association to zero.3

Consistent with our argument, the evidence indicates that adjusting the

scaled accrual and cash flow measures by capitalizing intangible invest-

ments (numerator adjustment) and using market value of equity, which

reflects the value of intangible investments, as the deflator (denominator

adjustment) are sufficient to fully explain the weakening trend in the

accrual–cash flow association. The trend weakens when we adjust the nu-

merator for the expensing of intangible investment, switch the deflator

from book assets to book equity, or adjust book equity for intangible in-

vestments by using the market value of equity. The numerator adjustment

or the denominator adjustment alone is not sufficient to fully explain the

apparent declining trend in the accruals and cash flows association. How-

ever, the trend totally disappears after we make both the numerator and

the denominator adjustments.

We conduct various tests that, combined, strongly support the interpre-

tation that the disappearance of the weakening trend in the accrual–cash

flow association is due to our adjustments for the effects of intangible in-

vestments. First, we find that the association between assets-deflated accru-

als and cash flows is significantly weaker for high-intangible intensity firms

than for low-intangible intensity firms. However, this intangible-intensity

2U.S. GAAP requires firms to immediately expense most of their intangible investments on

the income statement. For example, U.S. GAAP requires that a firm’s R&D investments be

expensed in the period in which they are incurred. This accounting treatment is influenced

by the standard setters’ perceived high degree of uncertainty regarding the future economic

benefits of R&D investments (Kothari et al. [2002]). Advertising investments to build brand

capital are also expensed in the period in which they are incurred. Prior research has exten-

sively explored the accounting treatment of intangible investments and highlighted the poten-

tial flaw in accounting standards that require the expensing of investments in intangible assets

(e.g., Kothari et al. [2002], Lev and Sougiannis [1996], Lev, Sarath, and Sougiannis 2005).

Not surprisingly, some academics continue to raise concerns about the U.S. GAAP accounting

for intangibles (Lev [2018]).

3We provide detailed explanations for our arguments in the next section.