The Changing Landscape of Accrual Accounting

• Author: X. FRANK ZHANG,ROBERT M. BUSHMAN,ALINA LERMAN
• Date: 01 March 2016
• DOI: http://doi.org/10.1111/1475-679X.12100
• Published date: 01 March 2016

DOI: 10.1111/1475-679X.12100

Journal of Accounting Research

Vol. 54 No. 1 March 2016

Printed in U.S.A.

The Changing Landscape of

Accrual Accounting

ROBERT M. BUSHMAN,

∗ALINA LERMAN,

†

AND X. FRANK ZHANG

†

Received 22 July 2014; accepted 21 October 2015

ABSTRACT

A fundamental property of accrual accounting is to smooth temporary tim-

ing fluctuations in operating cash flows, indicating an inherent negative cor-

relation between accruals and cash flows. We show that the overall correla-

tion between accruals and cash flows has dramatically declined in magnitude

over the past half century and has largely disappeared in more recent years.

The adjusted R2from regressing (changes in) accruals on (changes in) cash

flows drops from about 70% (90%) in the 1960s to near zero (under 20%)

in more recent years. In exploring potential reasons for the observed atten-

uation, we find that increases in non-timing-related accrual recognition, as

proxied by one-time and nonoperating items and the frequency of loss firm-

years, explain the majority of the overall decline. On the other hand, tempo-

ral changes in the matching between revenues and expenses, and the growth

of intangible-intensive industries play only a limited role in explaining the ob-

served attenuation. Finally, the relative decline of the timing role of accruals

∗The University of North Carolina at Chapel Hill; †Yale University.

Accepted by Douglas Skinner. We thank the editor, an anonymous referee, Ted

Christensen, Ilia Dichev, Greg Miller, and workshop participants at Florida International

University, Fordham University, Fudan University, Peking University, Tsinghua University,

University of Chicago, University of Michigan, and the 2014 AAA Meeting for helpful sug-

gestions and comments. We also acknowledge financial support from Yale University. An

online appendix to this paper can be downloaded at http://research.chicagobooth.edu/

arc/journal-of-accounting-research/online-supplements.

41

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

42 R.M.BUSHMAN,A.LERMAN,AND X.F.ZHANG

does not appear to be associated with an increase in the asymmetrically timely

loss recognition role.

JEL codes: M40; M41; G12; G14

Keywords: accrual accounting; accruals; cash flows; earnings management;

accrual quality

1. Introduction

A central role of accrual accounting is to smooth out temporary fluctu-

ations in cash flows (e.g., Dechow [1994], Dechow, Kothari, and Watts

[1998]), as accrual accounting systems recognize economic events in firms’

financial statements independently of the timing of cash flows associated

with these events.1We refer to this role as the timing role (or the smooth-

ing or noise reduction role) of accruals. By adding accruals to operating

cash flows, accrual accounting systems produce an earnings number that

should be a less noisy measure of operating performance than operating

cash flows. As Dechow [1994] points out, a central implication of the timing

role of accrual accounting is that contemporaneous accruals and cash flows

are negatively correlated. This negative correlation is often taken as given in

the literature and serves as the cornerstone of a variety of earnings/accrual

quality models (e.g., Dechow and Dichev [2002]). In this paper, we show

that the correlation between accruals and cash flows has dramatically di-

minished in magnitude over the past half century and has largely disap-

peared in more recent years.

We adopt two models to examine the overall correlation between ac-

cruals and cash flows. The first one is based on Dechow [1994] and re-

gresses total accruals on contemporaneous operating cash flows. We run

the model both in levels and in changes specifications for each year from

1964 through 2014 and examine the temporal change in the goodness of

fit measure and in the coefficient on contemporaneous cash flows. We find

that the adjusted R2drops from about 70% (90%) in the 1960s to near zero

(under 20%) in more recent years for the levels (changes) specification.

At the same time, the negative coefficient on contemporaneous cash flows

experiences a drastic increase over the years. Under the levels (changes)

specification, an increase of $1 in operating cash flows was associated with

a decrease of approximately 70 cents (90 cents) in accruals in 1960s, but

1We use the term “independently” to highlight the standard definition of accrual account-

ing as a practice of recognizing revenues when earned and expenses when incurred, with-

out regard to the time of receipt or payment of cash (Kieso, Weygandt, and Warfield [2012,

p. 121]). We abstract from the notion that cash flows may influence the recognition of rev-

enues and expenses under accrual accounting such as in situations when their presence or

absence may indicate a diminished degree of certainty regarding the estimation of future cash

flows.

THE CHANGING LANDSCAPE OF ACCRUAL ACCOUNTING 43

the effect on accruals dropped to under 10 cents (about 50 cents) in the

last 10 years. The results suggest that the overall correlation between accru-

als and cash flows has significantly diminished over the past 50 years in a

persistent and smooth manner.

The second model we use is the Dechow and Dichev [2002] regression

of total accruals on past, current, and future operating cash flows. Again,

we find a dramatic decline in the adjusted R2of the model and a smooth

increase in the coefficient on contemporaneous cash flows over the 50-year

period. The adjusted R2has dropped from about 70% in the 1960s to below

10% in the latest years, whereas the coefficient on contemporaneous cash

flows has increased from about −0.8 to −0.4 over the same time period. In

contrast, the coefficients on past and future cash flows show only a small

positive change in magnitude over time. While we use the balance sheet

approach to estimate total accruals for the early years of the sample and the

statement of cash flows approach from 1988 forward, we observe a similar

pattern of decline when carrying out our analysis with the balance sheet

approach on the full sample for consistency.

Having documented the pronounced and continuous decline in the

overall correlation between accruals and cash flows, we explore potential

reasons for this attenuation. A number of economic and accounting devel-

opments could be associated with this decline. For example, if cash flows

and economic earnings have become more volatile, reflecting increasing

economic shocks to firms’ operations, then accruals are likely to have a

weaker correlation with cash flows in the later years. A temporal increase

in the frequency of reported nonrecurring and nonoperating items and

net losses may also contribute to the attenuation of the negative correla-

tion both because these items are not often accompanied by large posi-

tive cash flows and because the accruals made in response to the underly-

ing negative shocks are likely to involve significant estimation error. The

growing prominence of firms with high intangible intensity could lead to

an increase in transactions that do not generate accruals due to immedi-

ate expensing of cash outflows. Accruals may also increasingly reflect the

timely loss recognition role, which suggests a positive correlation between

accruals and cash flows and thus attenuate the overall negative correlation.

From the accounting standards perspective, the FASB’s expansion of the

balance sheet–based model of financial reporting, in such manifestations as

the push toward fair value accounting, may have made accruals less corre-

lated with cash flows overall (without necessarily increasing the amount of

estimation errors in the accrual generating process). Overall, even though

the conceptual timing role of accrual accounting has not been changed, a

significant increase in the magnitude of other elements of accruals (e.g.,

economic-based cash flow shocks, accrual estimation errors, fair value ad-

justments, one-time and nonoperating items, timely loss recognition, net

losses, and earnings management) may lead to a decline in the extent