Back to Fundamentals: The Accrual–Cash Flow Correlation, the Inverted-U Pattern, and Stock Returns

Abstract

Economic and reporting development factors affect the timing and non-timing roles of accruals, which in turn affect the correlation between accruals and operating cash flows (CFO). We show that the strength of the accrual anomaly varies predictably with the economic determinants of the accruals-CFO relation, including intangible intensity, the length of operating cycles, extreme positive and negative financial performance, the magnitude of the non-timing-related accruals, and firm-specific estimation of the accruals-CFO relation in a cross-section analysis. Next, using variations in the correlation between accruals and CFO, we explain several seemingly unrelated empirical regularities of the accrual anomaly. First, we explain the stronger accrual anomaly among profit firms, large-sized firms, firms with higher covariation between accruals and the employment growth rate, and firms with higher earnings response coefficients. Second, we explain the inverted U-shape relation between accruals and future stock returns in the recent two decades and the time-series decline of abnormal returns of the accrual anomaly. Third, we further demonstrate that the strength of the return predictability of components of accruals depends on the strength of the correlation between individual accrual components and CFO. Finally, we extend our analysis to a large class of accounting-based return predictors that are related to accruals, and still find stronger return predictability for firms with more negative correlations between the predicting variables and CFO.