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The Effect of Cash Flow Forecasts on Accrual Quality and Benchmark Beating

When analysts provide forecasts of both earnings and operating cash flow, they also implicitly provide a forecast of total operating accruals. Thus, cash flow forecasts enable parties external to the firm to more readily decompose an earnings surprise into the portion attributable to unexpected cash flows and a portion attributable to abnormal accruals.

We posit that cash flow forecasts increase the transparency of accrual manipulations used to manage earnings. As the transparency of opportunistic earnings management increases, so does the likelihood of restatements and regulatory interventions, which in turn, increases the expected costs to the firm and to managers of engaging in opportunistic earnings management.

As the expected costs of engaging in earnings management through accrual manipulations increase, managements’ incentives to do so are expected to decrease. Thus, we posit that by increasing the transparency of accrual manipulations, analysts’ provision of cash flow forecasts serve as an effective earnings management constraint that increases the quality of reported accruals.

We also predict that by reducing accrual manipulations, the provision of cash flow forecasts will reduce the likelihood that firms will meet or beat earnings targets. In addition, we hypothesize that when firms’ ability to manage earnings through accruals is constrained they are likely to shift to other mechanisms in an effort to achieve earnings benchmarks. Thus, we predict that the incidence of real activities management and expectations management will increase in the presence of cash flow forecasts.

The Effect of Cash Flow Forecasts on Accrual Quality and Benchmark Beating