The Role of Accruals in the Prediction of Future Earnings

Abstract

Although past accruals can explain current earnings, whether current accruals can predict future earnings has not been examined. I introduce three regression-based prediction models to predict future earnings: using only cash flows only, both cash flows and accruals, and earnings, to determine whether current accruals contribute to the prediction of future earnings. I find a cash flows and accruals model is more precise than a cash flows-only model, but the earnings model is the most precise. This result suggests that current earnings are a more accurate predictor of future earnings, and that accruals’ persistence is less important in prediction of future earnings. I also document that predictions based on these models are more precise than time series-based predictions, but not as precise as analysts’ forecasts. Additionally, I investigate how current earnings management negatively affects prediction of future earnings and hypothesize that current accrual management and real earnings management are positively associated with the prediction errors of the three models. The result shows that only the measure of real earnings management is positively associated with prediction error.