The Ability of Earnings to Predict Future Operating Cash Flows Has Been Increasing—Not Decreasing

DOI: 10.1111/j.1475-679X.2005.00189.x Journal of Accounting Research Vol. 43 No. 5 December 2005 Printed in U.S.A.

The Ability of Earnings to Predict Future Operating Cash Flows Has Been Increasing—Not Decreasing

MYUNGSUN KIM∗ AND WILLIAM KROSS† Received 6 August 2002; accepted 24 June 2005

ABSTRACT

We investigate the relationship between earnings and one-year-ahead operating cash flows from 1973 to 2000. Although the extant research indicates a weakening relationship between contemporaneous earnings and stock prices over time, we find that the relationship between current earnings and future operating cash flows has increased over time. This result holds for numerous divisions of our sample. Out-of-sample predictions of operating cash flows generally show increasing forecast accuracy over time. Increasing accounting conservatism appears to play a role in this phenomenon.

1. Introduction

This research investigates the relationship between current earnings and future operating cash flows from 1973 through 2000. We find that this relationship has been strengthening over time. Two separate streams of research motivate our investigation. Extant research on the “value relevance” of earnings includes Amir and Lev [1996], Collins, Maydew, and Weiss [1997], Brown, Lo, and Lys [1999], Chang [1999], Ely and Waymire [1999], Francis and Schipper [1999], Lev and Zarowin [1999], and Ryan

∗ University at Buffalo–SUNY; †Purdue University. We would like to thank our colleagues at SUNY–Buffalo, Missouri, and Purdue (particularly Byung Ro and Frank Heflin) and the participants of the annual AAA meetings in 2002 for helpful comments. We also thank Susan Watts and Mark Bagnoli for their encouragement. Finally, we thank the editor (Richard Leftwich) and the referee for numerous helpful suggestions. 753

Copyright

C

, University of Chicago on behalf of the Institute of Professional Accounting, 2005

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M. KIM AND W. KROSS

and Zarowin [2003], among others. Some...