Review of Accounting Studies, 3, 205–229 (1999)

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c 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Accruals, Cash Flows, and Equity Values

MARY E. BARTH
Graduate School of Business, Stanford University

WILLIAM H. BEAVER
Graduate School of Business, Stanford University

JOHN R. M. HAND
Kenan-Flagler Business School, University of North Carolina at Chapel Hill

WAYNE R. LANDSMAN
Kenan-Flagler Business School, University of North Carolina at Chapel Hill

Abstract. We find, as predicted, that the differential ability of accrual and cash flow components of earnings to
help forecast future abnormal earnings and the persistence of the components result in the components having
different valuation implications. We base our tests on Ohlson (1999) applied to fourteen industries. We find:
(1) Accruals and cash flows aid in forecasting future abnormal earnings incremental to abnormal earnings and
equity book value. (2) Accruals and cash flows provide explanatory power for equity market value incremental to
equity book value and abnormal earnings. (3) There is evidence that accruals and cash flows valuation coefficients
are consistent with the Ohlson model.

Accrual accounting is at the heart of earnings measurement and financial reporting. The
basic premise of accrual accounting is that earnings, which is cash flows from operations
plus accruals, is a better indicator of future earnings, dividends, and cash flows than current
and past cash flows (e.g., Barth, Cram, and Nelson (1998)).1 If this premise is correct
and if equity value reflects expected future earnings, then accruals will be priced in equity
valuation, i.e., they will be valuation relevant. Surprisingly, the valuation implications of
the accrual and cash flow components of earnings are largely unexplored.2 The objective
of this study is to provide insights into the characteristics of the accrual and cash flow
components of earnings that affect their relation to firm value.
We achieve our objective by utilizing the framework in Ohlson (1999), which extends
Ohlson (1995) by modeling earnings components. The modeling extension suggests that the
value relevance of an earnings component depends on its ability to predict future abnormal
earnings incremental to abnormal earnings and on the persistence of the component. This
framework leads us to address three research questions relating to the accrual and cash flow
components of earnings. One, do the accrual and cash flow components of earnings aid
in forecasting future abnormal earnings incremental to abnormal earnings? Two, do the
accrual and cash flow components of earnings have incremental explanatory power in a
valuation model that also includes equity book value and abnormal earnings? Three, do the
valuation multiples on accruals and cash flows vary as predicted by the Ohlson model based
on the persistence of the components and their ability to predict future abnormal earnings?
206 BARTH, BEAVER, HAND AND LANDSMAN

We address these questions using separate industry estimation equations based on a sample
of Compustat firms between 1987 and 1996 with available annual data. We implement the
model by estimating two sets of four jointly estimated equations, one set each for accruals
and cash flows.
We address our first research question by estimating the relation between future abnormal
earnings and current abnormal earnings and, separately, each earnings component. Finding
a significant relation for the accrual or cash flow earnings component indicates that the com-
ponent is incrementally informative in predicting future abnormal earnings. We address our
second research question by estimating the relation between equity market value and equity
book value, abnormal earnings, and the earnings component. Finding a significant relation
for the earnings component indicates that it is incrementally informative in explaining the
market value of equity. We address our third research question by comparing the valuation
multiples on each earnings component obtained from this equity market value relation to
those obtained from estimating the relation after constraining the valuation multiples to be
equal to those implied by the Ohlson model. In addressing our research questions, we also
estimate the relation between future and current realizations of the earnings component,
i.e., we estimate the component’s persistence or its “predictability” (Ohlson, 1999).
Regarding our first research question, because accruals are more affected by the estima-
tion procedures of Generally Accepted Accounting Principles and, therefore, managerial
discretion, we expect accruals and cash flows to have different abnormal earnings fore-
casting ability. Consistent with this prediction, we find that for all industries accruals and
cash flows each have significant explanatory power in forecasting future abnormal earnings
incremental to abnormal earnings. In particular, we find that the relation is negative and
positive for accruals and cash flows, respectively, indicating that abnormal earnings is less
persistent when accruals comprise a larger proportion of current earnings. We also find
considerable cross-industry variation in the magnitude of the estimated coefficients. Find-
ings from estimating the persistence equations indicate that both earnings components have
significant predictability that varies by industry. Regarding our second research question,
we find that for all industries accruals and cash flows each have significant incremental
explanatory power in the valuation relation that also includes equity book value and ab-
normal earnings. There is considerable cross-industry variation in the valuation multiples,
although they are predominantly negative for accruals and positive for cash flows.
Regarding our third research question, we find that the constraints on the components’
valuation multiples implied by the Ohlson model are binding for most industries. In addition,
the correlations between the valuation coefficient implied by the autoregressive equations
and the constrained and unconstrained valuation coefficients are not consistently positive.
We consider several possible explanations for this result. However, there is substantial
agreement between the signs of the implied valuation coefficient and the unconstrained
coefficient estimate. Moreover, the correlations across industries between the constrained
and unconstrained valuation multiple estimates are high.
Taken together, the findings suggest that the interaction between two key characteristics
of the components, their ability to aid in forecasting future abnormal earnings and the
persistence of the components themselves, results in different valuation implications for the
accrual and cash flow components of earnings.
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 207

The remainder of the paper is organized as follows. Section 1 motivates the study and
describes the research design. Section 2 describes the sample and data, and section 3
presents the results. Section 4 summarizes and concludes the study.

1. Hypotheses and Research Design

1.1. Model Development

In developing our predictions of how the accrual and cash flow components of earnings
relate to equity value, we utilize a generalized version of the Ohlson (1999) model. The
model comprises four equations:3
a
xt+1 = ω11 xta + ω12 x2t + ω13 bvt + ε1t+1 (1)
x 2t+1 = ω22 x2t + ω23 bvt + ε2t+1 (2)
bvt+1 = + ω33 bvt + ε3t+1 (3)
MVEt = bvt + α1 xta + α2 x2t + u t (4)

1.1.1. Abnormal Earnings Equation

Equation (1) is the abnormal earnings prediction equation, where abnormal earnings, xta , is
defined in the usual way as earnings less a normal return on equity book value. Although
x 2 in Ohlson (1999) is modeled as transitory earnings, the model applies to any component
of earnings. In our context, x2 is either accruals or cash flows.
The coefficient on the earnings component x2 , ω12 , reflects the incremental effect on
the forecast of abnormal earnings of knowing x2 . If all earnings components have the
same ability to forecast abnormal earnings, ω12 will equal zero, and thus knowing that
component of earnings does not aid in forecasting abnormal earnings. As a result, to
address our first research question, we test the null hypothesis that ω12 = 0 against the
alternative that ω12 6= 0. We test the null hypothesis that ω12 = 0 because a central premise
of the accrual accounting system is that earnings components are additive, i.e., various
revenues are added to obtain total revenues, individual expenses are added to obtain total
expenses, and expenses are subtracted from revenues to obtain net income. Thus, there
is no distinction among earnings components. Most importantly for our study, there is no
distinction between accruals and cash flows.4
We predict neither the sign nor magnitude of ω12 , for either accruals or cash flows, because
they depend on the accounting and economic environments in which a firm operates. For
example, with respect to accruals, an increase in inventories could be an indication of
unexpectedly low demand. On the other hand, an increase in inventories could result
from higher expected future sales. It is also possible that a fluctuation in accruals merely
represents compensation for temporary changes in cash flows with no implications for future
abnormal earnings. Therefore, it is difficult to categorize accruals as good news, bad news, or
no news vis-à-vis future abnormal earnings. The relation between future abnormal earnings
208 BARTH, BEAVER, HAND AND LANDSMAN

and cash flows is equally ambiguous. High current cash flows can indicate a successful
firm with high future abnormal earnings. Conversely, low current cash flows could be
indicative of high future abnormal earnings associated with future economic rents from
items currently expensed, e.g., current research and development expenditures. Because
firms within a given industry are likely to be affected similarly by economic and accounting
factors, we test the null hypothesis that ω12 = 0 separately by industry. If ω12 = 0, then the
composition of earnings, at least with respect to accruals and cash flows, does not matter
for purposes of forecasting future abnormal earnings.
Even though our alternative hypothesis for ω12 is two-sided, Sloan (1996) suggests a
one-sided alternative. Citing the financial statement analysis literature, he argues that
accruals possess less predictive ability with respect to future earnings. The reason is that
accruals involve a higher degree of subjectivity than cash flows, are more likely the object
of management discretion, and are more apt to contain unusual accruals that are less likely
to recur in future periods. Sloan’s evidence supports lower predictability of accruals with
respect to future earnings. If accruals also have lower predictability for future abnormal
earnings, then the alternative hypotheses are one-sided. In particular, we would predict
ω12 < 0 for accruals and ω12 > 0 for cash flows.
In equation (1), ω11 reflects the persistence of abnormal earnings. Prior research (e.g.,
Dechow, Hutton, and Sloan (1999), Hand and Landsman (1999)) leads us to predict that
ω11 is positive. Note that because net income is a component of xta , the total coefficient
on x2 (the earnings component of interest) equals ω11 + ω12 . Thus, if ω11 + ω12 = 0,
x 2 is irrelevant for forecasting abnormal earnings. Ohlson labels this condition abnormal
earnings “forecasting irrelevancy.” Conversely, if ω11 + ω12 6= 0, then x2 is said to have
abnormal earnings “forecasting relevance.” Because we do not expect that either accruals or
cash flows are entirely transitory, we predict that each component has forecasting relevance.
Thus, we test the null hypothesis that ω11 +ω12 = 0 against the alternative that ω11 +ω12 6= 0.

1.1.2. Earnings Component and Equity Book Value Autoregressive Equations

Equation (2) describes the autocorrelation, or persistence, of each earnings component,

which Ohlson labels “predictability.” Transitory earnings can be characterized as a process
in which ω22 = 0. For earnings components that are not entirely transitory, the higher is
ω22 , the more predictable the component. Because we expect accruals and cash flows to
be positively autocorrelated, we predict ω22 > 0 for each component. Because we expect
predictability to vary by industry, as with equation (1), we estimate equation (2) separately
by industry.
Note that equations (1) and (2) include equity book value. Including equity book value
allows for the effects of conservatism to manifest themselves (Feltham and Ohlson (1995,
1996)) and partially relaxes the assumption that the cost of capital associated with calcu-
lating abnormal earnings is a predetermined cross-sectional constant. Separate industry
estimation of all equations permits the level of conservatism and, at least partially, the cost
of capital associated with abnormal earnings to vary by industry. Equation (3) preserves the
triangular information structure of the generalized version of Ohlson’s (1999) model. This
triangular structure ensures that, in theory, parameters relating to equity book value have
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 209

no effect on the valuation multiples on abnormal earnings and the earnings components in
equation (4).

1.1.3. Equity Market Value Equation

Finally, equation (4) is the valuation equation based on the information dynamics in equa-
tions (1) through (3). α2 is the valuation multiple on x2 , i.e., accruals or cash flows.
Analogous to the interpretation of ω12 in equation (1), α2 reflects the incremental effect
on valuation from knowing x2 . If both earnings components have the same relation with
equity value, α2 will equal zero, and knowing that component of earnings does not aid in
explaining equity value. Thus, to address our second research question, we test the null
hypothesis that α2 = 0 against the alternative that α2 6= 0. Also analogous to equation (1),
note that the total valuation coefficient on x2 equals α1 + α2 . Thus, if α1 + α2 = 0, x2 is
irrelevant for valuation. Ohlson labels this condition “value irrelevance.” Conversely, if
α1 + α2 6= 0, then x2 is “value relevant.” Thus, we test the null hypothesis that α1 + α2 = 0
against the alternative that α1 + α2 6= 0.
Equations (1) and (2) provide a model of the link between forecasting relevance, pre-
dictability, and value relevance for x2 . In particular,

(1 + r )ω12
α2 = (5)
[(1 + r ) − ω11 ] × [(1 + r ) − ω22 ]

where r is the discount rate applied to equity capital.

To address our third research question relating to the model’s descriptive validity, we test
whether equation (5) holds for our sample. There are several things to note about equation
(5). First, because we expect each expression in square brackets in the denominator to be
positive, the sign of ω12 determines the sign of α2 . Also, the higher the predictive ability
of the component for future abnormal earnings, the larger, in absolute value, will be α2 .
Second, all else equal, the higher is the persistence parameter, ω22 , the higher is α2 . This
positive relation between persistence and value relevance is consistent with predictions made
and tested in prior research (e.g., Lipe (1986), Kormendi and Lipe (1987), Barth, Beaver and
Wolfson (1990) and Barth, Beaver and Landsman (1992)). Third, α2 is similarly dependent
on the persistence of abnormal earnings, ω11 , i.e., the higher the persistence of abnormal
earnings, the higher is α2 . Fourth, the triangular structure of equations (1) through (3)
results in ω33 not appearing in equation (5).

1.2. Estimating Equations

For each earnings component separately, accruals and cash flows, we estimate equations (1)
through (4) as a system using Seemingly Unrelated Regressions, permitting regression errors
to be correlated across equations. We estimate the system industry by industry, pooling
available firm-year observations from the ten sample years, with untabulated year-specific
210 BARTH, BEAVER, HAND AND LANDSMAN

intercepts. The two systems of equations are:5

Accruals system
NI ait = ω10 + ω11 NI ait−1 + ω12 ACCit−1 + ω13 BV it−1 + ε1it (1a)
ACCit = ω20 + ω22 ACCit−1 + ω23 BV it−1 + ε2it (2a)
BV it = ω30 + ω33 BV it−1 + ε3it (3a)
MVEit = i 0 + i 1 BV it + α1 NI ait + α2 ACCit + u it (4a)

Cash flows system

NI ait = ω10 + ω11 NI ait−1 + ω12 CFOit−1 + ω13 BV it−1 + ε1it (1b)
CFOit = ω20 + ω22 CFOit−1 + ω23 BV it−1 + ε2it (2b)
BV it = ω30 + ω33 BV it−1 + ε3it (3b)
MVEit = i 0 + i 1 BV it + α1 NI ait + α2 CFOit + u it (4b)

Abnormal earnings, NI at , equals NI t − r BV t−1 , where BV is equity book value and net
income, NI, is income before extraordinary items and discontinued operations. Although
defining NI in this way violates the clean surplus assumption of Ohlson (1995), it eliminates
potentially confounding effects of large one-time items and is consistent with prior research
(e.g., Dechow, Hutton, and Sloan (1999)).6 Findings in Hand and Landsman (1999) suggest
that violating clean surplus should have little effect on our findings. We set r = 12%,
the long-term return on equities (Dechow, Hutton, and Sloan (1999), Hand and Landsman
(1999)).7 Net accruals, ACC, is the difference between net income and cash from operations,
CFO, i.e., ACC = NI − CFO. If the Ohlson model holds, in equations (4a) and (4b) the
coefficients on equity book value will equal one. We include intercepts, i 0 , to allow for the
valuation effects of other information.
We estimate equations (la) through (4b) cross-sectionally, industry by industry, for two
reasons.8 First, there is a maximum of ten years of annual cash flow data available from
Compustat, making firm-by-firm time-series regressions impracticable. Second, as noted
above, separate industry estimation permits the coefficients to reflect systematic variation in
economic and accounting environments across industries; we view industry membership as
a proxy for these factors. We use the same industry classifications as in Barth, Beaver, and
Landsman (1998).9 All equations are estimated using unscaled data (Barth and Kallapur
(1996)).
Because by definition net income equals accruals plus cash flows, one would expect the
findings relating to accruals in equations (la) and (4a) to be “mirror images” of the findings
relating to cash flows in equations (lb) and (4b). For example, if ω12 is significantly negative
in equation (la), one would expect ω12 to be significantly positive in equation (lb). Equations
(la) and (lb) are not econometrically equivalent, however, because each equation contains
abnormal earnings, not net income.10 This is also the case for equations (4a) and (4b). Thus,
we report findings for both the accruals and cash flows systems.
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 211

2. Sample Selection and Descriptive Statistics

We obtain data for 1987–1996 from the Compustat Primary, Secondary, and Tertiary,
Full Coverage, and Research Annual Industrial Files. Our sample period begins in 1987
because prior to that date cash flow from operations disclosed under Statement of Financial
Accounting Standards No. 95 (SFAS 95 (1987)) is unavailable. To mitigate the effects of
outliers, for each variable, by year and within each industry, we treat as missing observations
those that are in the extreme top and bottom first percentile (Kothari and Zimmerman (1995),
Collins, Maydew and Weiss (1997), Fama and French (1998)). We also restrict the sample
to firms with full data to estimate the system of equations and with total assets in excess of
$10 million to avoid the influence of small firms. All variables are measured as of fiscal
year end, including equity market value, and are expressed in millions of dollars.
Table 1 presents descriptive statistics for each of the variables used in the estimating
equations. Panel A reports distributional statistics, panel B contains Pearson and Spearman
correlations, and panel C describes the industry composition of the sample. Panel A reveals
that, on average, the market value of equity exceeds the book value of equity, indicating
that equity book value alone is insufficient to explain equity market value. Panel A also
reveals that, on average, accruals are negative and cash flows are positive. This is consistent
with prior research (Sloan (1996), Barth, Cram, and Nelson (1998)) in which depreciation
expense is included in accruals but capital expenditures are included in investing cash flows.
Panel A also reveals that mean abnormal earnings is negative, which could be attributable
to the cost of capital being less than 12%.11 Panel B reveals that most of the variables
are highly correlated with each other, and Panel C reports the industry breakdown of our
sample. Industries with the largest concentrations of firm-year observations are Durable
Manufacturers, 27.3%, and Retail firms, 13.3%.

3. Results

3.1. Abnormal Earnings Equations

Table 2, panels A and B, present regression summary statistics corresponding to the abnor-
mal earnings equations (la) and (lb) for each of the fourteen industries. Mean parameter
estimates, t-statistics, and adjusted R 2 values across industries are summarized at the bot-
tom of each panel of table 2 and in all subsequent tables in which industry results are
presented.
Regarding our first research question, panel A reveals that, as predicted, accruals are
incrementally informative regarding future abnormal earnings for each of the fourteen
industries. Moreover, consistent with predictions based on Sloan (1996), ω12 is significantly
negative in all industries, suggesting that the lower the proportion of current earnings
attributable to accruals, the higher future abnormal earnings will be. Panel A also reveals
that ω12 varies substantially across industries. The coefficient estimates (t-statistics) range
from −0.75 to −0.02 (−22.51 to −1.67). The industries with the most extreme coefficients
are Pharmaceuticals and Financial Institutions. Because of the link between ω12 in the
abnormal earnings equation and α2 in the valuation equation, these two industries also
212 BARTH, BEAVER, HAND AND LANDSMAN

Table 1. Descriptive statistics for the sample of 15,405 Compustat firm year observations, 1987–1996.

Panel A: Distributional statistics (in $ millions)

Description Variable Mean Median Std dev

Market value of equity MVE 506.18 94.37 1,511.74
Book value of equity BV 231.05 54.74 637.09
Market-to-book ratio MB 2.19 1.58 18.27
Abnormal earnings NI a −0.79 −0.80 57.63
Accruals ACC −33.75 −4.70 128.06
Cash flows CFO 58.54 8.16 199.49

Panel B: Correlations, with Pearson (Spearman) correlations above (below) the diagonal

Variable MVE BV NI a ACC CFO

MVE 0.85 0.39 −0.65 0.83
BV 0.88 0.12 −0.78 0.89
NI a 0.30 0.16 0.02 0.30
ACC −0.41 −0.45 0.16 −0.71
CFO 0.71 0.73 0.29 −0.92

Panel C: Industry composition

# firm- % of
Industry Primary SIC codes years obs.
1 Mining + construction 1000–1999, excluding 1300–1399 401 2.6
2 Food 2000–2111 420 2.3
3 Textiles + printg/pubg 2200–2780 1,018 6.6
4 Chemicals 2800–2824, 2840–2899 341 2.1
5 Pharmaceuticals 2830–2836 410 2.6
6 Extractive industries 2900–2999, 1300–1399 628 4.1
7 Durable manufacturers 3000–3999, excluding 3570–3579 4,079 27.3
and 3670–3679
8 Computers 7370–7379, 3570–3579, 3670–3679 911 6.5
9 Transportation 4000–4899 862 4.8
10 Utilities 4900–4999 1,109 6.8
11 Retail 5000–5999 2,027 13.3
12 Financial institutions 6000–6411 1,017 5.3
13 Insurance + real estate 6500–6999 893 6.1
14 Services 7000–8999, excluding 7370–7379 1,289 8.9
Total 15,405 100.0
Mean 1,100 7.1
Abnormal earnings, NI a , is net income before extraordinary items and discontinued operations, NI, minus 0.12 ×
book value of equity, BV, lagged one year. Accruals, ACC, is NI minus cash flows from operations, CFO, disclosed
under SFAS 95. MVE is market value of equity at fiscal year end.

stand out as exceptions in the valuation equation findings reported below. In addition, we
reject forecasting irrelevance of accruals in each industry, i.e., we reject the null hypothesis
that ω11 + ω12 = 0.
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 213

Table 2. Summary statistics from regressions of abnormal earnings on lagged abnormal earnings and accruals or
cash flows. Sample of 15,405 Compustat firm year observations, 1987–1996.

Panel A: Accruals: NI ait = ω10 + ω11 NI ait−1 + ω12 ACCit−1 + ω13 BV it−1 + ε1it
ω11 ω12 ω13 ω11 + ω12 = 0
Industry coef t-stat coef t-stat coef t-stat p-value Adj. R 2
Mining + construction 0.40 9.82 −0.06 −1.67 −0.47 −7.20 <0.01 0.40
Food 0.86 28.25 −0.45 −11.85 −0.03 −6.41 <0.01 0.76
Textiles + printg/pubg 0.27 11.82 −0.11 −4.07 −0.05 −11.05 <0.01 0.28
Chemicals 0.63 15.44 −0.22 −4.38 −0.06 −6.59 <0.01 0.29
Pharmaceuticals 0.94 28.74 −0.75 −12.20 −0.02 −1.90 <0.01 0.89
Extractive industries 0.59 16.59 −0.26 −10.68 −0.06 −12.38 <0.01 0.33
Durable manufacturers 0.55 50.58 −0.24 −22.51 −0.05 −24.72 <0.01 0.41
Computers 0.38 10.00 −0.10 −2.72 −0.07 −7.99 <0.01 0.14
Transportation 0.88 37.73 −0.17 −8.82 −0.03 −6.03 <0.01 0.65
Utilities 0.36 16.18 −0.04 −3.15 −0.01 −4.13 <0.01 0.15
Retail 0.67 36.22 −0.11 −8.86 −0.01 −4.23 <0.01 0.43
Financial institutions 0.69 26.11 −0.02 −2.58 −0.01 −5.06 <0.01 0.36
Insurance + real estate 0.83 39.27 −0.29 −8.94 −0.01 −4.22 <0.01 0.43
Services 0.69 32.31 −0.10 −7.07 −0.03 −7.49 <0.01 0.41

Mean 0.62 25.65 −0.25 −7.82 −0.07 −7.81 0.42

Panel B: Cash Flows: NI ait = ω10 + ω11 NI ait−1 + ω12 CFOit−1 + ω13 BV it−1 + ε1it
ω11 ω12 ω13 ω11 + ω12 = 0
Industry coef t-stat coef t-stat coef t-stat p-value Adj. R 2
Mining + construction 0.43 10.82 0.10 2.86 −0.06 −7.14 <0.01 0.42
Food 0.16 3.49 0.52 15.92 −0.09 −10.72 <0.01 0.76
Textiles + printg/pubg 0.23 9.54 0.10 3.87 −0.06 −8.85 <0.01 0.29
Chemicals 0.18 4.12 0.27 5.89 −0.10 −7.28 <0.01 0.26
Pharmaceuticals 0.26 6.19 0.66 13.67 −0.07 −5.58 <0.01 0.90
Extractive industries 0.19 4.89 0.26 11.49 −0.09 −12.77 <0.01 0.32
Durable manufacturers 0.26 20.68 0.25 23.87 −0.07 −28.24 <0.01 0.40
Computers 0.21 6.65 0.08 2.13 −0.07 −5.90 <0.01 0.13
Transportation 0.76 34.87 0.16 9.38 −0.05 −7.40 <0.01 0.66
Utilities 0.25 11.76 0.03 2.50 −0.01 −3.39 <0.01 0.14
Retail 0.57 31.08 0.12 9.83 −0.02 −7.47 <0.01 0.43
Financial institutions 0.65 24.48 0.02 2.85 −0.01 −5.03 <0.01 0.36
Insurance + real estate 0.47 16.81 0.31 8.57 −0.05 −8.09 <0.01 0.43
Services 0.53 22.62 0.10 7.28 −0.04 −8.09 <0.01 0.41

Mean 0.37 14.86 0.21 8.58 −0.06 −9.00 0.42

Variable definitions and number of observations by industry are per table 1. Tables 2, 3, and 4 estimates are based
on Seemingly Unrelated Regression estimation of the system of equations.

Consistent with prior research (Dechow, Hutton, and Sloan (1999), Hand and Landsman
(1999)), the coefficient on lagged abnormal earnings, ω11 , is positive and significant for
all industries. Although the mean of 0.62 is similar to that reported in prior research, the
coefficients range from 0.27 to 0.94, indicating substantial cross-industry variation in the
214 BARTH, BEAVER, HAND AND LANDSMAN

persistence of abnormal earnings. Finally, ω13 is always significantly negative, which is

inconsistent with conservatism, but consistent with the cost of capital being less than 12%.
In addition, the cross-industry variation in ω13 suggests that there is inter-industry variation
in the cost of capital and/or the level of conservatism.
The findings relating to cash flows in table 2, panel B, reveal inferences consistent with
those for accruals in panel A. In particular, panel B reveals that, as predicted, cash flows are
significantly incrementally informative regarding future abnormal earnings for all fourteen
industries. The findings also reveal that the sign of ω12 for cash flows is opposite of that for
accruals, as expected, i.e., the findings relating to accruals and cash flows in the abnormal
earnings equations are “mirror images” of each other. As with accruals, the ω12 estimates
(t-statistics) vary across industries from 0.02 to 0.66 (2.13 to 23.87), and the industries with
the most extreme coefficients are Pharmaceuticals and Financial Institutions. Also, consis-
tent with the accruals findings, ω12 is significantly positive for all industries, suggesting that
the higher the proportion of current earnings attributable to cash flows, the higher future
abnormal earnings will be. Finally, as predicted, we reject forecasting irrelevance for cash
flows in each industry, i.e., we reject the null hypothesis that ω11 + ω12 = 0.
Panel B also reveals that the mean estimated persistence of abnormal earnings, ω11 , is
0.37, which is lower than the mean relating to the accruals equation. As with the accruals
equation, there is substantial cross-industry variation in estimates of ω11 , 0.16 to 0.76. The
coefficient on lagged equity book value, ω13 , is significantly negative in all industries, with
cross-industry variation again suggesting that there is inter-industry variation in the cost of
capital and in the level of conservatism.

3.2. Accruals and Cash Flows Autoregression Results

Table 3 presents regression summary statistics corresponding to the earnings component

autoregression equations (2a) and (2b). The accruals autoregressions reveal that ω22 is
less than 1.00 in all industries, ranging from 0.19 for Utilities to 0.92 for Transportation
firms, indicating stationary autoregressive processes for accruals in all industries. The
cash flows autoregressions indicate that ω22 ranges from 0.31 for Utilities to 1.03 for
firms in the Food industry. For all but two industries, Food and Transportation, ω22 is
less than 1.00, indicating, as with accruals, that the cash flows autoregressive process is
generally stationary.12 Comparison of the autoregressive parameter estimates across in-
dustries shows that accruals are less persistent than cash flows for all but two industries,
Mining & Construction and Textiles & Printing/Publishing. The coefficient on lagged
equity book value, ω23 , is significantly negative (positive) for accruals (cash flows) in all
industries.

3.3. Valuation Equations

Table 4, panels A and B, present regression summary statistics corresponding to the valuation
equations (4a) and (4b). Regarding our second research question, panel A reveals that α2 ,
Table 3. Summary statistics from first-order autoregressions of accruals and cash flows. Sample of 15,405 Compustat firm year observations,
1987–1996.

ACCit = ω20 + ω22 ACCit−1 + ω23 BV it−1 + ε2it CFOit = ω20 + ω22 CFOit−1 + ω23 BV it−1 + ε2it
ω22 ω23 ω22 ω23
Industry coef t-stat coef t-stat Adj. R 2 coef t-stat coef t-stat Adj. R 2
Mining + construction 0.47 9.19 −0.04 −3.57 0.40 0.38 7.00 0.07 6.18 0.39
Food 0.58 13.03 −0.06 −10.82 0.74 1.03 44.91 0.02 2.52 0.97
Textiles + printg/pubg 0.42 11.02 −0.09 −14.89 0.68 0.41 11.94 0.13 14.95 0.76
Chemicals 0.23 5.24 −0.11 −14.81 0.84 0.69 16.98 0.06 4.55 0.89
Pharmaceuticals 0.28 3.87 −0.04 −5.00 0.51 0.99 22.03 0.04 2.63 0.96
Extractive industries 0.50 15.40 −0.11 −16.33 0.89 0.79 28.14 0.07 7.79 0.95
Durable manufacturers 0.42 25.56 −0.08 −31.94 0.57 0.75 53.53 0.07 19.42 0.82
Computers 0.45 10.77 −0.06 −7.86 0.52 0.64 14.85 0.03 1.86 0.59
Transportation 0.92 43.98 −0.03 −5.44 0.90 1.02 48.58 0.02 2.75 0.94
Utilities 0.19 7.20 −0.14 −26.85 0.82 0.31 11.04 0.20 24.03 0.93
ACCRUALS, CASH FLOWS, AND EQUITY VALUES

Retail 0.46 22.33 −0.04 −13.58 0.40 0.58 27.82 0.10 18.40 0.77
Financial institutions 0.48 21.42 −0.09 −13.47 0.53 0.52 22.80 0.15 17.61 0.72
Insurance + real estate 0.53 16.35 −0.03 −8.26 0.39 0.88 34.08 0.05 11.15 0.89
Services 0.79 35.11 −0.06 −9.85 0.63 0.89 44.29 0.06 9.03 0.79

Mean 0.48 17.18 −0.07 −13.05 0.63 0.71 27.71 0.08 10.21 0.81
Variable definitions and number of observations by industry are per table 1. Tables 2, 3, and 4 estimates are based on Seemingly Unrelated
Regression estimation of the system of equations.
215
216 BARTH, BEAVER, HAND AND LANDSMAN

the coefficient on accruals, is significantly different from zero in all industries, as predicted.
This indicates that the accrual component of earnings is incrementally valuation relevant,
i.e., the coefficient on accruals differs from that on abnormal earnings. In addition, α2
is negative for all industries except Pharmaceuticals and Financial Institutions, the two
industries with extreme values for ω12 in table 2, and ranges from −8.34 to 10.89. Also
as predicted, we reject the null hypothesis that α1 + α2 = 0 for every industry, indicating
that accruals are valuation relevant, i.e., their total coefficient in each industry differs from
zero.
Recall from equation (5) that the Ohlson model indicates that the sign of α2 depends
on the sign of ω12 . However, all coefficients in tables 2 through 4 are estimated without
imposing the coefficient restrictions implied by the Ohlson model. Thus, agreement of
the signs of ω12 and α2 is initial evidence consistent with predictions relating to our third
research question, regarding whether the valuation multiples on accruals and cash flows
vary as predicted by the Ohlson model. In table 5, below, we provide additional evidence
on this question by comparing the α2 estimates in table 4 to those estimated after imposing
the coefficient restrictions in equation (5). Comparing the signs of ω12 in table 2, panel A,
and the signs of α2 in table 4, panel A, indicates that they are consistent for all but the two
extreme industries in table 2, Pharmaceuticals and Financial Institutions, both of which
have positive α2 estimates.
Table 4, panel A, also reveals substantial cross-industry variation in the valuation coeffi-
cients on equity book value and abnormal earnings.13 Although it is significantly positive for
all industries, the coefficient on equity book value ranges from 0.99 to 2.91. We reject the
null hypothesis that the coefficient on equity book value equals one in all but one industry,
Extractive industries. These findings suggest that the extent of accounting conservatism
varies across industries. Similarly, the coefficient on abnormal earnings is significantly
positive in all industries and ranges from 4.89 to 21.67.
Turning to the valuation equations for cash flows, the findings in table 4, panel B, also
reveal that, as predicted, α2 is significantly different from zero in all industries. This
indicates that the cash flow component of earnings is incrementally valuation relevant,
i.e., the coefficient on cash flows differs from that on abnormal earnings. In addition,
α2 is positive for all industries, except Pharmaceuticals and Financial Institutions, and
ranges from −11.25 to 8.05. As with accruals, we reject the null hypothesis that α1 +
α2 = 0 for every industry, indicating that cash flows are valuation relevant, i.e., their total
coefficient differs from zero. As with ω12 in the abnormal earnings equation, the reversal
of signs of α2 between accruals and cash flows in the valuation equations is consistent with
accruals and cash flows being mirror images of each other. As with accruals, comparing
the signs of ω12 in table 2, panel B, and the signs of α2 in table 4, panel B, indicates
that they are consistent for all but the same two industries, Pharmaceuticals and Financial
Institutions.
Panel B also reveals substantial cross-industry variation in the valuation coefficients on
equity book value and abnormal earnings. The coefficient on equity book value ranges
from 0.40 to 3.99, and we reject that it equals one in all industries. As in panel A, the
coefficient on abnormal earnings is significantly positive in all industries and ranges from
1.30 to 33.60.
Table 4. Summary statistics from regressions of market value of equity on book value of equity, abnormal earnings, and accruals or cash flows. Sample of
15,405 Compustat firm year observations, 1987–1996.

Panel A: Accruals: MVEit = i 0 + i 1 BV it + α1 NI ait + α2 ACCit + u it

i1 α1 α2 p-values
Industry coef t-stat coef t-stat coef t-stat i1 = 1 α 1 + α2 = 0 Adj. R 2
Mining + construction 1.83 23.11 6.14 9.85 −4.89 −11.37 <0.01 0.01 0.63
Food 2.10 26.46 7.64 14.47 −1.83 −3.10 <0.01 <0.01 0.87
Textiles + printg/pubg 1.67 39.48 4.89 18.27 −0.65 −2.65 <0.01 <0.01 0.79
Chemicals 1.24 12.85 7.05 l6.06 −4.97 −8.26 0.01 <0.01 0.83
Pharmaceuticals 2.91 16.60 21.67 23.30 10.89 7.21 <0.01 <0.01 0.92
Extractive industries 0.99 26.01 5.74 28.61 −4.52 −24.61 0.79 <0.01 0.96
Durable manufacturers 2.09 90.73 6.66 40.86 −0.52 −3.72 <0.01 <0.01 0.80
Computers 2.67 32.48 12.39 29.73 −6.57 −12.60 <0.01 <0.01 0.78
Transportation 2.03 26.36 5.30 15.04 −1.57 −5.72 <0.01 <0.01 0.76
ACCRUALS, CASH FLOWS, AND EQUITY VALUES

Utilities 1.39 57.92 5.37 20.84 −0.44 −3.30 <0.01 <0.01 0.94
Retail 2.03 59.18 13.05 39.58 −1.86 −8.15 <0.01 <0.01 0.81
Financial institutions 1.59 60.69 9.62 28.43 0.32 3.08 <0.01 <0.01 0.84
Insurance + real estate 1.43 40.10 10.19 24.21 −8.34 −18.41 <0.01 <0.01 0.82
Services 2.25 35.77 9.55 22.35 −2.18 −8.93 <0.01 <0.01 0.68

Mean 1.87 39.12 8.95 23.69 −1.94 −7.18 0.82

217
Table 4. Continued.

218
Panel B: Cash Flows: MVEit = i 0 + i 1 BV it + α1 NI ait + α2 CFOit + u it

i1 α1 α2 p-values
Industry coef t-stat coef t-stat coef t-stat i1 = 1 α 1 + α2 = 0 Adj. R 2
Mining + construction 1.28 13.10 1.43 2.84 4.66 10.58 <0.01 <0.01 0.62
Food 1.70 14.04 3.95 4.73 2.96 5.53 <0.01 <0.01 0.87
Textiles + printg/pubg 1.49 23.08 3.96 12.90 1.10 4.56 <0.01 <0.01 0.79
Chemicals 0.55 3.69 2.11 4.03 5.26 9.72 <0.01 <0.01 0.84
Pharmaceuticals 3.99 14.18 33.60 21.28 −11.25 −7.87 <0.01 <0.01 0.92
Extractive industries 0.40 7.18 1.30 5.69 4.73 26.90 <0.01 <0.01 0.96
Durable manufacturers 2.01 57.84 6.22 36.10 0.62 4.53 <0.01 <0.01 0.80
Computers 1.86 15.13 6.14 11.27 7.06 13.74 <0.01 <0.01 0.78
Transportation 1.81 18.13 3.63 8.96 1.72 6.44 <0.01 <0.01 0.77
Utilities 1.33 34.84 4.99 19.47 0.47 3.55 <0.01 <0.01 0.94
Retail 1.90 37.78 11.43 35.38 1.50 6.78 <0.01 <0.01 0.81
Financial institutions 1.64 49.48 9.90 29.65 −0.36 −3.55 <0.01 <0.01 0.84
Insurance + real estate 0.65 9.72 2.96 8.34 8.05 18.26 <0.01 <0.01 0.81
Services 2.03 27.18 7.63 17.74 2.17 9.24 <0.01 <0.01 0.68

Mean 1.62 23.24 7.09 15.60 2.05 7.74 0.82

Variable definitions and number of observations by industry are per table 1. Tables 2, 3, and 4 estimates are based on Seemingly Unrelated Regression
estimation of the system of equations.
BARTH, BEAVER, HAND AND LANDSMAN
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 219

Table 5. Comparisons between unconstrained estimates of valuation coefficients on accruals and cash flows,
estimates constrained by model of assumed information dynamics, and estimates calculated from unconstrained
parameters. Sample of 15,405 Compustat firm year observations, 1987–1996.

Panel A: Comparison of unconstrained, constrained, and calculated α2 estimates.

Accruals Cash Flows

Industry Unconst. Constr. Calcd. p-value Unconst. Constr. Calcd. p-value
Mining + construction −4.89 −0.85 −0.14 <0.01 4.66 0.99 0.22 <0.01
Food −1.83 −3.12 −3.65 0.02 2.96 3.88 6.94 0.06
Textiles + printg/pubg −0.65 −0.23 −0.21 0.08 1.10 0.21 0.17 <0.01
Chemicals −4.97 −2.85 −0.56 <0.01 5.26 3.91 0.74 <0.01
Pharmaceuticals 10.89 13.65 −5.78 <0.01 −11.25 n.a. 6.59 <0.01
Extractive industries −4.52 −4.22 −0.88 <0.01 4.73 4.35 0.93 <0.01
Durable manufacturers −0.52 −0.67 −0.69 0.25 0.62 0.82 0.87 0.10
Computers −6.57 −1.04 −0.23 <0.01 7.06 6.46 0.20 <0.01
Transportation −1.57 −2.17 −4.05 <0.01 1.72 2.16 4.97 0.02
Utilities −0.44 −0.08 −0.06 <0.01 0.47 0.07 0.05 <0.01
Retail −1.86 −0.56 −0.43 <0.01 1.50 0.55 0.45 0.01
Financial institutions 0.32 −0.03 −0.07 <0.01 −0.36 0.03 0.07 <0.01
Insurance + real estate −8.34 −7.43 −1.91 <0.01 8.05 7.43 2.31 <0.01
Services −2.18 −1.19 −0.81 <0.01 2.17 1.46 0.83 <0.01

Mean −1.94 −0.77 −1.39 2.05 2.31 1.81

3.4. Estimation of Restricted System of Equations

We now turn to findings relating to our third research question. To test predictions of the
Ohlson model directly, we estimate the accruals system, equations (la) through (4a), and
the cash flows system, equations (lb) through (4b), while imposing the constraint specified
in equation (5).
Table 5 presents a comparison of the constrained α2 estimates and the unconstrained
α2 estimates reported in table 4. As an additional test, table 5 also presents estimates
of α2 calculated using the unconstrained estimates of ω11 , ω12 , and ω22 , which we re-
fer to as calculated α2 . Panel A presents the unconstrained, constrained, and calculated
α2 estimates, as well as p-values from the Wald χ 2 statistic corresponding to a test of
whether the restriction relating to the constrained α2 estimate is binding. Panel B presents
Pearson and Spearman correlations among the unconstrained, constrained, and calculated
α2 estimates. Note that there is no constrained α2 estimate for Pharmaceuticals firms,
one of the two extreme industries; convergence failed to occur during system estima-
tion.
The findings in panel A indicate that the constrained and unconstrained α2 estimates
differ for both accruals and cash flows, and the Wald test indicates that the coefficient
constraint in equation (5) is binding for all but Durable Manufacturers in both the accru-
als and cash flows systems. However, for both accruals and cash flows, the correlations
220 BARTH, BEAVER, HAND AND LANDSMAN

Table 5. Continued.

Panel B: Correlations across industries between unconstrained, constrained, and calculated α2 estimates. Pearson
(Spearman) correlations are above (below) the diagonal.

Accruals
Unconstr. Constr. Calcd.
Unconstr. — 0.92 −0.57
— (<0.01) (0.03)
Constr. 0.77 — −0.48
(<0.01) — (0.08)
Calcd. 0.05 0.46 —
(0.85) (0.10) —

Cash Flows
Unconstr. Constr. Calcd.
Unconstr. — 0.91 −0.44
— (<0.01) (0.12)
Constr. 0.94 — 0.30
(<0.01) — (0.32)
Calcd. 0.19 0.63 —
(0.51) (0.02) —

Panel C: Correlations across industries between unconstrained and constrained estimates of ω11 , ω12 , and ω22
(p-values).
Accruals Cash Flows
Pearson Spearman Pearson Spearman
ω11 0.82 0.79 0.99 0.97
(<0.01) (<0.01) (<0.01) (<0.01)
ω12 0.91 0.82 0.81 0.81
(<0.01) (<0.01) (<0.01) (<0.01)
ω22 1.00 0.99 0.83 0.66
(<0.01) (<0.01) (<0.01) (0.01)

Variable definitions and number of observations by industry are per table 1. Parameter estimates are based on
Seemingly Unrelated Regression estimation of the following systems of equations: [1] NI ait = ω10 + ω11 NI ait−1 +
ω12 ACCit−1 + ω13 BV it−1 + ε1it , ACCit = ω20 + ω22 ACCit−1 + ω23 BV it−1 + ε2it , BV it = ω30 + ω33 BV it−1 + ε3it ,
and MVEit = i 0 + i 1 BV it + α1 NI ait + α2 ACCit + u it for accruals, and [2] NI ait = ω10 + ω11 NI ait−1 + ω12 CFOit−1 +
ω13 BV it−1 + ε1it , CFOit = ω20 + ω22 CFOit−1 + ω23 BV it−1 + ε2it , BV it = ω30 + ω33 BV it−1 + ε3it , and
MVEit = i 0 + i 1 BV it + α1 NI ait + α2 CFOit + u it for cash flows. The autoregressive equation for BV is estimated
but not tabulated. Constrained α2 is the estimate of α2 estimated from the system of equations in which α2 is
constrained to equal ω12 /[(1.12 − ω11 )(1.12 − ω22 )], as predicted by the model’s information dynamics. The
p-value in panel A refers to a Wald χ 2 test of whether the constraint on α2 is binding. Calculated α2 equals
ω12 /[(1.12 − ω11 )(1.12 − ω22 )], where the ωs are estimated in an unconstrained system.
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 221

in panel B indicate that imposing the constraint results in α2 estimates that are highly
positively correlated with unconstrained α2 estimates. For accruals, the Pearson and Spear-
man correlations are 0.92 and 0.77; for cash flows, the correlations are 0.91 and 0.94.
However, for both accruals and cash flows, panel B indicates no consistent positive corre-
lation between the calculated α2 estimates and either the constrained or unconstrained α2
estimates.14
Finding that the constrained and unconstrained α2 estimates correlate highly but no con-
sistent positive association between the calculated and the constrained and unconstrained
estimates suggests the possibility that, for the constrained accruals and cash flows sys-
tems, the valuation regressions “dominate” the autoregressive equations in minimizing the
system weighted sum of squared residuals. If this is the case, then the constrained and
unconstrained ωs should not be significantly correlated. However, table 5, panel C, which
presents Pearson and Spearman correlations between constrained and unconstrained es-
timates for ω11 , ω12 , and ω22 , indicates high correlation between the estimates for both
accruals and cash flows. The Pearson (Spearman) correlations range from 0.81 to 0.99
(0.66 to 0.99). Hence, the lack of consistent positive correlation between the calculated
α2 and the unconstrained and constrained α2 estimates appears to be the result of other
factors.
One possible explanation is that although the Ohlson model provides a parsimonious
description of the mapping from accounting data into equity value, the model may not be
entirely descriptively valid. For example, our empirical estimations exclude consideration
of “other information,” because, if the model holds, it has no bearing on parameters relating
to accounting data, abnormal earnings, equity book value, or the accrual and cash flow
earnings components. However, evidence presented in tables 2, 4, and 5 indicates that
the model performs particularly poorly for Pharmaceuticals and Financial Institutions, two
industries for which other information could be significant in determining future abnormal
earnings and current equity value. Thus, if other information and accounting data are
not unrelated, i.e., the model does not literally hold, parameter estimates for accounting
amounts could be affected by omitting consideration of other information in the estimating
equations.
A second possible explanation is that even if the model is descriptively valid, it relates to
a particular firm as of a particular date. Even though we permit coefficients to vary across
industries, we constrain them to be cross-sectional constants within industries. In addi-
tion, although we allow for year-specific intercepts, all other coefficients are intertemporal
constants. In related studies, Collins, Pincus, and Xie (1998) and Hand and Landsman
(1999) find that Ohlson model valuation estimates differ for positive and negative earnings
firms. We examine below whether pooling positive and negative earnings firms affects
our inferences. Finally, it is possible that prices do not fully reflect differences in valu-
ation implications for accruals and cash flows (Sloan (1996), Barth and Hutton (1999),
Frankel and Lee (1999), Dechow, Hutton and Sloan (1999), Lee, Myers, and Swaminathan
(1999)).15
Nonetheless, taken together, the findings in tables 2 through 5 provide support for the
prediction that accruals and cash flows are incrementally informative in predicting fu-
ture abnormal earnings and in explaining current equity market values. In addition, ac-
222 BARTH, BEAVER, HAND AND LANDSMAN

cruals and cash flows have forecasting and valuation relevancy in all industries. More-
over, correspondence in sign between α2 and ω12 for all but two industries for both
accruals and cash flows confirms the link between forecasting relevancy and valuation
relevancy.16

3.5. Positive Earnings sample

As noted above, prior research finds that Ohlson model valuation estimates differ for firms
with positive and negative earnings. This is predictable from the Ohlson model given that
negative earnings is less persistent than positive earnings (Hayn (1995), Collins, Maydew
and Weiss (1997), Collins, Pincus, and Xie (1999)). The findings presented in tables 2
through 5 are based on all firm-years without regard to the sign of earnings. Thus, we
reestimate the unconstrained and constrained accruals and cash flows systems, limiting the
samples to positive earnings firm-years. Table 6, panels A and B, present the findings
for accruals and cash flows. Panel C presents the correlations among the unconstrained,
constrained, and calculated α2 estimates.
Although the positive earnings sample comprises only about 60% of the full sample,
the findings in table 6 largely support those presented for the full sample. As expected,
the persistence of abnormal earnings as measured by ω11 is higher for the positive earn-
ings subsample, with means of 0.68 and 0.41 for accruals and cash flows versus 0.62 and
0.37 for the full sample. With the exception of one industry, Mining + Construction,
the abnormal earnings forecasting coefficients on accruals and cash flows, ω12 , are com-
parable to those based on the full sample. Also as expected, estimates of the earn-
ings components’ persistence parameters, ω22 , are higher than those based on the full
sample.
Turning to the valuation equations, the signs of α2 generally are the same as those based
on the full sample. The p-values in panels A and B indicate that the equation (5) constraint
is binding in fewer industries for positive earnings firms than is the case for the full sample.
Panel C reveals that the correlations between the constrained and unconstrained estimates of
α2 are similar to those based on the full sample reported in table 5. However, the correlations
between the calculated α2 and the constrained and unconstrained α2 estimates generally are
higher than those reported in table 5. Taken together, the findings in table 6 suggest that
inferences relating to the full sample are largely unaffected by constraining coefficients to
be the same for both negative and positive earnings firms.

4. Summary and Concluding Remarks

This study provides insights into the characteristics of the accrual and cash flow components
of earnings that affect their relation with firm value. We base our analysis on the valuation
framework in Ohlson (1999), in which the value relevance of an earnings component de-
pends on its ability to predict future abnormal earnings incremental to abnormal earnings
and the persistence of the component. Using a sample of Compustat firms with available
annual data between 1987 and 1996, we implement the Ohlson (1999) model by estimating
Table 6. Summary statistics from system of equations including market value of equity, book value of equity, abnormal earnings, and accruals or cash flows.
Subsample of 9,369 Compustat firms with NI > 0 in any firm-years 1987–1996.

Panel A: Accruals: NI ait = ω10 + ω11 NI ait−1 + ω12 ACCit−1 + ω13 BV it−1 + ε1it , ACCit = ω20 + ω22 ACCit−1 + ω23 BV it−1 + ε2it ,
MVEit = i 0 + i 1 BV it + α1 NI ait + α2 ACCit + u it

ω11 ω12 ω22 α2

Industry coef t-stat coef t-stat coef t-stat coef t-stat α2 constr. α2 calcd. p-value N
Mining + construction 0.40 4.63 0.01 0.21 0.62 7.13 −4.53 −6.51 −4.00 0.03 <0.01 179
Food 0.88 23.37 −0.43 −8.93 0.64 11.23 −1.49 −2.10 −3.10 −3.93 0.01 309
Textiles + printg/pubg. 0.37 10.66 −0.11 −2.91 0.59 10.38 −0.86 −2.77 −0.37 −0.30 0.09 686
Chemicals 0.67 15.81 0.30 −5.93 0.25 5.31 −4.86 −6.81 −1.98 −0.86 <0.01 252
Pharmaceuticals 0.93 14.70 −0.73 −5.62 0.32 2.03 13.41 5.94 n.a. −5.35 <0.01 117
Extractive industries 0.61 11.43 −0.23 −7.04 0.50 10.83 −4.64 −17.74 −4.46 −0.83 <0.01 318
Durable manufacturers 0.36 20.25 −0.19 −14.71 0.46 18.95 0.72 3.39 −0.40 −0.43 <0.01 2,306
Computers 0.86 20.68 −0.13 −2.62 0.48 7.67 −3.63 −3.94 −1.43 −0.87 <0.01 506
ACCRUALS, CASH FLOWS, AND EQUITY VALUES

Transportation 0.88 25.93 −0.16 −7.23 0.90 31.51 1.41 4.87 0.82 −3.31 <0.01 480
Utilities 0.40 16.46 −0.03 −2.82 0.18 6.40 −0.09 −0.62 −0.06 −0.06 0.83 956
Retail 0.74 30.27 −0.09 −6.24 0.48 16.45 −1.10 −4.10 −0.49 −0.43 0.02 1,239
Financial institutions 0.75 27.42 −0.02 −3.63 0.48 18.93 0.50 4.54 −0.02 −0.11 <0.01 816
Insurance + real estate 0.88 29.20 −0.16 −3.20 0.82 14.79 −8.78 −13.18 −7.95 −2.40 <0.11 511
Services 0.81 23.99 −0.06 −3.65 0.86 28.15 −1.12 −3.54 −0.92 −0.79 0.41 694

Mean 0.68 19.63 −0.19 0.02 0.54 13.55 −1.08 −3.04 −1.87 −1.40 669
223
Table 6. Continued.

224
Panel B: Cash Flows: NI ait = ω10 + ω11 NI ait−1 + ω12 CFOit−1 + ω13 BV it−1 + ε1it , CFOit = ω20 + ω22 CFOit−1 + ω23 BV it−1 + ε2it ,
MVEit = i 0 + i 1 BV it + α1 NI ait + α2 CFOit + u it
ω11 ω12 ω22 α2
Industry coef t-stat coef t-stat coef t-stat coef t-stat α2 constr. α2 calcd. p-value N
Mining + construction 0.47 5.31 −0.02 −0.39 0.53 6.86 4.25 5.94 4.54 −0.05 <0.01 179
Food 0.17 2.93 0.52 13.02 1.04 36.71 2.66 4.10 3.71 7.17 0.11 309
Textiles + printg/pubg. 0.34 9.42 0.09 2.75 0.61 12.70 1.27 4.16 0.40 0.26 <0.01 686
Chemicals 0.19 4.17 0.35 7.75 0.77 17.33 4.92 7.67 3.61 1.20 <0.01 252
Pharmaceuticals 0.26 3.24 0.57 5.78 0.91 9.35 −13.02 −6.02 n.a. 3.65 <0.01 117
Extractive industries 0.16 2.76 0.25 8.04 0.78 19.73 5.00 20.10 4.63 0.84 <0.01 318
Durable manufacturers 0.21 11.24 0.19 15.12 0.63 27.48 −0.42 −2.02 0.44 0.49 <0.01 2,306
Computers 0.45 9.39 0.25 5.86 0.76 15.75 2.23 2.56 1.32 1.16 0.25 506
Transportation 0.62 17.28 0.18 8.94 1.02 42.11 −1.34 −4.65 0.38 3.89 <0.01 480
Utilities 0.29 12.35 0.03 2.13 0.29 9.47 0.10 0.70 0.05 0.04 0.70 956
Retail 0.62 23.69 0.10 7.17 0.61 22.83 0.66 2.57 0.47 0.45 0.45 1,239
Financial institutions 0.71 26.20 0.03 4.05 0.52 20.40 −0.54 −5.04 0.03 0.12 <0.01 816
Insurance + real estate 0.58 10.91 0.28 5.93 1.01 28.90 8.55 13.33 8.37 5.14 0.11 511
Services 0.71 20.87 0.07 5.02 0.90 31.21 1.14 3.75 0.99 0.87 0.49 694

Mean 0.41 11.41 0.21 6.54 0.74 21.49 1.10 3.37 2.23 1.80 669
BARTH, BEAVER, HAND AND LANDSMAN
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 225

Table 6. Continued.

Panel C: Correlations across industries between unconstrained, constrained, and calculated α2 estimates. Pearson
(Spearman) correlations are shown above (below) the diagonal.

Accruals
Unconstr. Constr. Calcd.
Unconstr. — 0.91 −0.53
— (<0.01) (0.05)
Constr. 0.92 — 0.25
(<0.01) — (0.40)
Calcd. 0.00 0.29 —
(0.99) (0.33) —

Cash Flows
Unconstr. Constr. Calcd.
Unconstr. — 0.95 −0.03
— (<0.01) (0.93)
Constr. 0.92 — 0.49
(<0.01) — (0.09)
Calcd. 0.15 0.43 —
(0.62) (0.14) —
Variable definitions and number of observations by industry are per table 1. Parameter estimates are based on
Seemingly Unrelated Regression estimation. The autoregressive equation for BV is estimated but not tabulated.
Constrained α2 is the estimate of α2 estimated from the system of equations in which α2 is constrained to equal
ω12 /[(1.12 − ω11 )(1.12 − ω22 )], as predicted by the model’s information dynamics. The p-value in panel A refers
to a Wald χ 2 test of whether the constraint on α2 is binding. Calculated α2 equals ω12 /[(1.12 − ω11 )(1.12 − ω22 )],
where the ωs are estimated in an unconstrained system.

two sets of four jointly estimated equations, one set each for accruals and cash flows. Based
on these estimating equations, we address three research questions relating to the accrual
and cash flow components of earnings.
Relating to our first research question, as predicted, we find that for all industries, accruals
and cash flows each have significant explanatory power in forecasting future abnormal earn-
ings incremental to abnormal earnings. That is, the two components do not have the same
ability to predict future abnormal earnings. In particular, the coefficients on accruals and
cash flows are negative and positive, respectively, indicating that abnormal earnings is less
persistent when accruals comprise a larger proportion of current earnings. We also find that
accruals and cash flows have forecasting relevance in that each has a significant relation with
future abnormal earnings. There is considerable cross-industry variation in the magnitude
of the coefficients on the components in the abnormal earnings forecasting equation.
As to our second research question, we find that for all industries, as predicted, accruals
and cash flows each have significant incremental explanatory power in the relations between
market value of equity and equity book value, abnormal earnings, and each earnings com-
ponent. That is, knowing the accrual and cash flow components of earnings helps explain
market value of equity, incremental to knowing equity book value and abnormal earnings. In
particular, as predicted based on the findings of the abnormal earnings forecasting analysis
226 BARTH, BEAVER, HAND AND LANDSMAN

and the Ohlson model, the coefficients are predominantly negative for accruals and positive
for cash flows. We also find, as predicted, that both components have value relevance in
that their estimated total valuation coefficients differ from zero, indicating that they each
have a significant relation with equity market value. As with abnormal earnings prediction
equations, there is considerable cross-industry variation in the valuation coefficients on the
earnings components.
As to our third research question, we find evidence that the valuation coefficients on
accruals and cash flows vary as predicted by the Ohlson model based on the persistence of
the components and their ability to predict future abnormal earnings. In particular, as noted
above, there is considerable agreement between the signs of the valuation and abnormal
earnings equations coefficients on accruals and cash flows. However, we find that the
correlations between the estimated component valuation coefficients and those calculated
from the abnormal earnings and component autoregressive equations and implied by the
Ohlson model are not consistently positive. We also find that the constraint on the accruals
and cash flows valuation coefficients implied by the Ohlson model is binding for most
industries. Yet the correlations across industries between the constrained and unconstrained
valuation coefficient estimates are high.
Prior accruals and cash flows research investigating potential differences in value rele-
vance for the two components focuses primarily on the persistence of the components in
predicting future earnings and cash flows. Taken together, our findings suggest that, consis-
tent with the accounting-based valuation model of Ohlson (1999), the interaction between
two key characteristics of the components, their ability to aid in forecasting future abnormal
earnings and the persistence of the components themselves, results in different valuation
implications of the accrual and cash flow components of earnings.

Acknowledgments

We thank Ed Maydew, James Myers, Jim Ohlson, Stephen Penman (editor), an anony-
mous reviewer, and workshop participants at UCLA, University of Colorado, University
of Michigan 1999 Spring Training, University of North Carolina, University of Oregon,
University of Washington, and the 1999 Review of Accounting Studies Conference, espe-
cially discussant Richard Sloan, for helpful comments. We appreciate funding from the
Financial Research Initiative, Graduate School of Business, Stanford University, the Cen-
ter for Finance and Accounting Research at UNC-Chapel Hill, and NationsBank Research
Fellowships.

Notes

1. We define cash flows as cash flows from operations, and use the terms interchangeably.
2. Extant literature includes Rayburn (1986), Wilson (1986, 1987), Bowen, Burgstahler, and Daley (1987),
Bernard and Stober (1989), Ali (1994), Dechow (1994), and Sloan (1996). Prior empirical research on
components of earnings other than specifically accruals and cash flows indicate that earnings components
can differ in valuation relevance (e.g., Lipe (1986), Barth, Beaver, and Wolfson (1990), Barth, Beaver, and
Landsman (1992), Hayn (1995), Collins, Maydew and Weiss (1997), and Collins, Pincus, and Xie (1999)).
ACCRUALS, CASH FLOWS, AND EQUITY VALUES 227

3. The basic structure of this model is analogous to the “other information” model of Ohlson (1995) and the
LIM2 information dynamic of Myers (1999). One can interpret x2 as Ohlson’s other information, v, in those
models.
4. Ohlson and Zhang (1998) explores aggregation and its importance in enabling the accounting system to provide
summary performance measures, such as earnings, return on equity, and leverage ratios.
5. We use the same notation for coefficients across the two systems to facilitate exposition. They likely differ.
6. This also is consistent with one-time items having zero persistence with respect to future abnormal earnings
(Ohlson (1999)).
7. We estimated the equations assuming several alternative values for r , with no change in our inferences.
8. We estimate equations (3a) and (3b) and use the residuals in estimating each system’s parameters. However,
we do not tabulate findings for these equations because the parameter estimates do not affect the predictions or
inferences regarding coefficients in the other three equations, which are the equations of interest in this study.
9. Our study eliminates industry #15, “all other,” in Barth, Beaver, and Landsman (1998) because it has too few
observations to estimate reliably regression equations.
10. That is, equations (1a) and (1b) place different implicit restrictions on the coefficient on the portion of abnormal
earnings that comprises the normal return on equity book value, r BV. In equations (1a) and (1b), it is restricted
to be the coefficient on the cash flow and accrual components of earnings, respectively.
11. The finding of a negative ω13 , reported below, also is consistent with 12% being too high. However, as
discussed in footnote 7, our inferences are unaffected by assuming alternative values for r . Also, as explained
above, including BV in the abnormal earnings equation partially relaxes the assumption of r being a fixed
cross-sectional constant.
12. Nonstationarity of the earnings components is a concern for two reasons. First, autoregressive parameters
in excess of one imply that future realizations increase without bound. Second, as ω22 approaches (1 + r ),
which we set equal to 1.12, α2 also increases without bound. Fortunately, nonstationarity is the exception
and not the rule, and ω22 is well below 1.12 even for the two industries for which ω22 for cash flows exceeds
1.00.
13. Using a somewhat different specification and sample period, Barth, Beaver, and Landsman (1998) also docu-
ment variation in equity book value and income coefficients across industries.
14. As expected, the correlations computed without Pharmaceuticals and Financial Institutions generally are higher
than those reported in table 5. In particular, the Pearson (Spearman) correlation between the calculated and
unconstrained α2 estimates for accruals is −0.07 (0.14) with a p-value of 0.84 (0.16) compared with −0.57
(0.05) with a p-value of 0.03 (0.85) reported in table 5. For cash flows, the correlation is −0.02 (0.30) with
a p-value of 0.95 (0.34) compared with −0.44 (0.19) with a p-value of 0.12 (0.51). Similarly, the Pearson
(Spearman) correlation between the calculated and constrained α2 estimates for accruals is 0.44 (0.78) with
a p-value of 0.15 (0.01) compared with −0.48 (0.46) with a p-value of 0.08 (0.10). For cash flows, the
correlation is 0.25 (0.54) with a p-value of 0.43 (0.07) compared with 0.30 (0.63) with a p-value of 0.32
(0.02).
15. Stated another way, our tests represent joint tests of the Ohlson model and the mispricing of accruals. To
determine whether the lack of consistent positive correlation between the calculated α2 and the unconstrained
and constrained α2 estimates is attributable in part to mispricing of accruals, following Sloan (1996), one could
form hedge portfolios based on the difference between α2 implied by the ωs and the unconstrained α2 . This
would involve taking a long (short) position in industries for which the difference between α2 implied by the
ωs and the unconstrained α2 is positive (negative). We leave this for future research.
16. Based on a binomial test, assuming independence, this sign agreement is significant. The test indicates there
is less than a 1% probability of observing by chance the same sign for twelve of fourteen industries.

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