The value-relevance of cash flows and accruals : The role of investment opportunities

We examine how the value-relevance of earnings components – cash flows from operations (CFO), and accruals – varies with investment opportunities. We consider three hypotheses for how CFO and accrual response coefficients (CRCs and ARCs) can vary with IOS. The growth information hypothesis suggests that both CRCs and ARCs increase with IOS because investors infer the abnormal earnings potential of growth opportunities from current earnings surprises. The internal resource hypothesis posits that information asymmetries create a cost wedge between internal and external financing that causes CFO response coefficients (CRCs) to vary directly with IOS and vary more substantially than accrual response coefficients (ARCs). The noisy measure hypothesis proposes that measurement deficiencies cause both CRCs and ARCs to vary inversely with IOS. Using a larger and more representative sample, updated measures, and enhanced model specifications relative to those used in prior studies, we find that both CRCs and ARCs first increase with IOS and then decline. We conduct two additional tests to distinguish between the first two hypotheses. First, we find, conditional on IOS, that CRCs are higher and ARCs lower when investments are intangible intensive. Second, both CRCs and ARCs are higher when liquid resources in excess of normal operating and investing needs are low than when they are high. These findings support the internal resource hypothesis and the noisy measure hypothesis but do not favor the growth information hypothesis. Furthermore, the impact of the internal resource hypothesis dominates at low-IOS levels and for CRCs, while the noisy measure hypothesis dominates at high-IOS levels and for ARCs. The findings have implications for financial analysis and accounting regulation.