Accrual accounting and gross domestic product

Abstract This paper examines the management discretion in the accrual accounting system as the explanation for the predictive ability of aggregate accounting earnings for gross domestic product (GDP), using a sample from China. According to the influence of management discretion, we decompose accounting earnings into cash flows and accruals, and further decompose accruals into discretionary accruals and non-discretionary accruals. Among them, accruals and discretionary accruals are respectively more affected by management discretion than cash flows and non-discretionary accruals. Empirical results show that the aggregate accruals growth (AAG) is more predictive for future GDP growth than the aggregate cash flows growth (ACG), and the aggregate discretionary accruals growth (ADAG) is consistently more predictive than the aggregate non-discretionary accruals growth (ANAG). Further analysis based on the China setting shows that AAG and ADAG both have stronger predictive ability for future GDP growth after the implementation of the new accounting standards in 2007, and in provinces with greater economic freedom. Moreover, the AAG and ADAG of non-state-owned companies have stronger predictive ability than that of state-owned companies. Taken together, these results imply that the influence of management discretion on accounting earnings can shed light on why aggregate accounting earnings can predict future macroeconomic development.