Cash versus accrual components: forecasting future cash flows through line item decomposition

Purpose This study aims to examine the predictive ability of cash and accrual components of income statement line items in forecasting future cash flows. By decomposing these line items, the paper provides a detailed understanding of the information content contained within each component. Design/methodology/approach Each income statement line item [sales, cost of goods sold (COGS), operating expenses, non-operating income] is decomposed into its cash and accrual components, and the predictive abilities of these components are analyzed in relation to future cash flows. The study uses a regression analysis approach on a sample of 46,723 firm-year observations from the Compustat database covering the period from 1987 to 2020. Findings The results indicate that cash components generally demonstrate stronger predictive ability for future cash flows compared to their accrual counterparts. However, accrual components offer additional relevant information, particularly in situations involving timing and matching issues, where they align revenues and expenses more accurately. Disaggregating earnings into cash and accrual components yields superior predictive accuracy compared to aggregated earnings. Research limitations/implications The findings highlight the significance of incorporating both cash and accrual information in financial analysis and forecasting. This suggests that future research could explore the impact of accounting standards, industry-specific factors and macroeconomic conditions on the predictive abilities of these components. Practical implications The paper emphasizes the importance of considering both cash and accrual information when evaluating the potential risks and opportunities associated with a firm’s financial performance. Originality/value This research contributes to the ongoing debate regarding the relative predictive power of cash flows versus accruals. By decomposing income statement line items, the study provides new insights into the distinct roles that cash and accrual components play in financial performance analysis.