The effect of conservative reporting on the relationship between long-term accruals and operating cash flows: Implications for the persistence and value relevance of earnings

This study investigates the effect of conservative reporting on the relationship between long-term accruals and operating cash flows. Focusing on conservative reporting of depreciation, I find that the discretionary portion of depreciation accruals has a strong, negative relationship with future operating cash flows. These results remain strong even using different measures of discretionary accruals, different sample compositions and the addition of control variables. As depreciation accruals are "inherently" negative as an earnings component, this implies that higher discretionary depreciation is associated with higher future cash flows. This finding is consistent with the positive private information hypothesis, that conservative reporting reveals managers' expectations of superior future performance. I also document that this negative relationship depresses earnings persistence. However, the market ignores the lower earnings persistence and places a higher valuation weight on earnings for firms that are more conservative in reporting their depreciation.; This study makes several contributions to accrual accounting and conservative reporting. First, inherently negative accruals such as depreciation and asset write-downs behave very differently from short-term and other non-negative long-term accruals, both theoretically and empirically. Researchers should be cautious of the potential adverse impact of combining all accruals together in their inquiries. Second, theorists have long suggested that conservative reporting can reveal managers' private information. No study has tested the private information hypothesis from the perspective of depreciation. The findings in this study confirm the positive private information hypothesis for conservative recording of depreciation. Third, this study shows that the conventional framework of higher persistence of earnings leading to higher value relevance does not work when considering the conservative reporting of depreciation. This framework serves as a backbone for the literature on earnings quality and accrual mispricing. Researchers should be cautious with their conclusions in these avenues of accounting research when dealing with aggregate accruals.