JOURNALOF Accounting &Economics ELSEVIER Journal of Accounting and Economics 18 (1994) 3-42 Accounting earnings and cash flows as measures of firm performance The role of accounting accruals Patricia M. Dechow Wharton School, University of Pennsylvania, Philadelphia, PA 19104-6365, USA (Received October 1992; final version received September 1993) Abstract This paper investigates circumstances under which accruals are predicted to improve earnings’ ability to measure firm performance, as reflected in stock returns. The import- ance of accruals is hypothesized to increase (i) the shorter the performance measurement interval, (ii) the greater the volatility of the firm’s working capital requirements and investment and financing activities, and (iii) the longer the firm’s operating cycle. Under each of these circumstances, cash flows are predicted to suffer more severely from timing and matching problems that reduce their ability to reflect firm performance. The results of empirical tests are consistent with these predictions. Key words: Capital markets; Accruals; Operating cycle; Timing and matching problems; Summary measures of performance JEL classification: C52; G14; M41 I am grateful for the encouragement and guidance from Ross Watts, Ray Ball, S.P. Kothari, Jay Shanken and Jerry Zimmerman (the editor). This paper has benefited from Sudipta Basu, Fischer Black, Michele Daley, Neil Fargher, Stephen Fisher, Bob Holthausen, Krishna Palepu, Terry Shevlin, Amy Sweeney, and Peter Wilson. I am also grateful to Dan Collins (the referee) and Richard Sloan for many insightful comments and to Philip Kearns for his help on nonnested model selection techniques. The paper has benefited from workshop participants at University of Chicago, Columbia University, Harvard University, Massachusetts Institute of Technology, University of Michigan, Northwestern University, University of Rochester, Wharton School of the University of Pennsylvania, and Yale University. 0165-4101/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 016541019400356 A