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The pricing of earnings and cash flows in the presence of abnormal and normal accruals

Abstract This paper proposes a framework to assess the effects of abnormal and normal accruals on the valuation relevance of earnings and cash flows. We use this framework to investigate the relative weights placed by investors on earnings and cash flows, as a function of estimated normal and abnormal accruals. Assuming that the construct capitalised by investors is (unobservable) economic earnings, and that normal accruals capture the noise in cash flows as a measure of economic earnings, while abnormal accruals capture the noise in reported earnings as a measure of economic earnings, we predict that normal accruals (abnormal accruals) reduce the valuation weights placed by investors on cash flows (earnings). We find that abnormal accruals estimated using a modified version of the Jones (1991) model are associated with lower valuation weights placed on earnings. Results for the cash flow prediction are mixed, in that the valuation weight placed on cash flows in the presence of high magnitudes of normal accruals is lower when abnormal accruals are negative, but not when abnormal accruals are positive. © City University of Hong Kong.