This study uses an experiment to examine (1) what factors give rise to investors' inability to fully incorporate operating cash flows and accruals into their earnings forecasts, and (2) what conditions help to improve investors' forecast accuracy when operating cash flows and accruals exhibit differential persistence. I investigate how decomposing the forecasting task and altering the presentation format combine to enable analysts and nonprofessional investors to acquire and accurately process financial statement information when operating cash flows and accruals are differentially persistent. I find that the earnings forecasts of analysts and M.B.A. students are more accurate only when participants are required to provide separate forecasts for operating cash flows and accruals and the income statement is altered to present the disaggregated cash and accrual components of earnings.

A fundamental accounting question is whether investors perceive low risk when earnings are smooth relative to the volatility of operating cash flows. We conduct two experiments to examine this question. Absent additional information concerning the likelihood of earnings management, our first experiment finds that investors give managers the benefit of the doubt and perceive low risk when earnings are relatively smooth. Given this finding, our second experiment examines whether additional information that supports investors' suspicions of earnings management affects investors' risk judgments when earnings are relatively smooth. We find that investors no longer give managers the benefit of the doubt when additional information suggests that managers have either the opportunity or the incentive to report smooth earnings. Our study provides important insights to the literature concerning both “whether” and “when” relatively smooth earnings affect investors' risk judgments. Data Availability: Contact the authors.

Although the differential persistence of accruals and operating cash flows is a firm-specific phenomenon, research seeking to exploit the differential persistence of these earnings components typically employs cross-sectional forecasting models. We find that a model based on firm-specific estimates of the differential persistence of accruals and operating cash flows is incrementally useful for out-of-sample forecasting relative to state-of-the-art cross-sectional models. In doing so, we show that firm-specific estimates of differential persistence are particularly useful when forecasting earnings for more stable firms (e.g., more profitable, lower growth, and less levered firms). We also demonstrate that a trading strategy exploiting investors' fixation on earnings and based on firm-specific estimates of differential persistence earns statistically and economically significant excess returns that are incremental to those generated by trading strategies based on the size of accruals. These results suggest that firm-specific estimates of differential persistence are incrementally informative for forecasting and valuation. JEL Classifications: M41.

No abstract

We examine how shareholders' trust in managers is affected by (i) the outcome of earnings management (inconsistent vs. consistent with shareholders' interests) and (ii) the method of earnings management (accruals vs. real methods). Using a controlled experiment, we predict and find that trust is impaired when the outcome of earnings management suggests that managers have put their interests above shareholders' interests and/or when the method of earnings management suggests that managers misreported the firm's economic performance. We argue that shareholders assess managers putting their interests above shareholders' interests as a signal of untrustworthiness because it involves a transfer of the firm's resources away from shareholders to managers. We argue that shareholders also assess managers' use of accruals to manage earnings as a signal of untrustworthiness because, in this instance, managers misreport the firm's economic performance. Finally, we show that trust mediates the combined effects of the outcome of earnings management and the method of earnings management on investment decisions. Our study incrementally contributes to the literature by highlighting the adverse implications of managers' use of accruals to manage earnings even when its outcome serves shareholders' interests.