The Differential Persistence of Accrual and Cash Flow Components of Earnings and Predicting of Future Profitability

Profitability in prior studies is typically defined as one-year-ahead operating income divided by one-year-ahead average total assets. This scaling transforms operating income into return on assets (ROA). Their results reveal that the accrual component of profitability is less persistent than the cash flow component and has been widely interpreted as signaling earnings management. Accordingly, we investigate whether differential persistence of the accrual and cash flow components of profitability is attributable to their differential impacts on one-year-ahead operating income (the numerator of ROA) or one-year-ahead average total assets (the denominator of ROA)? We test hypotheses based on sample includes 1860 firm-years observation in Tehran Stock Exchange for the 10-year period 1375 to1385 and results reveal that accruals are more highly associated than cash flows with invested capital in the denominator of the profitability measure. In contrast, accruals and cash flows have no differential relation to one-year-ahead operating income. This suggests that the lower persistence of accruals versus cash flows may not be due to earnings management but may rather be due to the effect of growth on future profitability.