An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Oliver Kim
University of Maryland

Steve Lim
Texas Christian University

Taewoo Park
Kennesaw State University

Abstract: We test the validity of the prediction test of future cash flows as a substitute for the test of value relevance of earnings. We theoretically show that the R2 of the cash flows prediction regression is contaminated by (1) the relative presence of noise in future cash flows (2) the relative presence of noise in the covariance between future cash flows and current earnings. We test if either of the above two factors contribute to the result of Kim and Kross (2005) that the ability of earnings to predict one-year-ahead cash flows has increased over the recent decades, in contrast to the evidence of decreasing value relevance of earnings presented by others. We find empirical evidence that both factors contributed to their result. From the signi?cant presence of noise in cash flows (97%) and also in the covariance (87%), we conclude that the cash flows prediction test is a poor substitute for the test of value relevance of earnings, and perhaps of other accounting numbers as well.

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