Conservative Accounting and Free Cash Flow

The extant literature has paid little attention to the effect on earnings of conservative accounting for free cash flow. Rather, it has focused on the relation between earnings and returns. Our primary contribution is to add to the analysis of the earnings/return relation an analysis of the relation between earnings and free cash flow. We argue and show that the portion of cash flow that is captured in earnings reflects accounting rules, which require expensing of the investment rather than capitalizing into book value. Our core empirical result is that free cash flows in either direction explain more of operating (i.e., firm-level) income than is explained by returns. It follows that failure to recognize the additional free cash flow/earnings relation may lead to misunderstanding of reported operating income, particularly when free cash flows are considerable. We argue and show that incorporating the direction of a firm’s free cash flow (into vs. out of the firm) adds substantially to understanding the relation between earnings and returns both when returns are negative and when they are positive. We illustrate our contributions by examining: (1) how accounting for free cash flow changes with leverage; and, (2) how the effect of leverage on the earnings/return relation differs with the sign of free cash flow.