Revisiting Measurement Error in Surrogate Measures of Operating Cash Flows: Have We Solved the Problem?

Prior research documents that surrogate measures of operating cash flows contain measurement error. However, numerous studies in accounting and finance continue to use these measures. We find the measurement error in surrogate cash flow measures is not only correlated with non-articulation events, but also firm characteristics. Further, we find the common method for addressing the measurement error problem (i.e., removing observations with mergers and acquisitions, divestitures, and foreign currency translations) does little to reduce the magnitude of the error. We also demonstrate the measurement error in surrogate cash flows yields incorrect inferences. Several studies using surrogate measures of cash flows find that earnings better predict future cash flows than do cash flows (e.g., Kim and Kross, 2005).

However, we show that:

(1) this relation is reversed when cash flows are measured correctly, and

(2) removing observations with non-articulation events does not correct the measurement error issue.

In summary, we recommend researchers avoid using surrogate measures of cash flows. If information from the statement of cash flows is not available for the entire sample period under consideration, researchers should verify the robustness of the main findings using a subsample for which statement of cash flows data is available.