This paper examines the relation between earnings and operating cash flow to derive and test an indicator of financial statement fraud. Accrual measurement concepts indicate that financial statement fraud should be associated with high levels of earnings relative to operating cash flow. We demonstrate that the excess of earnings over operating cash flow is extreme in most fraud cases in years immediately prior to the fraud discovery based on a sample of 56 fraud cases from 1978 to 1991. We compare the distribution of the earnings minus operating cash flow variable for fraud firms with that for a sample of 60,453 firm‐years for firms listed on COMPUSTAT. We test a logistic regression model in which the discovery/nondiscovery of fraud is the dependent variable, and earnings minus operating cash flow is the explanatory variable. Other control variables are included in the model based on prior studies. Results are consistent with expectations derived from accrual measurement theory. We then examine the predictive ability of the model using our sample of fraud firms and a sample of nonfraud firms in the same four‐digit SIC code industries. Observations for the fraud firms are for the fiscal year prior to the discovery of fraud. Observations for the nonfraud firms are for the same fiscal years as the fraud firms in the same industries. The predictive ability of the model, including the excess of earnings over operating cash flow, is substantially higher than the predictive ability of the model omitting this variable. We conclude that the earnings‐operating cash flow relation provides important information for those interested in identifying financial statement fraud, especially when considered in conjunction with other factors associated with fraud risk.

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The proposal by the Financial Accounting Standards Board (FASB) in 2002 to produce principles-based accounting standards is an explicit commitment to use its conceptual framework to improve financial accounting. In effect, it is a proposal to assist accounting for economic reality. However, an evaluation of the proposal and related FASB communications reveals a global strategy more concerned with achieving comparability and consistency than identifying improved ways of recognizing and representing socially-constructed reality by accounting numbers. The paper examines the philosophical notions of social reality and truthful correspondence in light of principles-based accounting standards and suggests that the FASB's superficial use of its conceptual framework in this respect is consistent with a history of conceptual frameworks as means of legitimating standard setting activities. As such, the FASB proposal would be no more than a short-term palliative to the long-term ills of financial accounting world-wide. The paper recommends a better understanding of the construction and representation of social reality by all concerned with the world of financial accounting.

This article examines accrual and cash-flow measures useful for observing companies' financing, investing and operating activities. It addresses the information provided jointly by income and operating cash flow, and reveals that information provided by these accounting measures is dependent on their relative magnitudes. A consistent pattern of income in excess of operating cash flow, with both measures appropriately adjusted and scaled, indicates superior company growth. Income and cash-flow patterns are associated significantly with various company financing, investing and operating attributes. Empirical tests confirm that both income and operating cash flow are important for observing company performance and prospects when considered jointly and when interpreted with respect to accounting measurement theory. At least for many companies, the results do not support the conventional wisdoms that accounting measures of income and operating cash flow converge over long periods of time and that earnings provide a reliable basis for cash-flow prediction.This article investigates accrual and cash-flow measures useful for observing corporate financial performance. Empirical research involving the accrual/cash-flow relation has concentrated primarily on information provided by reported earnings and the related components of accruals and operating cash flow (e.g., Bowen et al., ). Those works examine the incremental information provided by accruals with respect to cash flow 1 or the incremental information provided by cash flow with respect to earnings.We examine the information provided jointly by accrual and cash-based measures. Accounting measurement theory provides a basis for identifying this information. A theoretical analysis of the accounting measurement process indicates that the information provided by accrual and cash-based measures depends on their joint relation rather than on either measure alone or on their incremental contributions. In the analysis presented and ROBERT W.