A Modified Dechow and Dichev (2002) Model with Cash Flow Forecasts

We propose a modification to the Dechow and Dichev (2002) model (DD hereafter) by replacing realized next-period cash flows with forecasted future cash flows. We first theorize the relation between the modified- and original DD model and that between abnormal accruals from the modified DD model and future stock returns. Our empirical evidence shows that the accruals quality from the modified DD model is associated with established measures of earnings quality. Further, we find that the residuals from the modified DD model, especially under information asymmetry, are predictive of future size-adjusted returns, matching the performance from Jones-type models. Overall, our modified DD model without the foresight requirement is as effective as the original DD model in measuring earnings quality. More importantly, expanding the usefulness of the DD model, our model can estimate the current-year information on earnings management and allow investors to predict stock returns.