In this section we develop a simple model of operating cash flows and the accounting process by which operating cash flow forecasts are incorporated into accounting earnings. The model explains why operating cash flow changes have negative serial correlation and how earnings incorporate the negative serial correlation to become a better forecast of future operating cash flows than current operating cash flows. The model also explains other time series properties of earnings, operating cash flows and accruals. Further, the model provides predictions as to how the relative forecast abilities of earnings and operating cash flows vary across firms and explicit.
