Accrual and cash flow accounting models: A comparison of the value relevance and timeliness of their components

This research uses the empirical framework developed by Easton, Harris and Ohlson (1992) to examine the relative ability of the accrual and cash flow accounting models to capture value relevant events. In particular, components of clean surplus accrual earnings are compared with components of total cash flows to determine their relative abilities to recognise value relevant events in a timely manner. The results indicate that the association between stock returns and earnings is higher than that with total cash flows for return intervals of between one and ten years. Cash flows from operations and current accruals are able to recognise value relevant events in a timely manner, while non-current and non-operating accruals only become consistently value relevant when longer return intervals are considered. Cash flows from investing and financing activities are less value relevant than the other components considered, especially over longer return intervals.     

Professionalism vs Commercialism: The Association Between Non-Audit Services (NAS) and Audit Independence

This paper examines the relative information content of earnings and cash flows for security returns using a methodology incorporating contextual factors which may affect earnings and cash flow response coefficients. For our UK dataset, we provide evidence that the earnings coefficient is related to earnings permanence, growth and firm size and that the cash flow coefficient may be related to growth. Although our results emphasise the value relevance of earnings, they also suggest that both contemporaneous and prior period cash flow are positively related to security returns and that market-to-book and market value of equity have predictive power for returns.     

The Information Content of Cash Flow Figures

This paper investigates the link between earnings and share prices for a sample of UK companies for the years 1961 to 1977. Three measures of earnings were used: the traditional historical cost accounting return and two which were closer to cash flow measures. The strength of the link between earnings and cumulative abnormal returns was investigated relative to the level of inflation. The results indicate that, while there is substantial information content in the traditional historical cost rate of return, there is very little information conveyed by the measure closest to pure cash flow. No support was therefore found for the use of cash flow based reports. Evidence was found showing substantial changes in the nature of the relationship between accounting and stock returns, but this could not be explained by the effects of inflation.     

The Relation between Returns and Earnings: Evidence for the UK

This paper presents an empirical study of the explanatory power of annual earnings figures for annual stock returns using UK data. The analysis is performed on a sample of companies, with varying year-ends, over the period 1969–1990. The research exploits Ohlson's recent theoretical contributions to the study of the valuation relevance of accounting information, and it complements a study by Easton and Harris (1991) on US data. Similar to the results of Easton and Harris, the results for the UK provide consistent evidence that both earnings levels and earnings differences have significant explanatory power for security returns. However, unlike Easton and Harris, the evidence from individual year regressions suggests that changes in earnings rather than the level of earnings may be more important in explaining security returns in the UK.     

Aggregate Earnings and Asset Prices

A principal-components analysis demonstrates that common earnings factors explain a substantial portion of firm-level earnings variation, implying earnings shocks have substantial systematic components and are not almost fully diversifiable as prior literature has concluded. Furthermore, the principal components of earnings and returns are highly correlated, implying aggregate earnings risks and return risks are related. In contrast to previous studies, the correlation we report between the systematic components of earnings and returns is stable over time. We also show that the earnings factors are priced, in the sense that the sensitivities of securities' returns to the earnings factors explain a significant portion of the cross-sectional variation in returns, even controlling for return risk. This suggests earnings performance is an underlying source of priced risk. Our evidence that the information sets of returns and earnings are jointly determined implies cash flow risk and return risk are not fully separable, and raises the possibility that it is the common variation of earnings and returns that is priced.     

Earnings, cashflows and returns: Functional relations and the impact of firm size

The relation between stock returns, earnings and cashflows is of importance because it directly addresses the issue of whether accounting data provide value relevant information. The empirical evidence to date, however, has documented low explanatory power for earnings and inconclusive incremental information content for cashflows. This research re-evaluates the incremental information content debate using Australian data. Our research is motivated by: recent innovations in research design, including the specification of nonlinear functional relations between accounting variables and prices, and the fact that differences in firm size characteristics may influence the relative information content of the accounting variables. We observe that: (i) a nonlinear functional relation provides greater explanatory power for both earnings and cashflows;(ii) the results are consistent with more transitory earnings components for smaller firms; and (iii) contrary to received theory, cashflows add greater incremental explanatory power for large firms.     

The role of accruals and cash flows in explaining security returns: Evidence from New Zealand

This paper empirically examines the relative and incremental information content of earnings and cash flows and the role of firm-specific contextual factors in moderating information content in New Zealand. Accounting earnings are considered to be the premier information source for decision making and a substantial volume of literature, primarily in the United States, shows that earnings provide superior information to that of cash flows. However, significant reporting differences in New Zealand warrant and investigation of the role of earnings and cash flows to explain security returns. Results show that (a) earnings have higher explanatory power than cash flows, although the difference is not statistically significant, and (b) both earnings and cash flows have incremental information content for stock returns. Further analysis shows that the valuation role of earnings and cash flows is moderated by firm-specific factors.     

Earnings forecasts and idiosyncratic volatilities

We test the theoretical relation between idiosyncratic return volatilities and the volatilities of cash-flow news based on the expected returns on equity (ROE) for CRSP stocks over the period 1977–2008. Consistent with economic intuition, we find that using analyst forecasts of earnings is superior to using realized earnings to proxy for market expectations about future cash flow news. Our findings are consistent with a market where stock return volatilities are positively and asymmetrically related to changes in the volatilities of expectations for a fundamental driver of cash flow news (ROE). Our findings are robust after correcting for forecast biases, various fundamental variables, newly-listed and mature firms, and periods with and without earnings announcements.     

Relative performance evaluation in board cash compensation: UK empirical evidence

This paper presents an empirical examination of whether evidence of the implicit use of relative performance evaluation (RPE) can be found in the cash compensation of boards of directors for 169 UK non-financial listed companies that existed for all of the period from 1971 to 1998. We perform two types of analyses. Initially, we estimate individual firm time series regressions of the change in board cash compensation against measures of firm and peer group performance. The measures of firm performance we use are annual cash stock market returns and pre-tax accounting earnings. Peer group measures of performance are industry value-weighted average cash stock market returns and industry value-weighted average pre-tax accounting earnings. Subsequently, we analyse the data as a balanced panel.We provide evidence that board cash compensation is positively related to accounting earnings and negatively associated with peer group pre-tax accounting earnings. Some evidence suggests that board cash compensation is related to firm stock market returns but none suggests it is related to peer group market returns. This result implies the presence of RPE based on accounting earnings in the design of UK board compensation, with the cash compensation of boards of directors implicitly (partially) protected from industry uncertainties.     

An Analysis of the Relation between the Stewardship and Valuation Roles of Earnings

In this paper, we seek a deeper understanding of how accounting information is used for valuation and incentive contracting purposes. We explore linkages between weights on earnings in compensation contracts and in stock price formation. A distinction between the valuation and incentive contracting roles of earnings in Paul [1992] produces the null hypothesis that valuation earnings coefficients (VECs) and compensation earnings coefficients (CECs) are unrelated. Our empirical analyses of the relations between earnings and both stock prices and executive compensation data at the firm and industry levels over the period 1971–2000 rejects Paul's [1992] hypothesis of no relation. We also document an increasing weight over time on other public performance information captured by stock returns in the determination of cash compensation. Specifically, we find that the incentive coefficient on returns is significantly higher in the second of two equal sample subperiods relative to the incentive coefficient on earnings.     

Impact of Earnings,Dividends and Cash Flows on Stock Returns: Case of Taiwan's Stock Market

The study uses Taiwan's stock market, a newly developed market with different characteristics from that of the U.S., as an experimental case to examine the influences of the market's characteristics on the relationship between stock returns and fundamental accounting information, such as earnings, dividends and cash flows. The testing period is from 1990 to 1994, right after the promulgation of Taiwan's accounting standard for statement of cash flows in 1989.Similar to the findings of U.S. studies, the study shows that earnings data is key information for investors. Unlike the U.S. results, however, both operating income and non-operating income are positively related to stock returns. The usefulness of non-operating income to explain stock returns is due mainly to its recurrent characteristic in Taiwan. The market views non-operating income, mostly from disposal of real-estate and short-term equity investments, as a complementary factor to operating income. It is a possible common phenomenon in a booming economy. Unlike from the results of U.S. studies, Taiwan's stock returns are strongly associated with stock dividends. Cash dividends, however, are relatively less important information to the market. The fast booming economy as well as Taiwan's free tax rate on capital gains are the explanations for the different findings. The results also support McNicholes and Dravid's (1990) and etc. results that stock dividends may act as a signal for favorable future earnings. Examining the association between stock returns and cash flow information, the results indicate that stock returns are positively associated with cash flows from both operating and financing activities. The phenomenon implies that the market appreciates not only the cash inflows from operating activities, but also cash inflows from new issues of bonds or stocks for further expansion. It is consistent to Taiwan's booming economy. The finding also supports Ross (1977) and Leland and Pyles' (1977) signaling hypothesis.The study concludes that the relationships between stock returns and fundamental variables are subject to the market's characteristics. The case of the Taiwan stock market shows that usefulness of accounting information depends upon the different roles of the information in the tested market. The results of the study also indicate that directly applying the U.S. experiences without any adjustment may cause incorrect conclusions for empirical studies.     

Direct versus indirect regression estimates of foreign exchange cash flow exposure

To estimate foreign exchange (FX) cash flow exposure, one may choose between direct and indirect regression approaches, where the direct approach uses accounting-based cash flow data and the indirect approach uses equity returns as a cash flow proxy. The indirect approach typically includes one or more additional independent variables to control for the impact of FX changes on the required rate of return. Frequently, the control variable is an equity index. We propose that using a bond return control variable instead of equity returns addresses several theoretical problems inherent in the indirect estimation approach. In our empirical analysis we find that using the bond-based control variable results in FX cash flow exposure estimates that are more highly correlated with direct measures than using an equity index as a control variable.     

Detecting news in aggregate accounting earnings: implications for stock market valuation

How much news is there in aggregate accounting earnings? I provide evidence that earnings changes at the stock market level are correlated with new information about not only expected future cash flows but also discount rates. A comprehensive investigation of the link to discount rates reveals that aggregate earnings changes are tied to news about all components of the expected future stock market return, i.e., the real riskless rate, expected inflation, and the expected equity risk premium. Over the sample period studied, cash flow news and discount rate news in aggregate earnings changes covary positively and have offsetting impacts on stock market prices. As a result, stock market prices appear to be insensitive to aggregate earnings changes. The findings highlight the importance of separating cash flow news from discount rate news when evaluating the information content of accounting earnings at the stock market level. Overall, my study sheds new light on the informativeness and relevance of accounting earnings for valuation at the stock market level.     

The Incremental Information Content of Earnings and Cash Flows from Operations Affected by Their Extremity

Previous returns studies have shown that extreme earnings and extreme cash flows from operations are less informative than moderate (i.e., less extreme) earnings and moderate cash flows. Studies also report that cash flows supplement to earnings in firm valuation by showing a higher association of cash flows with returns when earnings are extreme than when earnings are moderate. We propose that this supplementary role of cash flows is affected by cash flows extremity. Using data from the US capital markets, we find that the supplementary role of cash flows exists only when cash flows are not extreme. We also investigate the supplementary role of earnings to cash flows and search for a higher association of earnings with returns when cash flows are extreme than when cash flows are moderate. Similar to results on cash flows, our findings show that the supplementary role of earnings exists only when earnings are not extreme. Our results imply that investors and researchers should consider both earnings and cash flows extremity when assessing the information content of these variables.     

The relevance of earnings and cash flows in a heavily regulated industry: Evidence from the Greek banking sector

This study examines the informational quality of annual accounting earnings within Greek banking institutions taking into consideration the most significant risks facing by such firms and specifically interest rate risk, credit risk, liquidity risk and solvency risk, alongside with the persistence of earnings and bank size as significant determinants of ERCs. Data analysis over a period of ten years (1995-2004) revealed that earnings have higher incremental importance in explaining stock return movements compared to cash flows since earnings change has been found to affect stock returns positively. Additionally, interest rate risk has a positive but not significant impact on the return-earnings relation but on the contrary solvency risk, credit risk and liquidity risk proved to have a negative impact on the valuation process for both small and big-sized banks. Finally, tests on the incremental informativeness of cash flows when earnings are transitory provide significant results suggesting that investors seek for alternative measures of banks' performance when earnings are characterized by increased extremity but inversely cash flows and earnings seem to be equally value relevant when investors evaluate big-sized banking institutions. The results are generally robust to the specification of the empirical models and the research design employed in our study.     

Financial reporting quality and idiosyncratic return volatility

Campbell et al. (2001) document that firms’ stock returns have become more volatile in the U.S. since 1960. We hypothesize and find that deteriorating earnings quality is associated with higher idiosyncratic return volatility over 1962–2001. These results are robust to controlling for (i) inter-temporal changes in the disclosure of value-relevant information, sophistication of investors and the possibility that earnings quality can be informative about future cash flows; (ii) stock return performance, cash flow operating performance, cash flow variability, growth, leverage and firm size; and (iii) new listings, high-technology firms, firm-years with losses, mergers and acquisitions and financial distress.     

Portfolio performance and accounting measures of earnings: an alternative look at usefulness

Measures of economic performance, such as accounting earnings, working capital and cash flows, have been evaluated in tests of relative explanatory power of regressions of market returns on earnings, working capital and cash flows. We employ a different test. Using Basu’s (J Finance 663–682, 1977) investment trading strategy, we measure portfolio returns based on these three accounting measures of earnings. The objective is to ascertain whether investment performance also supports the findings of the explanatory power studies that accounting earnings is the premier measure of performance. The evidence does not support this conclusion. Our findings are at variance with prior conclusions that accounting earnings is more useful than cash flow. The Basu trading strategy is effective for all three measures. Excess market returns are observed for all three measures, even when controlled for risk and for low priced stocks. But accounting earnings portfolios do not dominate working capital or cash flow portfolios. In fact, the raw returns to cash flow portfolios are marginally (statistically) larger than accounting earnings portfolios. Economically, a dollar invested in a portfolio using accounting earnings to select the stock would have an accumulated value of 22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of 33.94 over the same 16 years starting with the second quarter of 1988 and concluding at the end of the first quarter of 2004. Thus, our results have implications for the studies of explanatory power of different measures of earnings and their comparison in the US and other markets.     

Information Provided by Accrual and Cash-Flow Measures of Operating Activities

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.     

Accounting Conservatism and the Relation Between Returns and Accounting Data

This study adds change in cash investments and change in lagged operating assets to the regression of returns on earnings levels and earnings changes examined in Easton and Harris (1991). We argue that a positive coefficient on change in cash investments captures conservatism associated with investments in positive net present value projects the effects of which will not flow into the accounting statements until the expected future benefits are realized. A positive coefficient on change in lagged operating assets implies accounting conservatism associated with the application of accounting rules to operating assets in place. Our empirical results are, in general, consistent with these arguments. We examine differences in conservatism across samples with different market to book ratios, we compare firms with non-negative returns with firms with negative returns, we compare firms reporting losses with firms reporting profits, and we examine firms in different industries, firms with different levels of research and development expenditure, different amounts of depreciation, different amounts of advertising expense, and firms that adopt LIFO inventory valuation compared with those that adopt an alternative to LIFO.JEL Classification: M41     

The decision relevance and timeliness of accounting earnings in Saudi Arabia

This study examines the decision relevance and timeliness of accounting earnings in Saudi Arabia during the 1995-1999 sample period. The empirical results suggest that the publication of accounting earnings does not cause significant revision to the market assessment of future cash flows of Saudi firms. On the other hand, it appears that the publication of accounting earnings leads individual investors to revise their security holdings. However, this evidence is limited to cases where firms reported profit. The empirical results further suggest that earnings are timely in terms of their association with security returns and that increasing the measurement interval significantly improves this association. The tests also show that positive and negative earnings have differential implications for the timeliness of accounting earnings. Further tests show that this evidence is not consistent with the loss liquidation argument [J. Account. Econ. 20 (1995) 125] and, potentially, may reflect the lack of tax incentives to liquidate investments in loss firms. Finally, the results show that Saudi managers do not incorporate economic losses into accounting earnings on a timely basis which may reflect reduced market demand for accounting information, low levels of public debt, low expected litigation costs, and weak monitoring by analysts and other stakeholders.