Cash flow disaggregation and the prediction of future earnings

We examine the incremental information content of the components of cash flows from operations (CFO). Specifically the research question examined in this paper is whether models incorporating components of CFO to predict future earnings provide lower prediction errors than models incorporating simply net CFO. We use Australian data in this setting as all companies were required to provide information using the direct method during the sample period. We find that the cash flow components model is superior to an aggregate cash flow model in terms of explanatory power and predictive ability for future earnings; and that disclosure of non‐core (core) cash flows components is (not) useful in both respects. Our results are of relevance to investors and analysts in estimating earnings forecasts, managers of firms in regulators’ domains where choice is provided with respect to the disclosure of CFO and also to regulators’ deliberations on disclosure requirements and recommendations.     

Changes in accrual properties and operating environment: Implications for cash flow predictability

This paper reconciles conflicting evidence in prior literature on the relative ability of earnings and cash flows in predicting future cash flows. Further, we investigate the implications of temporal shifts in accrual properties and operating environment for cash flow predictability. Three key insights emerge. First, cash flows consistently outperform earnings in predicting future cash flows. Second, accruals and its components, including those capturing non-articulating events, have incremental (albeit small) predictive ability over cash flows. Third, earnings’ ability to predict future cash flows has increased over the period 1989–2015, due to changes in operating environment rather than accrual properties.     

The usefulness of operating cash flow and accrual components in improving the predictive ability of earnings: a re‐examination and extension

We examine whether the components of accruals and operating cash flows improve the predictive ability of earnings for forecasting future cash flows. Unlike most previous studies, we avoid data estimation errors and sample self‐selection bias because we exploit data from Australia where reporting of actual cash flow components had been mandatory since 1992. We show that accrual components and operating cash flow components together are more useful than (i) earnings, (ii) operating cash flows and total accruals and (iii) the combination of operating cash flows with accrual components in forecasting future cash flows. These results are robust to several contextual factors, including the length of the operating cash cycle, industry membership, firm profitability and firm size.     

Earnings Reported under IFRS Improve the Prediction of Future Cash Flows? Evidence from European Banks

This paper examines the relative costs and benefits of International Financial Reporting Standards (IFRS) adoption in the European Union by testing the ability of earnings computed under IFRS to predict future cash flows. The study considers the contribution of net income, comprehensive income and other comprehensive income to the usefulness of earnings to predict cash flows, and it compares IFRS with domestic Generally Accepted Accounting Principles (GAAP). Evidence from a sample of Continental European banks shows that IFRS improve the ability of net income to predict future cash flows. Comprehensive income, too, provides relevant information to predict future cash flows, although with a measurement error which is higher than that in net income for greater lags of time. In our interpretation, these findings are consistent with unrealised gains and losses recognised in other comprehensive income being more transitory and volatile in nature. Overall, our results are relevant to academics and standard setters debating the merits of IFRS adoption and to those who use financial statements and adopt reported earnings to form expectations about future cash flows.     

The Relationship between Earnings,Funds Flows and Cash Flows: Evidence for the UK

Recent UK information content studies have provided evidence of a significant relationship between earnings and share prices, as in the US, but have also identified an apparent lack of information content for operating cash flow, which is in marked contrast to findings from US research. This paper provides direct evidence on the relationship between earnings, funds flows and cash flows in the UK during the period 1965–84, using tests of association and predictive tests based on a research methodology applied by Bowen, Burgstahler and Daley (1986) to US data. The results provide UK evidence on the contemporaneous and predictive relationships between measures of earnings, funds flows and cash flows which are generally consistent with the US findings of Bowen et al. and which do not support the view that earnings in the UK are superior to cash flows as predictors of future cash flows.     

Prediction of Operating Cash Flows: Further Evidence from Australia

This paper examines empirically the relative abilities of current operating cash flows (hereafter OCF) and earnings in predicting future operating cash flows in Australia. It extends prior Australian research on cash flow prediction ( Percy and Stokes 1992 ; Clinch, Sidhu and Sing 2002 ; Farshadfar, Ng and Brimble 2009 ) by examining future cash flow predictions for one‐, two‐ and three‐year‐ahead forecast horizons; incorporating additional contextual variables likely to affect the predictive association between current cash flows or earnings and future cash flows; and comparing cross‐sectional versus time series‐based prediction models to ascertain the relative superiority of one approach over the other. Regression results reveal that the cash flow‐based models are more accurate in predicting future operating cash flows than earnings‐based models. This result, however, is moderated by firm‐specific contextual factors like firm size, negative versus positive cash flow pattern, cash flow variability and firm operating cycle. Finally, a comparison between cross‐sectional and time series approaches reveals that the cross‐sectional model outperforms the time series model for both the operating cash flows and earnings models in most of the forecast years.     

The Usefulness of Direct and Indirect Cash Flow Disclosures

We investigate the ability of disclosed operating cash flow and indirect accruals components to explain annual returns for a sample of Australian firms. Consistent with claims made by accounting standard setters, we find evidence of significant explanatory power for disclosed operating cash flow components beyond aggregate operating cash flows when they also have significant incremental predictive power for future (one year ahead) operating cash flows. Accrual components also have incremental explanatory power for returns. In addition, we find evidence of significant explanatory power for operating cash flow components beyond estimates of the components (based on other financial statement disclosures) for firms with large differences between disclosed and estimated components.     

Corporate Data and Future Cash Flows

Abstract:   This article examines the ability of current accounting data to explain future cash flows for UK firms, as disclosed under FRS1 (1991). Rather than examining price data — from which cash flow implications have to be inferred — we follow the more direct approach used in several recent US studies, in which actual future cash flow data are examined. Specifically, our methodology is a development of the OLS regression framework employed by Barth et al. (2001) . We provide a replication of their main OLS analysis, and then extend this to deal with fixed effects and time trends in the levels of cash flow data. Our study finds that the disaggregation of earnings into cash flows and accruals, generates superior explanatory power with regard to future cash flows.     

Unusual operating cash flows and stock returns

The current financial reporting of cash flows from operations does not present individual sources of these cash flows, making it difficult for investors to assess a firm’s future performance. I hand-collect individual cash flows from unusual operations and examine their characteristics for predicting future cash flows. The results show that the unusual individual cash flow items contain a significant incremental predictive ability for future cash flows. Additional return tests show that stock prices fail to fully reflect their predictive value, suggesting that the current reporting practice may mislead investor perceptions of a firm’s cash generating ability and investors could benefit from a more explicit presentation of cash flows from operations.     

Effects of cash flow statement reclassifications pursuant to the SEC’s one-time allowance

In February 2006, the Securities and Exchange Commission (SEC) announced a one-time opportunity for firms with misclassified cash flow items to correct these errors without issuing an official restatement. To assess the impact of these reclassifications, we determine the types of firms affected by this allowance and the types of reclassifications in the operating, investing, and financing categories of the cash flow statement. We find that, consistent with the SEC’s concerns, firms overstated net operating cash flows and understated net investing cash flows, thereby misrepresenting cash flows. In addition, the most frequent line-item reclassifications echo the SEC’s concerns about the presentation of discontinued operations and dealer floor plan financing arrangements. Insurance claim proceeds and beneficial interests in securitized loans, however, appear less problematic than the SEC expected. Overall, our findings indicate that the SEC’s plan was relatively successful and, for firms that took advantage of the allowance period, these cash flow restatements only exerted a marginally negative effect in the capital market.     

Do core and non-core cash flows from operations persist differentially in predicting future cash flows?

This study investigates the persistence of cash flow components (core and non-core cash flows) using a cash flow prediction model. By extending the Barth, Cram, and Nelson (Account Rev 76(January):27–58, 2001) model, we examine the role of cash flow components in predicting future cash flows beyond that of accrual components. We propose a cash flow prediction model that decomposes cash flows from operations into core and non-core cash flow components that parallel the presentation and format of operating income from the income statement. Consistent with the AICPA and financial analysts’ recommendations, and as predicted, we find that core and non-core cash flows defined in our paper are differentially persistent in predicting future cash flows; and these cash flow components enhance the in-sample predictive ability of cash flow prediction models. We also analyze the association of in-sample prediction errors with earnings, cash flow and accruals variability. We find that disaggregating cash flows improve in-sample prediction, especially for large firms with high cash flows and earnings variability.

Time series versus cross-sectionally derived predictions of future cash flows

We refine the analysis of annual cash-flow prediction models originally developed and tested by Dechow et al. (1998), Barth et al. (2001) and Kim and Kross (2005) using cash flow from operations data reported in accordance with FASB Standard No. 95 for a constant sample of 1111 firms. We estimated annual cash-flow prediction models both cross-sectionally and on a time-series basis to assess whether restricting firm-specific parameter estimation in the cross-sectional approach adversely affects predictive performance. Predictive ability is assessed via “out-of-sample” forecasts in an inter-temporal holdout period (2001-2005) not used in model estimation. We provide new evidence that significantly greater enhancement to predictive performance is obtained when cash-flow prediction models are estimated on a time-series basis versus cross-sectionally. These inferences are robust across one-year ahead cash-flow predictions or one-thru-five-year ahead predictions. We find that the relative accuracy of cash-flow predictions is unaffected by whether the aforementioned prediction models employ cash flows or net earnings as independent variables. Finally, we also provide evidence that the predictive ability of cash flows is highly sensitive to firm size. That is, relatively larger firms provide significantly more accurate cash-flow predictions than those of smaller firms across cash-flow prediction models.     

The usefulness of accrual-based surpluses in the Canadian public sector

This paper investigates the usefulness of accrual-based surpluses for predicting future cash flows and surpluses in the context of the Canadian public sector. We provide evidence that surpluses incrementally enhance the ability of operating cash flows to predict future cash flows and surpluses. Analysis of our accrual quality model illustrates that accrual accounting is useful in the public sector for mitigating the noise in operating cash flows. We also find that decomposing surpluses into operating cash flows and accruals enhances the ability of surpluses to forecast future cash flows and surpluses, indicating that aggregate and disaggregated surpluses are positively related to both relevance and reliability. Our test results do not indicate the presence of conservatism in the Canadian public sector, and confirm that the usefulness of surpluses in making predictions is independent of selected control factors.     

CEO's Operating Ability and the Association between Accruals and Future Cash Flows

This study investigates whether an individual CEO's operating ability, operationalized as the extent to which an individual CEO utilizes the company's assets efficiently to generate profits, explains the association between accruals and future cash flows. While this mapping can be driven by both the quality of accounting measurement and CEO operating ability, there is little empirical evidence on the latter link. After controlling for the CEO's accounting estimation ability, we find that the association between current period accruals and future cash flows is stronger when the CEO demonstrates superior operating ability. This suggests that a CEO's operating ability is an important determinant of the informativeness of current accruals for future cash flows.     

Accruals, Cash Flows and the Post‐Earnings‐Announcement Drift

Abstract:   Several prior studies have shown that cash flows have significantly greater impact on stock prices than accruals. We examine the implications of these findings for the post‐earnings‐announcement‐drift anomaly. We argue that, if investors under‐react to earnings news, then the larger price impact of cash flows causes the cash flow component of earnings news to predict future returns better than the accruals component. Consistent with this argument, we show that unexpected cash flows are more positively related to future returns, than are unexpected accruals. Also, unexpected cash flows are found to predict future returns above and beyond that predicted by earnings surprises. Finally, we show that a strategy that decomposes earnings news into its components significantly outperforms strategies based on earnings news alone. The results support under‐reaction explanations for the drift.     

Further evidence on analyst and investor misweighting of prior period cash flows and accruals

We empirically investigate three questions: (i) whether analysts and investors mis-estimate the persistence of operating cash flows, (ii) if so, is the cash flow effect distinct from the accrual effect in the sense that one effect holds after controlling for the other, and (iii) if these are distinct effects, which effect is stronger in magnitude? We find that prior period operating cash flows have a significant positive effect on forecast errors and stock returns consistent with analysts and investors underestimating the persistence of operating cash flows. Further, we find that not only is the operating cash flow effect distinct from the accrual (more specifically the working capital accrual) effect but it is also considerably larger in magnitude. To our knowledge, this is the first study that documents the relative magnitude of prior period cash flow and working capital accrual effects on forecast errors and stock returns. Our findings have several implications for future research and practice. First, the consistency of results across the two sets of users (analysts and investors) suggests that analyst-forecast inefficiencies are less likely to be driven by their incentives to promote stocks and more likely to be a manifestation of a broader phenomenon that has not been thoroughly investigated in prior studies. Second, for practitioners, our results suggest that a trading strategy based on prior period working capital accruals and cash flows would earn higher abnormal returns than a trading strategy based on accruals alone.     

FURTHER EVIDENCE ON EMPIRICAL RELATIONSHIPS BETWEEN EARNINGS AND CASH FLOWS

Recently in Australia, regulations have been proclaimed requiring companies to make cashflow disclosures in addition to earnings disclosures from 30 June 1992. This paper provides evidence on relationships between earnings and cash flow measures and in so doing examines the external validity of a U.S.A. study of these relationships by Bowen, Burgstahler and Daley [1986]. We also extend their study through an industry analysis of the relationships. Evidence is presented first that shows low correlations between traditional cash flow measures (i.e., net income plus depreciation and amortisation; and working capital from operations) and a more refined cash flow measure (with additional adjustments for changes in non-cash current assets and current liabilities). Second, traditional cash flow measures exhibit high correlations with earnings, while the more refined cash flow measure has a lower correlation with earnings. Finally, traditional cash flow measures better predict future cash flows than models based on earnings or a more refined cash flow measure. The industry evidence, albeit on small sample sizes, shows that the results on the first two issues, but not the latter issue, are generalisable across industry categories.     

What do accruals tell us about future cash flows?

Our model, which is adapted from Feltham and Ohlson (Contemp Account Res 11:689–731, 1995) and Ohlson (Contemp Account Res 11:661–687, 1995) and extends Dechow and Dichev (Account Rev 77:35–59, 2002), characterizes the information about future cash flows reflected in accruals. It reveals investors can extract from accruals information about next period’s economic factor and the transitory part of one component of next period’s cash flow. The extent to which each accrual provides this information depends on whether the accrual aligns future or past cash flows and current period economics and whether it relates to the current or prior period. Thus each type of accrual has a different coefficient in valuation and forecasting cash flows or earnings. Each coefficient combines an information weight reflecting the information that accrual type provides and a multiple reflecting how that information is used in valuation and cash flow and earnings forecasting. The empirical evidence supports our main insight, namely that partitioning accruals based on their role in cash-flow alignment increases their ability to forecast future cash flows and earnings and explain firm value.     

Value‐Added Per Share (VAPS): A Value‐Relevant Corporate Performance Metric

The authors introduce Value Added Per Share (VAPS) as a value‐relevant metric that is intended to complement earnings per share (EPS) in helping corporate managers and analysts understand and overcome the limitations of GAAP‐based reporting. VAPS discounts a firm's past and projected cash flows at its “cost of capital,” allowing companies to avoid the subjective accounting accrual process and other practices that often make EPS misleading. A company's VAPS is calculated in three main steps: (1) estimate the change in the capitalized value of after‐tax operating cash flow by taking the net change (plus or minus) of the firm's operating cash flow after taxes and dividing that number by the firm's cost of capital; (2) subtract total investment expenditures; and (3) divide by the number of shares outstanding. By capitalizing the change in after‐tax operating cash flow, one finds the net change in a firm's current operations value. By subtracting investment expenditures from that change in current operations value, the analyst gets a clearer picture of the benefit to shareholders net of the funds used to create that benefit. Consistent with basic theory, VAPS is positive when a company earns a return at least equal to its cost of capital and negative otherwise. Because of their fundamental differences, EPS and VAPS are likely to send different signals, and VAPS is expected to provide greater insight into stock price changes. The authors provide the findings of statistical tests showing the superior explanatory power of VAPS and recommend that companies publish statements of VAPS along with standard GAAP results, especially since the former can be readily calculated using the available income statement, balance sheet, and cash flow statement data.