The usefulness of the double entry constraint for predicting earnings

Review of Quantitative Finance and Accounting - In the absence of an income statement, earnings can be calculated as cash flow from operating activities (CFO) plus accruals, rather than being...     

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.     

The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.     

Interfirm differences in earnings variability: an analysis of fundamentals,cash flows and accruals

Prior research shows that the time‐series variability of corporate earnings affects forecasting accuracy and corporate risk, yet little is known about the determinants of earnings variability. This study analyses interfirm differences in earnings variability. Large‐sample evidence shows how the ratio of accrual variability to cash‐flow variability varies across a cross‐section of firms and how these components and the correlation between contemporaneous cash flows and accruals are related to key economic fundamentals.     

Using accounting equation analysis to teach the statement of cash flows in the first financial accounting course

Understanding the statement of cash flows requires that students have some knowledge of accrual-basis accounting. This means that coverage of the statement of cash flows is deferred until late in the introductory financial accounting course and related textbooks, a time when student motivation and retention may be waning. The timing of statement of cash flow coverage is unfortunate for two reasons. First, the statement of cash flows is an important topic that all business students need to understand. Second, most students understand cash flows at the start of their financial accounting class, so there is no reason to defer coverage of this topic.This paper describes a user-oriented, pedagogical approach to integrating the statement of cash flows throughout the first financial accounting course. The essence of this approach is the use of an expanded accounting equation with temporary cash accounts corresponding to the major categories on the statement of cash flows. Directly capturing cash flow information simplifies the preparation of the statement of cash flows.     

Volatility of accounting earnings

The theoretical derivation of the volatility of accounting earnings is an important topic. Not only does it concern the uncertainty in earnings measurement, but it also allows for an objective comparison between different accounting allocation procedures. An accounting allocation that yields a lower volatility of earnings can be desirable because it makes periodic earnings better estimates of underlying long-term earnings of a firm over time. Based on this information, accounting professionals can make more rational judgements of the most appropriate accounting method to be used in preparing financial reports. This paper shows how to calculate the volatility of earnings under uncertainty across a range of different scenarios.     

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.     

Capital budgeting with continuous cash flows: An application of calculus to managerial accounting

Project valuation in managerial accounting often involves discounting approximately continuous cash flows. Calculus is the natural mathematical tool for dealing with continuous flows and is a required part of the business curriculum in most major universities. Typical managerial accounting textbooks provide students with little opportunity to use calculus in solving accounting problems. Discounting continuous flows is a natural medium for introducing calculus into managerial accounting courses. This article illustrates the application of calculus to capital budgeting. Explicit but simplified consideration of inflation and taxation leads to interesting conclusions while maintaining enough simplicity for upper-division managerial accounting presentation     

Discretionary accounting choices and the predictive ability of accruals with respect to future cash flows

Using a sample of restatement firms and a meet-or-beat model to classify firms as making discretionary accounting choices for opportunistic meet-or-beat (OP-MB) reasons, we show that originally reported earnings and accrual components are less predictive of future cash flows relative to the restated numbers. We find the opposite is true for firms classified as making discretionary accounting choices for non-OP-MB reasons. We consider a number of competing explanations for these latter results. Our findings are most consistent with the informational hypothesis, weakly consistent with conservative-motivated efficient contracting hypotheses, but inconsistent with opportunistic contracting and misapplication/errors of GAAP explanations.     

Independent director cash compensation and earnings management

This study examines the impact of independent directors’ cash compensation on firms’ financial reporting quality using a sample of Chinese listed companies from 2002 to 2008. Unlike in the U.S. where most listed firms provide stock-related compensations to outside directors, Chinese listed companies compensate independent directors with cash only. This context offers a cleaner setting for examining the effects of independent director cash pay on earnings management. Our study documents a positive association between independent director cash compensation and the magnitude of earnings management. This suggests that compensating independent directors with higher cash pay compromises their independence and reduces their effectiveness in financial reporting oversight. Our results are robust to an array of sensitivity checks. These findings have important implications for both investors and policy makers by showing that independent directors’ cash compensation is also a significant determinant of financial reporting quality.     

The use of earnings and cash flows in investment decisions in the U.S. and Mexico: Experimental evidence

In this study, we investigate which of two accounting performance measures, earnings or cash flows, is used more in valuation decisions by non-professional investors in the United States and in Mexico. This issue is relevant for the Mexican Stock Market (Bolsa Mexicana de Valores) because the Bolsa's growth has stagnated compared with markets of other Latin American countries. Results of the study reveal that the majority of participants in the U.S. rely on earnings while the majority of participants in Mexico rely on cash flows. Results also suggest that the users’ predisposition can be dysfunctional to the extent that they do not consider using the other accounting measure, even when doing so made it easier to arrive at the correct valuation result (i.e. they did not choose to use the more persistent and therefore easier to forecast accounting measure). However, results are mixed for participants using earnings, since we document a higher chance of forecasting errors for participants in both countries when using earnings rather than cash flows in their calculations for the failure of these participants to adjust earnings for depreciation.This study extends the existing international literature by documenting a country-specific predisposition to use cash flows or earnings as a valuation tool by non-professional investors. Moreover, this study also shows that this predisposition can be dysfunctional, leading participants to make incorrect valuation decisions as a result of their failure to consider the differential persistence of the two accounting measures presented in the experiment.     

Management accounting innovations for rationalizing the cost of services: The reassessment of cash and accrual accounting

ABSTRACT

Management accounting can be a useful tool in austerity government because it produces information about the costs of public services and can be used for informed decision-making. Spanish local governments are required to submit data on the cost of their services to central government, which publishes this information online. The calculation of costs is based on budgetary cash accounting instead of accrual accounting; therefore cash accounting is being used for decision-making and accrual accounting has no role in this process. This paper critically analyses the innovation from three perspectives: the use assigned to the cost information in the legal framework; the opinion of academics and experts; and the perception of professionals about the usefulness of the information produced with the new system.     

Financial accounting choice and earnings management

This paper presents a case that exposes students in graduate accounting or MBA financial accounting classes to the concepts of accounting choice and earnings management. In the case, students role-play as a manager who, facing conflicting incentives, must make and defend three expense estimates for a hypothetical company. Students also read selected business press articles that introduce earnings management and that highlight the importance of the issue to the business community. The articles give students some background from which to approach the choices they will make with respect to the financial statements.     

Financial accounting choice and earnings management

This paper presents a case that exposes students in graduate accounting or MBA financial accounting classes to the concepts of accounting choice and earnings management. In the case, students role-play as a manager who, facing conflicting incentives, must make and defend three expense estimates for a hypothetical company. Students also read selected business press articles that introduce earnings management and that highlight the importance of the issue to the business community. The articles give students some background from which to approach the choices they will make with respect to the financial statements.     

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.     

The options market response to accounting earnings announcements

We examine the reaction of the equity options market to accounting earnings announcements over the period 1996–2008 using changes in implied volatility to measure the options market response to earnings news. We find that positive earnings surprises and positive profit announcements produce a larger uncertainty resolution than negative earnings surprises and loss announcements. We demonstrate an inverse relation between the change in implied volatility and earnings news in a three-day window immediately after an earnings announcement. We refer to the magnitude of this relation as the ‘options market earnings response coefficient’. This ‘options market earnings response coefficient’ is stronger for both bad news announcements and positive profit announcements. We do not find any significant relation between changes in implied volatility and earnings news in the pre- or post-announcement periods. We conclude that the options market efficiently absorbs earnings information.     

The association between accounting earnings and security returns for large and small firms

The differential information hypothesis advanced by Atiase (1980) states that information production and dissemination by private parties for the purpose of identifying mispriced securities is an increasing function of firm size. This study examines two corollaries of that hypothesis. First, security prices of large firms anticipate accounting earnings earlier than security prices of small firms. Second, for a given level of ‘unexpected’ earnings, the cumulative abnormal returns of small firms exceed those of large firms. The results are generally consistent with Atiase's hypothesis.