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...     

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.     

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.     

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.     

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.     

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 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.     

Sensitivity analysis of long-term cash flows

This paper conducts a sensitivity analysis of long-term cash flows. The price of the cash flow at time zero is given by the pricing operator of a Markov diffusion acting on the cash flow function. We study the extent to which the price of the cash flow is affected by small perturbations of the underlying Markov diffusion. The main tool is the Hansen–Scheinkman decomposition, which is a method to express the cash flow in terms of eigenvalues and eigenfunctions of the pricing operator. By incorporating techniques developed by Fournié et al. (Finance Stoch. 3:391–412, 1999), the sensitivities of long-term cash flows can be represented via simple expressions in terms of eigenvalues and eigenfunctions.     

Negative accounting earnings and gross domestic product

Review of Accounting Studies - Konchitchki and Patatoukas Journal of Accounting and Economics 57 (1-2), 76–88, (2014a) show that aggregate accounting earnings growth predicts future nominal...     

The quality and conservatism of the accounting earnings of local governments

Our aim is to provide insight into the usefulness of accounting earnings for measuring the economic performance of local governments across Australia. Specifically, we explore whether (i) accrual accounting provides useful information, and (ii) earnings of local governments are conservative. We find that accrual accounting by local governments provides useful information as measured by the ability to predict one-year-ahead operating cash-flows. We find no conservatism in the financial reports of the average local government. This, we posit, is due to a lower level of demand for high-quality accrual-based financial reports from these entities. Consistent with this argument, both the quality of accruals and the degree of conservatism increase for local governments for which we predict a demand for higher-quality financial reporting.     

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.     

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.     

The ownership structure of UK firms and the informativeness of accounting earnings

This paper provides evidence that in the UK, a firm's ownership structure is related to the informativeness of its accounting earnings for price. Evidence is reported that concentrated outside ownership is negatively related to the contemporaneous price-earnings association. This is interpreted as indicative of more non-accounting information being collected and disseminated for firms whose ownership includes large outside (non-managerial) blocks and a consequential loss of informativeness of contemporaneous accounting earnings. Having controlled for the information environment, we provide evidence that the overall relation between return and earnings is attenuated for firms with diffuse outside ownership. This is interpreted as evidence of the market anticipating opportunistic managerial manipulation of earnings when outside ownership is diffuse.     

Equivalent valuations in cash flow and accounting models

This paper investigates the equivalence of equity valuation between the free cash flow model and the residual income model. Two conditions are found to be jointly sufficient for Residual Income and Free Cash Flow models to produce the same equity valuation: (a) the models’ discount rates jointly satisfy the Modigliani and Miller (Am Econ Rev 48:261–297, 1958) condition which relates discount rates for levered equity, unlevered equity, tax savings and debt, and (b) forecasts of the two models’ variables jointly satisfy the income statement and balance sheet identities. Past discussions fail by ignoring or misusing (a).     

Hedging,hedge accounting,and earnings predictability

Review of Accounting Studies - Studies suggest that, pursuant to the implementation of SFAS 133, even sophisticated users of financial statements find it difficult to comprehend earnings...     

Improving earnings quality: The effect of reporting incentives and accounting standards

We investigate the different effects on earnings quality of accounting standards and reporting incentives for Germany over the period 1994 to 2005. To this end, we control for reporting incentives at the firm level, instead of the country level, by using the timing of voluntary IFRS adoption as a proxy for reporting incentives. We then include reporting incentives in an analysis of earnings management and information asymmetry. Contrary to common expectation, we find that IFRS reporting potentially decreases earnings quality on average; but also that reporting incentives appear to have lower effects on earnings quality in IFRS statements than in GGAAP statements. Thus, IFRS may lead to more homogenous earnings quality across firms.     

Real effects of separating investment and operating cash flows

This paper investigates the rationale for the measurement of a firm's periodic performance through the accounting classification of its cash outflows into operating cash flow and investment. We show that when the accounting system does not attempt to measure periodic performance and reports only aggregate cash flow, equilibrium capital market prices are such that there is a perverse informational cost to investment over and above the real cost of investment. This induces distortions in the firms' equilibrium investment. We show that other sources of information, consisting of forecasts of future returns to investment play a vital counterbalancing role when the accounting system is inadequate in this way. An accounting signal that provides noisy information on periodic performance decreases the informational cost to investment and moves the economy closer to first best.The first author wishes to acknowledge financial support from McKnight Foundation and the Accounting Research Center, University of Minnesota. An earlier version of the paper was titled Capitalization vs. Expensing: Effects on Investment.