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.     

THE RELATIONSHIP BETWEEN DIVIDEND CHANGES AND CASH FLOW: AN EMPIRICAL ANALYSIS

It is often assumed that cash flow affects dividend payout. This study provides evidence on the incremental information content of cash flow numbers over Profits and Previous Year's Dividends (Lintner's model) in explaining changes in cash dividends. It further examines whether different measures of cash flow differ in information content for dividend-increasing and dividend-decreasing firms. Lintner's model of dividend changes is robust across firms with either dividend increases or decreases. The null hypotheses, that no definition of cash flow adds to the model, could not be rejected for any of the definitions.     

EXCESS RETURNS OF INDEX REPLACEMENT STOCKS: EVIDENCE OF LIQUIDITY AND SUBSTITUTABILITY

Excess returns of S&P index replacement stocks are attributed to price pressures and imperfect substitutes in previous research. However, parameter estimates are biased by the use of pre-announcement returns; replacements are characterized by rising stock prices. Using a future estimation period to avoid this bias, we find excess returns do not reverse. Further, we find no relation between excess returns and the amount of stock closely held or the size of index funds. The evidence supports efficient market assumptions: the stock market is liquid and stocks are close substitutes.     

FREE CASH FLOW AND PUBLIC GOVERNANCE: THE CASE OF ALASKA

In a widely cited 1986 article in the American Economic Review, Michael Jensen gave the concept of free cash flow (FCF) a new twist by redefining it as cash flow in excess of that required to fund all projects with positive net present values. Put another way, FCF represents funds available in the firm that managers may choose to hold as idle cash, return to shareholders, or invest in projects with returns below the firm's cost of capital. In redefining FCF in this way, Jensen converted FCF from a measure of economic income and value into a measure of corporate assets available for discretionary, and potentially value‐destroying, use by firm managers. And, as he argued in his important article, managers in mature businesses with substantial free cash flow have a tendency to destroy value by plowing too much capital back into those businesses or, often worse, making ill‐advised acquisitions in unrelated businesses. Several methods have been developed in financial markets and internal corporate governance systems to discourage managers from wasting FCF. Better monitoring by boards of directors, large ownership blocks, and properly aligned management compensation contracts are all parts of the solution. And the extraordinary increase in stock repurchases in recent years, invariably applauded by investors, is another illustration of the market's success in encouraging companies to address their free cash flow problems. But if the “FCF problem” of the private sector has attracted considerable attention from finance scholars, the problem is even more acute in the public sector, where FCF can be thought of as tax revenue in excess of what is required to finance well‐defined and generally accepted levels of public services. Unlike the private sector, in the public sector there are neither measures nor mechanisms by which to monitor and constrain wasteful spending by elected officials. In this article, the authors attempt to measure the costs to taxpayers of government FCF using the case of Alaska, which since 1969 has received a huge windfall of tax revenue from North Slope oil leases. After examining the state's public finances from 1968 through 1993, the authors offer $25 billion as a conservative estimate of the social losses from Alaska's waste of free cash flow during that 25‐year period.     

CASH FLOW ACCOUNTING AND THE ALLOCATION PROBLEM

Cash flow accounting (CFA) proposals typically have included firm statements that CFA data are allocation-free. This is not entirely true if the term allocation is interpreted in a wide sense. However, it can be argued that most allocations can be avoided in CFA systems, and this paper is an attempt to present this argument. In particular, it aims to strengthen the case for CFA in practice.     

THE INFORMATION CONTENT OF SIGN AND SIZE OF EARNINGS ANNOUNCEMENTS: NEW ZEALAND EVIDENCE

This paper examines the effect of 1196 earnings announcements on share prices, using the familiar cumulative abnormal return method of analysis. Earnings are partitioned into unexpected earnings increases and decreases using a martingale model. As well, six portfolios are established, based on the size of unexpected earnings, using two different measures of size.     

THE ACCURACY OF CASH FLOW ESTIMATION PROCEDURES

Prior research uses mechanical procedures to estimate cash flow data. This study examines the accuracy of these procedures by measuring errors between estimated cash flows and reported cash flows. The results indicate that mechanical rules provide poor estimates for reported cash flows. We also show that the errors between cash flow estimates and reported cash flows can be reduced by adjustments made from footnote disclosures. However, large errors remain, even after adjustments are made from footnote disclosures. These remaining errors are correlated with firm specific characteristics such as sales (firm size), extraordinary items, foreign currency gains and losses, and changes in inventory.     

A NOTE ON THE RELATIONSHIP BETWEEN REPORTED CASH FLOW MEASURES,RATIOS AND THEIR ACCRUAL COUNTERPARTS

This note focuses on information redundancy of cash flow measures reported in and financial ratios derived directly from Cash Flow Statements. Previous research utilised recomputed, “traditional” and “refined”, measures to proxy for cash flow. Comovements are derived amongst various earnings and cash flow key variable measures, select financial ratios and changes in financial ratios. Key variables' results support the notion that reported cash flows are correlated with funds flow and earnings. However, reported cash flows relative to funds flow are less correlated with most of their accrual based counterparts. Cash flows thus have potential to provide new and non-redundant information relative to funds and accruals. Also, the incremental benefit of reported, relative to reconstructed cash flow measures is apparent. In light of the above, the merit of cash flow for the specific decision context of identifying suspended firms is investigated. Cash flow data in this context is found to be as useful as, but not superior to, comparable accruals data.     

INFORMATION ASYMMETRY AND THE UNDERPRICING OF INITIAL PUBLIC OFFERINGS: FURTHER EMPIRICAL EVIDENCE

Information Asymmetry is usually assumed in most explanations of the underpricing of initial public offerings (IPOs). In Baron's (1982) model, the underwriter is better informed than the issuing firm concerning the demand for the IPO. The greater uncertainty associated with the demand will lead to a greater underpricing due to the enhanced value of the underwriter's expertise. In the case that the issuer is also an informed investment banker, Baron's hypothesis predicts no underpricing. Our results based on Canadian investment bankers do not support Baron's hypothesis.