Measuring income tax accrual quality

We develop and validate a measure of tax accrual quality. Tax accrual quality captures variation in the extent to which the income tax accrual maps into income tax-related cash flows, with lower variation indicating a higher quality tax accrual. Low tax accrual quality arises from (1) management estimation error and (2) financial reporting standards that lead to differences between income tax expense and income tax cash flows not captured by deferred tax assets and liabilities. We validate our tax accrual quality measure by showing it is associated with firm characteristics that capture both constructs and by demonstrating it predicts future tax-related restatements and internal control material weaknesses. We illustrate the importance of our measure by showing that investors view tax expense as more informative in firms with better tax accrual quality. Future researchers can use tax accrual quality to address questions related to estimation error in the income tax account.     

Accrual versus cash-basis accounting methods: An agency-theoretic comparison

In an agency setting with moral hazard, this paper analytically demonstrates that accrual accounting is superior to cash-basis accounting (subject to costs). The main reason is that accrual accounting information more fully reflects the overall effects of managerial actions or efforts on future cash flows than cash flow realizations in any given period. As a result, accrual accounting information is more efficient than cash-basis accounting information for both motivating managers to expend efforts and sharing risks under moral hazard.     

会计盈余、现金流量的价值相关性实证研究基于沪深股市的实证证据

已有的研究结果说明会计盈余具有价值相关性。从盈余等于经营现金流量与应计利润之和这一新的视角切入，以实证的方法对沪深两地上市的A股公司进行三大样本检验。并通过建立股票报酬与应计利润和现金流量的回归方程，利用应计利润回归系数的显著性对会计盈余与现金流量的价值相关性做比较，结果表明，会计盈余的价值相关性要大于现金流量的价值相关性。     

The Changing Landscape of Accrual Accounting

A fundamental property of accrual accounting is to smooth temporary timing fluctuations in operating cash flows, indicating an inherent negative correlation between accruals and cash flows. We show that the overall correlation between accruals and cash flows has dramatically declined in magnitude over the past half century and has largely disappeared in more recent years. The adjusted R ² from regressing (changes in) accruals on (changes in) cash flows drops from about 70% (90%) in the 1960s to near zero (under 20%) in more recent years. In exploring potential reasons for the observed attenuation, we find that increases in non‐timing‐related accrual recognition, as proxied by one‐time and nonoperating items and the frequency of loss firm‐years, explain the majority of the overall decline. On the other hand, temporal changes in the matching between revenues and expenses, and the growth of intangible‐intensive industries play only a limited role in explaining the observed attenuation. Finally, the relative decline of the timing role of accruals does not appear to be associated with an increase in the asymmetrically timely loss recognition role.     

The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition

We investigate the role of accrual accounting in the asymmetrically timely recognition (incorporation in reported earnings) of gains and losses. Timely recognition requires accruals when it precedes complete realization of the gains and losses in cash. We show that nonlinear accruals models incorporating the asymmetry in gain and loss recognition (timelier loss recognition, or conditional conservatism) offer a substantial specification improvement, explaining substantially more variation in accruals than equivalent linear specifications. Conversely, conventional linear accruals models, by omitting the loss recognition asymmetry, exhibit substantial attenuation bias and offer a comparatively poor specification of the accounting accrual process. Linear specifications also understate the ability of current earnings to predict future cash flows. These findings have implications for our understanding of accrual accounting and conservatism, as well as for researchers estimating discretionary accruals, earnings management, and earnings quality.     

Time and space in income accounting

Inspired by the work of DR Scott, we explore the formation of an internal logic of income accounting that bestows upon the income accounting system an institutional status. As large scale modern corporations emerged in the market, imaginative ways of doing income accounting were developed and exercised in the 19th century. Creative accounting practices of the time were eventually evolved into what is now known to be the accrual process. A distinctive feature of the accrual accounting system, that has the accrual process as its essential part, is that it creates internal space demarcated (de-marketed) from the external world. In the demarcated space of the accrual accounting system, “the Emptying-out of Internal Transaction Time” takes place. Internal transactions enable the accrual accounting system to generate smoothed income series out of cashflow chaos, which function as an “attractor” in the complex relationships between managers and stakeholders. Creative accounting practices induced phase transition so as to establish the accrual accounting system as a legitimate social institution.     

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.     

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.     

Accounting Information, Disclosure, and the Cost of Capital

In this paper we examine whether and how accounting information about a firm manifests in its cost of capital, despite the forces of diversification. We build a model that is consistent with the Capital Asset Pricing Model and explicitly allows for multiple securities whose cash flows are correlated. We demonstrate that the quality of accounting information can influence the cost of capital, both directly and indirectly. The direct effect occurs because higher quality disclosures affect the firm's assessed covariances with other firms' cash flows, which is nondiversifiable. The indirect effect occurs because higher quality disclosures affect a firm's real decisions, which likely changes the firm's ratio of the expected future cash flows to the covariance of these cash flows with the sum of all the cash flows in the market. We show that this effect can go in either direction, but also derive conditions under which an increase in information quality leads to an unambiguous decline in the cost of capital.     

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.     

Do Stock Prices of Property Casualty Insurers Fully Reflect Information about Earnings,Accruals, Cash Flows,and Development?

This paper examines whether the stock prices of property and casualty (P&C) insurers fully reflect information contained in earnings, cash flows and accruals, and one particular accrual—development of loss reserves. The reserve for policy losses is a major accrual for P&C firms, requires substantial judgment and is the subject of unique disclosures that reveal the ex post error in management estimates. We find that investors underestimate the persistence of cash flows and overestimate the persistence of accruals for P&C insurers, but our evidence suggests the market does not underestimate the persistence of the development accrual.     

Do investors value smooth performance?

This paper presents empirical evidence that cash-flow volatility is negatively valued by investors. The magnitude of the effect is substantial with a 1% increase in cash-flow volatility, resulting in approximately a 0.15% decrease in firm value. We show that this increase, however, is not associated with earnings smoothing resulting from managers’ accrual estimates. Our results are consistent with a preference by the market for less volatile cash flows and suggest that managers’ efforts to produce smooth financial statements add value, but only via the cash component of earnings.     

THE COST OF CAPITAL OF A COMPANY UNDER AN IMPUTATION TAX SYSTEM

One of the issues arising out of the introduction of an imputation tax for companies in Australia is the effect it is likely to have on the definition and measurement of a company's cost of capital. Insofar as there is a difference between the value of a dollar of franked relative to unfranked dividends, conventional definitions for the cost of capital are inappropriate and new definitions are required. This has implications for the measurement of a company's cost of capital and for the definition of net cash flows that are used in conjunction with the cost of capital. This paper sets out these definitions and an approach for measuring the cost of capital. The new definition of the cost of capital replaces the effective company tax rate T with T(l - γ) where γ is the value of personal tax credits. Further, the definition of the risk premium in the capital asset pricing model requires an adjustment for the capitalized value of personal tax credits to maintain consistency between the cost of capital and cash flows which are defined on an after-company tax but before-personal tax basis.     

Impact of foreign operations on reported effective tax rates: interplay of foreign taxes, U.S. taxes and U.S. GAAP

Effective tax rates can have a significant effect on a firm’s cash flows and reported earnings. As the operations of U.S. companies become increasingly global in scope, an important issue is how their foreign operations impact their effective tax rates, and, in turn, their reported earnings. This study describes how foreign taxes, U.S. taxes, and U.S. accounting principles interact to determine the impact of foreign operations on a firm’s effective tax rate. This analysis will assist users of financial statements in assessing the quality of earnings, making interfirm comparisons, evaluating the performance of management, judging the risks of additional tax assessments, and predicting future effective tax rates.     

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.     

Effect of derivative accounting rules on corporate risk-management behavior

I examine the effect of the accounting standard for derivative instruments (SFAS No. 133) on corporate risk-management behavior. I classify a derivative user as an “effective hedger” (EH firm) if its risk exposures decreased after the initiation of the derivatives program, and as an “ineffective hedger/speculator” (IS firm) otherwise. I find that volatility of cash flows and risk exposures related to interest rate, foreign exchange rate, and commodity price decrease significantly for IS firms but not for EH firms, suggesting that IS firms engaged in more prudent risk-management activities after the adoption of SFAS No. 133.     

Why Do Countries Mandate Accrual Accounting for Tax Purposes?

This study investigates why countries mandate accruals in the definition of corporate taxable income. Accruals alleviate timing and matching problems in cash flows, which smoothes taxable income and thus better aligns it with underlying economic performance. These accrual properties can be desirable in the tax setting as tax authorities seek more predictable corporate tax revenues. However, they can also make tax revenues procyclical by increasing the correlation between aggregate corporate tax revenues and aggregate economic activity. We argue that accruals shape the distribution of corporate tax revenues, which leads regulators to incorporate accruals into the definition of taxable income to balance the portfolio of government revenues and expenditures. Using a sample of 26 OECD countries, we find support for several theoretically motivated factors explaining the use of accruals in tax codes. We first provide evidence that corporate tax revenues are less volatile in high accrual countries, but high accrual countries collect relatively higher (lower) tax revenues when the corporate sector grows (contracts). Critically, we then show that accruals and smoother tax revenues are favored by countries with higher levels of government spending on public services and uncertain future expenditures, while countries with procyclical other tax collections favor cash rules and lower procyclicality of corporate tax revenues.     

On the conceptual foundations of financial reporting

Standard setters advocate a balance sheet approach to financial reporting, which views assets and liabilities as primary, and income as just the derivative change in net assets. This paper argues that income is conceptually and practically better described as ‘adjusted net cash flows,’ where the adjustments are the accounting accruals. One proof of that is seen in the existence of whole accounting systems like tax accounting and national income accounting, which emphasize the determination of income but have no balance sheets. The paper also argues that an income-based approach to financial reporting is by nature better suited to reflect the success of advancing cash to earn more cash, which defines what for-profit entities do. There are two main features of the income-based approach. One is attention on the cash flows as the natural foundation for financial reporting because they are precisely determined, and provide a clear link to firm valuation. The other is attention on the accounting accruals, which serve to adjust the raw cash flows to better show the current success of investing cash to ultimately earn more cash. Specifically, the paper argues for revenue recognition which is close to current practice, and for expense recognition which is aligned with the matching principle.     

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.     

Tax-induced clientele effects in the market for British government securities: Placing bounds on security values in an incomplete market

This paper develops a new methods for measuring tax effects in bond markets and presents empirical results for British Government Securities. The basic idea is to construct a least cost portfolio which, for investors in a given tax bracket, dominates a given bond. A portfolio is said to dominate a bond if it provides cash flows which are at least as great in every period, and has a lower price. In effect our method calculates an upper bound on the value of a bond to investors in a given tax bracket. The results demonstrate (i) the existence of clientele effects and (ii) the absence of an ‘effective tax rate’.