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Article
Publication date: 20 November 2023

Wael Mostafa and Rob Dixon

Recent studies on the securities market’s differential pricing of earnings components have shown that cash flow from operations is more highly valued than total accruals and that…

Abstract

Purpose

Recent studies on the securities market’s differential pricing of earnings components have shown that cash flow from operations is more highly valued than total accruals and that moderate cash flow from operations has higher valuation than extreme total accruals. An interesting question that follows is whether these findings hold regarding the differential valuations of cash flow and current accruals. This study aims to extend prior research by addressing this issue in two ways. First, the authors examine the incremental information content of cash flow from operations beyond working capital from operations. Second, the authors assess the effect of extreme working capital from operations on the incremental information content of cash flow from operations. This study aims to extend prior research by addressing this issue in two ways.

Design/methodology/approach

This study adopts market-based accounting research to test its hypotheses and to achieve its objectives. Specifically, this study uses statistical associations between accounting data and stock returns to examine the incremental information content (value relevance) of cash flow and working capital from operations and the effect of extreme working capital from operations on the incremental information content of cash flow.

Findings

The results show that cash flow from operations is not more highly valued than current accruals (both being valued equivalently). However, moderate cash flow from operations has higher valuation than extreme current accruals (each is valued differently). Overall, these research findings indicate that cash flow becomes more important for valuation as accruals get “extreme”.

Practical implications

As accruals are unlikely to persist to be permanent across the years, these results can be interpreted as indicating that cash flow and accruals information are used jointly by investors, with one being more important than the other depending on the relative “extremeness” of each. Therefore, both are of value to the investor and both should be reported.

Originality/value

The paper contributes to the UK research on determining the preferred level of disaggregation of earnings components, i.e. operating cash flow, current accruals and non-current accruals. This would help investors to improve their investment and credit decisions.

Article
Publication date: 19 January 2023

Wael Mostafa

Recent studies on the securities market's differential pricing of earnings components indicate that cash flows from operations are valued more highly than extreme total accruals…

Abstract

Purpose

Recent studies on the securities market's differential pricing of earnings components indicate that cash flows from operations are valued more highly than extreme total accruals. However, no previous study has examined whether cash flows from operations have a higher valuation than moderate total accruals. Therefore, this study examines the securities market's differential pricing of cash flows from operations and both moderate and extreme total accruals.

Design/methodology/approach

The study's sample is divided into two sub-samples: a moderate total accruals sub-sample; and an extreme total accruals sub-sample. To evaluate whether cash flows have a higher valuation when compared to total accruals, for the entire sample and for each of the two sub-samples, the study examines the statistical significance of the difference between slope coefficients of cash flows and total accruals for regression of returns on both unexpected cash flows from operations and unexpected total accruals.

Findings

Consistent with prior research, results from the entire sample show a differential higher valuation of cash flows when compared to total accruals. Another finding, consistent with recent studies, is that cash flows from operations have a higher valuation when compared to extreme total accruals. However, there is no higher differential valuation of cash flows over moderate total accruals. These findings support the decomposition of earnings into the components of cash flows from operations and total accruals only when total accruals are extreme (rather than moderate).

Practical implications

A possible explanation for these results is that since accruals predict cash flows, total accruals – when moderate (i.e. not extreme) – are priced similarly to cash flows. These results reveal that when total accruals are moderate, earnings are a better proxy for the underlying cash flows (over the entire future horizon, not just the current period) than is cash flows. However, since total accruals are unlikely to persist in a permanent way over the years, these results indicate that the decomposition of earnings into the components of cash flows from operations and total accruals is consistent with the information set used to value equity securities. Therefore, separate disclosure of cash flows is value relevant. In addition, users of financial statements certainly need the cash flows information as an ex-post validation of the prior earnings.

Originality/value

This study's contribution stems from its determination of the preferred level of disaggregation of earnings components (i.e. operating cash flows and total accruals). This is expected to help investors in their attempt to enhance the outcome of their informed investment and credit decisions.

Details

Managerial Finance, vol. 49 no. 8
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 18 July 2016

Wael Mostafa

In contrast to earlier studies, the most recent studies on the incremental value relevance of earnings and cash flows from operations find that both earnings and cash flows have…

Abstract

Purpose

In contrast to earlier studies, the most recent studies on the incremental value relevance of earnings and cash flows from operations find that both earnings and cash flows have incremental value relevance beyond each other. An interesting question that follows is whether these findings hold after controlling the extremity of earnings and cash flows. This study, therefore, aims to examine the incremental value relevance of earnings and cash flows in the following four cases: moderate earnings and moderate cash flows, moderate earnings and extreme cash flows, extreme earnings and moderate cash flows and extreme earnings and extreme cash flows.

Design/methodology/approach

To evaluate the incremental value relevance (information content) of earnings and cash flows for each of the four cases mentioned above, we examine the statistical significance of the slope coefficients for regression of returns on both unexpected earnings and unexpected cash flows from operations.

Findings

The results show that (i) both moderate and extreme earnings have incremental value relevance beyond both moderate and extreme cash flows, (ii) moderate cash flows have incremental value relevance beyond both moderate and extreme earnings and (iii) extreme cash flows lack incremental value relevance beyond moderate earnings; however, they (extreme cash flows) have incremental value relevance beyond extreme earnings. These results suggest that earnings and cash flows have incremental value relevance. However, only in cases when cash flows are extreme and earnings are moderate, cash flows do not possess incremental value relevance. In further analysis, we find that the value relevance for cash flows and earnings decreases when they are extreme and transitory. Moreover, the value relevance for cash flows increases when they are moderate (not extreme) and the other competing measure (earnings) is transitory and extreme.

Practical implications

The results support the idea that earnings and cash flows from operations complement each other in explaining variation in returns. However, when cash flows are extreme and less informative, investors rely more on earnings in firm valuation, especially when earnings are moderate. Because earnings are unlikely to persist to be permanent across the years, these results can be interpreted as indicating that cash flows and earnings information are used jointly by investors.

Originality/value

In contrast to previous studies, we control for the extremity of earnings and cash flows when evaluating the incremental value relevance of earnings and cash flows from operations.

Details

Management Research Review, vol. 39 no. 7
Type: Research Article
ISSN: 2040-8269

Keywords

Article
Publication date: 15 February 2013

Wael Mostafa and Rob Dixon

In contrast to recent US studies, almost all prior UK studies have not supported the incremental information content of cash flow beyond earnings. In addition, to date no UK study…

1787

Abstract

Purpose

In contrast to recent US studies, almost all prior UK studies have not supported the incremental information content of cash flow beyond earnings. In addition, to date no UK study has addressed the effect of earnings extremity on the incremental information content of cash flow and earnings whilst controlling for the extremity of cash flow. Therefore, and in order to assess the generality of recent US findings, the aim of this study is to examine the incremental information content of cash flow from operations and earnings and the effect of extreme earnings on the incremental information content of cash flow from operations in the UK firms.

Design/methodology/approach

Based on market‐based accounting research, this study uses statistical associations between accounting data (earnings and cash flow) and stock returns to assess/measure the incremental information content (value relevance) of cash flow and earnings and the effect of extreme earnings on the incremental information content of cash flow and earnings. The paper follows the recent methodology in this area that employs the level and change of cash flow and earnings as an estimation of their unexpected components and isolates the extreme cash flow and earnings apart from the moderate ones.

Findings

The results show that both earnings and cash flow from operations have incremental information content beyond each other. It is also found that extreme earnings lead to incremental information content for only moderate (not extreme) cash flow. These results are consistent with the findings of the recent US studies.

Practical implications

Overall, the findings of this study support the usefulness of using cash flow information, in addition to earnings in firm valuation by investors in the UK market, especially when earnings are extreme and cash flow is moderate. The accounting interpretation of these results, in terms of disclosure of earnings components, is discussed.

Originality/value

The study makes the following contributions to the incremental information content of cash flow and earnings literature in the UK. First, this study employs actual cash flow data derived from cash flow statements. Second, none of the prior UK studies shares the current research focus, which is to examine the effect of earnings extremity on the incremental information content of cash flow and earnings whilst controlling for the extremity of cash flow itself. Third, this study employs a large sample size for a more recent period.

Details

Review of Accounting and Finance, vol. 12 no. 1
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 19 September 2008

Shadi Farshadfar, Chew Ng and Mark Brimble

The purpose of this paper is to examine the relative predictive ability of earnings, cash flow from operations as reported in the cash flow statement, and two traditional measures…

3262

Abstract

Purpose

The purpose of this paper is to examine the relative predictive ability of earnings, cash flow from operations as reported in the cash flow statement, and two traditional measures of cash flows (i.e. earnings plus depreciation and amortisation expense, and working capital from operations) in forecasting future cash flows for Australian companies. Further, an empirical investigation of the extent to which firm size, as a contextual factor, influences the predictability of earnings and cash flow from operations is presented.

Design/methodology/approach

The authors' sample includes 323 companies listed on the Australian Stock Exchange between 1992 and 2004 (3,512 firm‐years). They employ the ordinary least squares and fixed‐effects approaches to estimate their regression models. To evaluate the forecasting performance of the regression models, both within‐sample and out‐of‐sample forecasting tests are employed.

Findings

The authors provide evidence that reported cash flow from operations has more power in predicting future cash flows than earnings and traditional cash flow measures. Further, the predictability of both earnings and cash flow from operations significantly increases with firm size. However, the superiority of cash flow from operations to earnings in predicting future cash flows is robust across small, medium and large firms.

Originality/value

The authors' results, in terms of firm size, imply that the users of accounting information should be cautious in assessing the utility of earnings and cash flow measures in forecasting future cash flows as firm size decreases.

Details

Pacific Accounting Review, vol. 20 no. 3
Type: Research Article
ISSN: 0114-0582

Keywords

Article
Publication date: 3 June 2014

Wael Mostafa

Many studies examine the relative information content of earnings and cash flows from operations. Most studies find that earnings have higher information content than cash flows

Abstract

Purpose

Many studies examine the relative information content of earnings and cash flows from operations. Most studies find that earnings have higher information content than cash flows. An interesting question that follows is whether these findings hold after controlling the extremity of earnings and cash flows. The purpose of this paper is to examine the relative information content of earnings and cash flows in the following four different cases: first, moderate earnings vs moderate cash flows, second, extreme earnings vs moderate cash flows, third, moderate earnings vs extreme cash flows, and fourth, extreme earnings vs extreme cash flows.

Design/methodology/approach

To assess the relative information content of earnings and cash flows for each of the four cases mentioned above, the authors compare the explanatory power for regression of returns on unexpected earnings relative to regression of returns on unexpected cash flows. Therefore, the author compares the adjusted R2 of the model with earnings variables and the model with cash flows variables using Vuong's test, that examines the statistical significance of the difference between adjusted R2s of the rival (non-nested) models, and interpret a statistically higher adjusted R2 as an indicator for higher relative information content.

Findings

The results show that: first, when both earnings and cash flows are moderate, earnings are more highly associated with stock market price changes than cash flows, second, when both earnings and cash flows are extreme, earnings also have greater relative information content than cash flows, third, when the extremity differs between earnings and cash flows, the moderate variable is superior to the other extreme variable in explaining security returns. These results suggest that earnings are definitely more value relevant than cash flows. However, only in cases when cash flows from operations are moderate and earnings are extreme, cash flows possess higher information content than earnings.

Practical implications

The explanatory power for stock returns will be higher for earnings or cash flows depending on which is more highly persistent. This result reverses the conventional finding of the superiority of earnings over cash flows in explaining security returns.

Originality/value

In contrast to previous studies, the authors control for the extremity of earnings and cash flows when evaluating the relative information content of earnings and cash flows from operations.

Details

Managerial Finance, vol. 40 no. 7
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 1 January 2003

Soon Suk Yoon and Gary Miller

This paper investigates the functional relationships between stock returns and two representative performance measures. The two measures are earnings and cash from operations. In…

Abstract

This paper investigates the functional relationships between stock returns and two representative performance measures. The two measures are earnings and cash from operations. In addition, this paper assesses the association of stock returns with the decomposed components of earnings. Our study documents that earnings dominate cash from operations in terms of the relationships with the stock returns. When the stock returns are regressed on the decomposed components of earnings, cash from operations consistently shows strong positive relationships with stock returns. The efficient capital market hypothesis posits that changes in reported earnings without cash flow implications should not affect stock prices. However, our regression results indicate that non‐current accruals have strong relationships with the stock returns even though they lack cash flow implications. Perhaps this may imply that cosmetic earnings increases might be rewarded with increases in stock prices.

Details

Review of Accounting and Finance, vol. 2 no. 1
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 21 June 2011

Ibrahim El‐Sayed Ebaid

The purpose of this paper is to examine the comparative abilities of current period cash flows and earnings (and its components) to predict one‐year‐ahead cash flow from operations

3126

Abstract

Purpose

The purpose of this paper is to examine the comparative abilities of current period cash flows and earnings (and its components) to predict one‐year‐ahead cash flow from operations in Egypt.

Design/methodology/approach

The study uses the cash flow prediction models developed by Barth, Cram, and Nelson to examine the predictive abilities of earnings and cash flows for future cash flows. The first set of prediction models uses cross‐sectional regression to compare the predictive abilities of cash flows and aggregate earnings for one‐year‐ahead cash flow from operations. The second set of prediction models tests whether disaggregating earnings into cash flows and the major components of accruals enhances the predictive ability of earnings for one‐year‐ahead cash flow from operations.

Findings

The findings of the study reveal that aggregate earnings have superior predictive ability than cash flows for future cash flows. Also, the results reveal that disaggregating accruals into major components – changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals – significantly enhances predictive ability of earnings.

Research limitations/implications

The study provides empirical evidence on the superiority of earnings in predicting future cash flows. The findings of the study should be considered in explaining the results of value relevance research Egypt. However, owing to relatively small sample size, given the thinness of the Egyptian capital market, these findings should be interpreted with caution.

Originality/value

The paper contributes to the limited body of research on the superiority of earnings and cash flows in predicting future cash flows by examining the predictive abilities of earnings and cash flows for future cash flows in Egypt as one of many emerging markets.

Details

Management Research Review, vol. 34 no. 7
Type: Research Article
ISSN: 2040-8269

Keywords

Article
Publication date: 25 February 2014

Karen Lightstone, Karrilyn Wilcox and Louis Beaubien

– The purpose of this paper is to investigate the accuracy and informational quality of the cash from operations section of the cash flow statement.

1197

Abstract

Purpose

The purpose of this paper is to investigate the accuracy and informational quality of the cash from operations section of the cash flow statement.

Design/methodology/approach

This paper empirically tested the accuracy of the cash from operations reported by Canadian non-financial companies. The authors studied 262 companies at three different time periods providing 786 firm observations. For each observation, the balance sheet was used to confirm the figures reported in the statement of cash flows. In addition, the authors investigated management's disclosure of the particular working capital items.

Findings

The findings suggest that in recent years, companies are more likely to overstate their cash flow from operations, thereby presenting a better financial picture than is supported by the balance sheet accounts. This would suggest that the investing or financing section would be correspondingly understated. The presence of acquisitions reduces overstatements, which may be the result of more auditor presence.

Research limitations/implications

This paper extends previous research from documented single, isolated instances of cash from operations being misstated to include a significant sample with more generalizable findings. The data are Canadian which may limit the generalizability to other countries. Future research should address the extent to which financial analysts rely on the reported cash from operations figure.

Practical implications

This preliminary study may have implications for financial analysts and others relying on the free cash flow figure.

Originality/value

This study expands on previous research which has taken place only on a case-by-case basis.

Details

International Journal of Accounting and Information Management, vol. 22 no. 1
Type: Research Article
ISSN: 1834-7649

Keywords

Article
Publication date: 12 December 2016

Wael Mostafa

Motivated by the lack of research on the value relevance of accounting information in the emerging markets of Middle Eastern countries, and the unique institutional and accounting…

2096

Abstract

Purpose

Motivated by the lack of research on the value relevance of accounting information in the emerging markets of Middle Eastern countries, and the unique institutional and accounting setting in Egypt, this paper aims to investigate the relation between capital market and accounting information in the emerging market of Egypt. Specifically, based on Egyptian data, this study examines the value relevance of earnings, cash flows from operations and book values.

Design/methodology/approach

To examine the value relevance of the above accounting measures, this study uses statistical associations between accounting information and capital market values: the association between earnings and annual returns; the association between cash flows and accruals, and annual returns; and the association between earnings and book values of equity, and stock prices.

Findings

The results show that, first, earnings have value relevance. However, earnings changes are significantly more successful than earnings levels in explaining security returns. These results suggest that changes in earnings are largely permanent; hence, earnings follow (close to) a random walk model. Second, contrary to what is stated in the literature, cash flows from operations are not successful in explaining stock returns. This result suggests that cash flows are less important and not value relevant in Egypt compared to the USA or the UK. A possible explanation is that cash flows in Egypt are very volatile (high variance) and not persistent, so the market does not rely on them. Third, individually, both earnings and book values significantly explain stock prices; however, jointly, earnings have incremental explanatory power beyond book values for stock prices whereas book values do not. These results suggest that in Egypt the income statement is much more important than the balance sheet for valuation purposes. Overall, these results are interesting because they do not completely replicate the results from other countries.

Practical implications

The existence of value relevance for earnings despite the apparent lack of value relevance for cash flows can be interpreted as indicating that accruals are designed to offset and smooth cash flows’ volatility and low value relevance, so that earnings are relatively more persistent and relevant. These results show that earnings potentially are a much more important and informative measure of a firm’s value than cash flows from operations in Egypt. However, we certainly need the cash flows information as an ex-post validation of the prior earnings. Overall, it appears that the investors in Egypt are looking at the accounting data when evaluating the value of the firm, which is a good sign. However, the empirical findings of this paper are discussed.

Originality/value

This study contributes to the limited research on value relevance of accounting information in the emerging market of Egypt.

Details

Management Research Review, vol. 39 no. 12
Type: Research Article
ISSN: 2040-8269

Keywords

1 – 10 of over 21000