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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: 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: 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 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

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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: 12 February 2018

Mark Kohlbeck, Jomo Sankara and Errol G. Stewart

This paper aims to examine whether external monitors (auditors and analysts) constrain earnings strings, an indicator of earnings management, and whether this monitoring is more…

Abstract

Purpose

This paper aims to examine whether external monitors (auditors and analysts) constrain earnings strings, an indicator of earnings management, and whether this monitoring is more effective after the implementation of the Sarbanes-Oxley Act of 2002 (SOX), given the emphasis of SOX on improving auditing, financial reporting and the information environment.

Design/methodology/approach

Agency theory establishes the premise between external monitoring and earnings strings. Auditor tenure and number of analysts following provide measures for external monitoring quality. Using prior research, empirical models explaining the presence of an earnings strings and earnings strings trend are developed to test the hypotheses.

Findings

Pre-SOX, extreme auditor tenure, indicating lower quality external monitoring, is associated with greater earnings strings trend, and analyst coverage is associated with increased likelihood of earnings strings and greater earnings strings trend consistent with analyst pressure on management. More effective auditor and analyst monitoring occurs post-SOX in terms of reduced likelihood of earnings strings and earnings strings trend.

Originality/value

The authors provide evidence on how elements of external monitoring are associated with increased earnings strings pre-SOX. Further, they contribute to the debate on the impact of SOX on external firm monitoring and the overall financial information environment. By focusing on earnings strings, the outcome of earnings management, the authors provide a unique understanding of external monitoring that also provides insight on the overvaluation of equity and ultimate destruction of firm value. The evidence demonstrates how regulation has contributed to an improved financial reporting environment and external monitoring.

Details

Review of Accounting and Finance, vol. 17 no. 1
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 14 August 2007

Gary K. Meek, Ramesh P. Rao and Christopher J. Skousen

The purpose of this paper is to examine the factors affecting the relationships between CEO stock option compensation and earnings management.Design/methodology/approach

3995

Abstract

Purpose

The purpose of this paper is to examine the factors affecting the relationships between CEO stock option compensation and earnings management.Design/methodology/approach – Regression of CEO stock option compensation and other factors on measures of discretionary accruals.Findings – A positive relationship between CEO stock option compensation and discretionary accruals was found, implying that earnings management is more likely where stock options are a larger part of CEO compensation. Earnings management is found to be moderated in large firms with stock option compensation and the relationship between stock options and earnings management has intensified in recent years. It was also found that stock options exacerbate earnings management in firms with growth opportunities.Research limitations/implications – Beyond the scope of this paper, these findings raise the following questions: What does the evidence of a size effect mean? Does it reflect information asymmetry, governance, external monitoring, or political risk? Why has the stock option effect on earnings management become more pronounced in recent years? Is it possible to mitigate the negative effects of option compensation on earnings management through the presence of stronger governance structures? Is it possible to mitigate the negative effects of option compensation on earnings management through the presence stronger governance structures? There are implications for compensation policies for corporate executives.Originality/value – This paper extends prior research on the relationship between CEO stock option compensation and earnings management. It provides new insight into the factors affecting this relationship.

Details

Review of Accounting and Finance, vol. 6 no. 3
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 29 June 2010

Abdullah Iqbal and Norman Strong

This paper aims to investigate the relation between corporate governance and earnings management around UK rights issues.

5027

Abstract

Purpose

This paper aims to investigate the relation between corporate governance and earnings management around UK rights issues.

Design/methodology/approach

The paper examines the effect of board structure, ownership structure, adviser structure, and capital structure on discretionary current accruals – a proxy for earnings management – for a sample of size‐controlled rights issuers. Rights issues are chosen as a context in which firms have particular incentives to manage earnings.

Findings

The results suggest that firms with higher debt to equity ratios, with lower proportions of non‐executive directors, or with no large block owner, are more likely to use discretionary current accruals to manipulate earnings around rights issues.

Research limitations/implications

Similar research can be conducted around other equity issuing methods such as open offers and around other major corporate events such as initial public offerings.

Practical implications

The paper's evidence contributes to an understanding of corporate governance and has practical implications for stakeholders. It suggests that investors can rely more on the financial disclosures of firms with lower debt to equity ratios, higher proportions of outside directors, and with a large blockholder. Regulators may propose that firms undertaking corporate events such as equity offerings should follow best corporate governance practices to enhance investor confidence.

Originality/value

This study is the first to investigate the corporate governance mechanisms in place to check opportunistic earnings management around specific corporate events for the UK market.

Details

International Journal of Managerial Finance, vol. 6 no. 3
Type: Research Article
ISSN: 1743-9132

Keywords

Article
Publication date: 1 September 1994

James J. Tucker and Louis A. Tucci

As a result of intense competition, many companies have changed theirfundamental marketing strategy from one of diversification of productsand services to a well‐focussed…

2026

Abstract

As a result of intense competition, many companies have changed their fundamental marketing strategy from one of diversification of products and services to a well‐focussed, concentrated effort on “core” products, services and markets. Examines the reasons why it has become increasingly difficult to identify and evaluate core earnings performance. Also examines the ominous implications of this problem for strategic marketing decisions which require an accurate assessment of core earnings performance. Describes a number of situations in which the use of unchallenged or unadjusted earnings figures could result in flawed or failed marketing strategies. Finally, provides insight regarding a number of issues related to earnings and cash flow to increase marketers′ ability to evaluate core earnings performance and thus avoid the marketing problems described.

Article
Publication date: 9 October 2017

Qingzhong Ma, Hui Wang and Wei Zhang

The purpose of this paper is to explore trading strategies that exploit investors’ anchoring bias.

Abstract

Purpose

The purpose of this paper is to explore trading strategies that exploit investors’ anchoring bias.

Design/methodology/approach

This paper forms portfolios based on nearness ratio and other anomaly variables under one- and two-way sorts. The portfolio return series are then regressed on Fama and French three factors to extract abnormal returns.

Findings

First is to use anchoring as a technical signal. A strategy that trades against anchoring buys stocks with prices near their 52-week high and sells stocks with prices far below their 52-week high. Based on deciles, the strategy generates a significant value-weighted monthly α of 1.13 percent, after accounting for the market, size, and value factors. Further, the strategy is profitable among both large and small stocks; the trading profit is higher among younger firms and more volatile stocks, but is similar between subsamples formed on number of analysts, level of institutional ownership, and number of institutional owners. The strategy is more profitable following periods of high investor sentiment. Second is to combine anchoring with known anomalies. For a broad set of 26 anomalies, a trading strategy that combines anchoring with the anomalies increases the value-weighted monthly α from an average of 0.61 percent to an average of 1.38 percent. While part of the profits can be attributed to momentum, momentum itself does not explain all the profits.

Originality/value

This paper presents empirical evidence that anchoring bias explains the profitability of a broad set of anomalies and describes practical trading strategies that exploit the anchoring bias.

Details

Review of Behavioral Finance, vol. 9 no. 3
Type: Research Article
ISSN: 1940-5979

Keywords

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