What do accruals tell us about future cash flows?

Mary E. Barth; Greg Clinch; Doron Israeli

doi:10.1007/s11142-016-9360-4

Review of Accounting Studies

September 2016, Volume 21, Issue 3, pp 768–807 | Cite as

What do accruals tell us about future cash flows?

Authors
Authors and affiliations

Mary E. BarthEmail author
Greg Clinch
Doron Israeli

Article

First Online: 14 June 2016

2.1k Downloads
1 Citations

Abstract

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.

Keywords

Accruals Cash flows Equity valuation Cash flow forecasting Valuation model

JEL Classifications

C13 C51 E37 G17 M41

This is a preview of subscription content, to check access.

Notes

Acknowledgments

We thank Robert Czernkowski, Kurt Gee, Richard Sloan, Dan Taylor, Patty Dechow (the editor), two anonymous reviewers, and workshop participants at the Review of Accounting Studies Conference, especially discussant Joseph Gerakos, and the University of California, Berkeley; University of California, Los Angeles, Spring 2015 Accounting Mini-Conference; University of Melbourne; University of Michigan, Accounting Kapnick Spring Conference; University of Technology, Sydney Summer Accounting Symposium; and Stanford Graduate School of Business informal seminar for helpful comments and suggestions.

Appendix 1: Proofs

Proposition 1 (Sect. 3.3)

Because investors are risk neutral, the value of the firm at time $t$ equals the expected present value of future dividends given information available to investors at $t$ . Because $Cash_{t}$ , i.e., the firm’s cash at $t$ , satisfies clean surplus, i.e., $Cash_{t} = RCash_{t - 1} + CFO_{t} - \, Div_{t}$ , dividends can be replaced in the dividend valuation expression using the clean surplus expression to yield:

$$P_{t} = Cash_{t} + {\text{E}}_{t} \left[ {\sum\limits_{\tau = 1}^{\infty } {\frac{{CFO_{t + \tau } }}{{R^{\tau } }}} } \right].$$

That is, the value of the firm at time $t$ equals current cash plus the expected present value of future operating cash flows. Using Eq. ( 4 ) from Sect. 3.2 , it is straightforward to determine that

$$\begin{aligned} {\text{E}}_{t} (CFO_{t + 1} ) & = \lambda^{A} \theta_{t} + (\lambda^{C} + \gamma \lambda^{B} ){\text{E}}_{t} (\theta_{t + 1} ) + {\text{E}}_{t} (e_{t + 1}^{A} ),\quad {\text{and}} \\ {\text{E}}_{t} (CFO_{t + \tau } ) & = \gamma^{\tau - 1} (\gamma^{ - 1} \lambda^{A} + \lambda^{C} + \gamma \lambda^{B} ){\text{E}}_{t} (\theta_{t + 1} ),{\text{ for }}\tau > 1. \\ \end{aligned}$$

Using these in the expression for $P_{t}$ above, together with standard expressions for the sum of an infinite series, yields Proposition 1.

Lemma (Sect. 4.1)

Given the definitions in Eq. ( 7 ) from Sect. 4.1 and assuming $\theta_{t}$ is known, it is straightforward to calculate the following:

$$\begin{aligned} Var(z1_{t} ) & = \sigma_{\theta }^{2} + \frac{1}{{(\lambda^{B} )^{2} }}\left( {\sigma_{{e^{A} }}^{2} + \sigma_{{e^{C} }}^{2} + \sigma_{{e^{B} }}^{2} } \right) \\ Var(z2_{t} ) & = \sigma_{\theta }^{2} + \frac{1}{{(\lambda^{B} )^{2} }}\left( {\sigma_{{e^{B} }}^{2} + \sigma_{{v^{B} }}^{2} } \right) \\ Var(z3_{t} ) & = \frac{1}{{(\lambda^{B} )^{2} }}\left( {\sigma_{{e^{A} }}^{2} + \sigma_{{v^{A} }}^{2} } \right) \\ Var(z4_{t} ) & = \left( {\sigma_{{e^{A} }}^{2} + \sigma_{{v^{A} }}^{2} } \right) \\ Cov(\theta_{t + 1} ,z1_{t} ) & = Cov(\theta_{t + 1} ,z2_{t} ) = \sigma_{\theta }^{2} \\ Cov(\theta_{t + 1} ,z3_{t} ) & = 0 \\ Cov(e_{t + 1}^{A} ,z4_{t} ) & = \sigma_{{e^{A} }}^{2} \\ Cov(z1_{t} ,z2_{t} ) & = \sigma_{\theta }^{2} + \frac{{\sigma_{{e^{B} }}^{2} }}{{(\lambda^{B} )^{2} }} \\ Cov(z1_{t} ,z3_{t} ) & = \frac{{\sigma_{{e^{B} }}^{2} }}{{(\lambda^{B} )^{2} }} \\ Cov(z2_{t} ,z3_{t} ) & = 0. \\ \end{aligned}$$

Using these expressions and the standard expression for conditional expectations in a multivariate normal distribution yields the following:

$${\text{E}}_{t} (\theta_{t + 1} ) = (1 - \beta_{1} - \beta_{2} )\gamma \theta_{t} + \beta_{1} z1_{t} + \beta_{2} z2_{t} + \beta_{3} z3_{t} ,$$

where $\beta_{1} = \frac{1}{D}(\sigma_{\varepsilon }^{2} \sigma_{{v^{B} }}^{2} (\sigma_{{e^{A} }}^{2} + \sigma_{{v^{A} }}^{2} )),\beta_{2} = \frac{1}{D}\sigma_{\varepsilon }^{2} (\sigma_{{e^{A} }}^{2} \sigma_{{e^{C} }}^{2} + (\sigma_{{e^{A} }}^{2} + \sigma_{{e^{C} }}^{2} )\sigma_{{v^{A} }}^{2} ),$ $\beta_{3} = - \frac{1}{D}(\sigma_{\varepsilon }^{2} \sigma_{{e^{A} }}^{2} \sigma_{{v^{B} }}^{2} ),D = \left( {\sigma_{\varepsilon }^{2} + \frac{{\sigma_{{e^{B} }}^{2} + \sigma_{{v^{B} }}^{2} }}{{(\lambda^{B} )^{2} }}} \right)\left( {\sigma_{{e^{A} }}^{2} \sigma_{{e^{C} }}^{2} + (\sigma_{{e^{A} }}^{2} + \sigma_{{e^{C} }}^{2} )\sigma_{{v^{A} }}^{2} } \right) + \left( {\sigma_{\varepsilon }^{2} + \frac{{\sigma_{{e^{B} }}^{2} }}{{(\lambda^{B} )^{2} }}} \right)\sigma_{{v^{B} }}^{2} \left( {\sigma_{{e^{A} }}^{2} + \sigma_{{v^{A} }}^{2} } \right)$, and

$$\begin{aligned} {\text{E}}_{t} (e_{t + 1}^{A} ) & = \beta_{4} z4_{t}, \quad {\text{where}} \quad \\ \beta_{4} & = \tfrac{{\sigma_{{e^{A} }}^{2} }}{{\sigma_{{e^{A} }}^{2} + \sigma_{{v^{A} }}^{2} }}. \\ \end{aligned}$$

Appendix 2: Variable definitions

MVE	market value of equity
CFO	cash flow from operations from the statement of cash flows plus after tax net interest paid
OPEARN	net income before extraordinary items plus after tax net interest expense
REV	total revenue
BVE	book value of equity
NI	net income before extraordinary items and discontinued operations
ACC	NI minus CFO
SFP ^A	total receivables plus deferred tax assets minus the sum of accounts payable, accrued expenses, pension liability, income taxes payable, and deferred tax liability
SFP ^B	the sum of inventories, prepaid expenses, income tax refund, property, plant, and equipment, intangible assets, deferred charges, investments and advances-equity, and long-term pension assets minus deferred revenues
OACC	ACC minus the sum of ΔSFP ^A and ΔSFP ^B

All variables are measured as of the firm’s fiscal year-end and deflated by average total assets. Δ denotes annual change

References

Abarbanell, J., & Bernard, V. (2000). Is the U.S. stock market myopic? Journal of Accounting Research, 38, 221–242.CrossRefGoogle Scholar
Ali, A. (1994). The incremental information content of earnings, working capital from operations, and cash flows. Journal of Accounting Research, 32, 61–74.CrossRefGoogle Scholar
Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6, 159–178.CrossRefGoogle Scholar
Barth, M. E., Beaver, W. H., Hand, J. R. M., & Landsman, W. R. (1999). Accruals, cash flows, and equity values. Review of Accounting Studies, 4, 205–229.CrossRefGoogle Scholar
Barth, M. E., Beaver, W. H., Hand, J. R. M., & Landsman, W. R. (2005). Accrual, accounting-based valuation models, and the prediction of equity values. Journal of Accounting, Auditing, and Finance, 20, 311–345.Google Scholar
Barth, M. E., Beaver, W. H., & Landsman, W. R. (1992). The market valuation implications of net periodic pension cost components. Journal of Accounting and Economics, 15, 27–62.CrossRefGoogle Scholar
Barth, M. E., Beaver, W. H., & Wolfson, M. A. (1990). Components of earnings and the structure of bank share prices. Financial Analysts Journal, 46, 53–60.CrossRefGoogle Scholar
Barth, M. E., Cram, D. P., & Nelson, K. K. (2001). Accruals and the prediction of future cash flows. The Accounting Review, 76, 27–58.CrossRefGoogle Scholar
Beaver, W. H., & Dukes, R. E. (1972). Interperiod tax allocation, earnings expectations, and the behavior of security prices. The Accounting Review, 47, 320–333.Google Scholar
Bowen, R. M., Burgstahler, D., & Daley, L. A. (1986). Evidence on the relationships between earnings and various measures of cash flow. The Accounting Review, 61, 713–725.Google Scholar
Bowen, R. M., Burgstahler, D., & Daley, L. A. (1987). The incremental information content of accruals versus cash flows. The Accounting Review, 62, 723–747.Google Scholar
Brochet, F., Nam, S., & Ronen, J. (2009). The role of accruals in predicting future cash flows and stock returns, Working paper, Harvard Business School.Google Scholar
Burgstahler, D., Jiambalvo, J., & Pyo, Y. (1998). The informativeness of cash flows for future cash flows, Working paper, University of Washington.Google Scholar
Chen, W., Liu, C., & Ryan, S. (2008). Characteristics of securitizations that determine issuers’ retention of the risks of the securitized assets. The Accounting Review, 83, 1181–1215.CrossRefGoogle Scholar
Cheng, C., Liu, C., & Schaefer, T. (1996). Earnings permanence and the incremental information content of cash flows from operations. Journal of Accounting Research, 34, 173–181.CrossRefGoogle Scholar
Clubb, C. D. B. (2013). Information dynamics, dividend displacement, conservatism, and earnings measurement: A development of the Ohlson (1995) valuation framework. Review of Accounting Studies, 18, 360–385.CrossRefGoogle Scholar
Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18, 3–42.CrossRefGoogle Scholar
Dechow, P. M., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77, 35–59.CrossRefGoogle Scholar
Dechow, P. M., Hutton, A. P., & Sloan, R. G. (1999). An empirical assessment of the residual income valuation model. Journal of Accounting and Economics, 26, 1–34.CrossRefGoogle Scholar
Dechow, P. M., Kothari, S. P., & Watts, R. L. (1998). The relation between earnings and cash flows. Journal of Accounting and Economics, 25, 133–168.CrossRefGoogle Scholar
Dichev, I. D., & Tang, V. W. (2008). Matching and the changing properties of accounting earnings over the last 40 years. The Accounting Review, 83, 1425–1460.CrossRefGoogle Scholar
Fairfield, P. M., Whisenant, J. S., & Yohn, T. L. (2003). Accrued earnings and growth: Implications for future profitability and market mispricing. The Accounting Review, 78, 353–371.CrossRefGoogle Scholar
Feltham, G. A., & Ohlson, J. (1995). Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research, 11, 689–731.CrossRefGoogle Scholar
Financial Accounting Standards Board (FASB). (1987). Statement of Financial Accounting Standards No. 95, Statement of Cash Flows. Norwalk, CT.Google Scholar
Financial Accounting Standards Board (FASB). (2010). Statement of Financial Accounting Concepts No. 8, Conceptual Framework for Financial Reporting, Chapter 1. The Objective of General Purpose Financial Reporting, Norwalk, CT.Google Scholar
Finger, C. A. (1994). The ability of earnings to predict future earnings and cash flow. Journal of Accounting Research, 32, 210–223.CrossRefGoogle Scholar
Francis, J., & Smith, M. (2005). A reexamination of the persistence of accruals and cash flows. Journal of Accounting Research, 43, 413–451.CrossRefGoogle Scholar
Givoly, D., & Hayn, C. (2000). The changing time-series properties of earnings, cash flows and accruals: Has financial accounting become more conservative? Journal of Accounting and Economics, 29, 287–320.CrossRefGoogle Scholar
Greenberg, R. R., Johnson, G. L., & Ramesh, K. (1986). Earnings versus cash flow as a predictor of future cash flow measures. Journal of Accounting, Auditing, and Finance, 1, 266–277.Google Scholar
Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics, 20, 125–153.CrossRefGoogle Scholar
Hribar, H., & Collins, D. W. (2002). Errors in estimating accruals: Implications for empirical research. Journal of Accounting Research, 40, 105–134.CrossRefGoogle Scholar
Lev, B., Li, S., & Sougiannis, T. (2010). The usefulness of accounting estimates for predicting cash flows and earnings. Review of Accounting Studies, 15, 779–807.CrossRefGoogle Scholar
Lipe, R. (1986). The information contained in the components of earnings. Journal of Accounting Research, 24, 37–68.CrossRefGoogle Scholar
Lorek, K. S., & Willinger, G. L. (1996). A multivariate time-series prediction model for cash-flow data. The Accounting Review, 71, 81–101.Google Scholar
McNichols, M. F., & Stubben, S. R. (2014). The effect of target-firm accounting quality on valuation in acquisitions. Review of Accounting Studies, 20, 110–140.CrossRefGoogle Scholar
Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6, 109–154.CrossRefGoogle Scholar
Nissim, D., & Penman, S. H. (2003). Financial statement analysis of leverage and how it informs about profitability and price-to-book ratios. Review of Accounting Studies, 8, 531–560.CrossRefGoogle Scholar
Ohlson, J. (1995). Earnings, book values, and dividends in security valuation. Contemporary Accounting Research, 11, 661–687.CrossRefGoogle Scholar
Ou, J. A. (1990). The information content of nonearnings accounting numbers as earnings predictors. Journal of Accounting Research, 28, 144–163.CrossRefGoogle Scholar
Ou, J. A., & Penman, S. H. (1989). Financial statement analysis and the prediction of stock returns. Journal of Accounting and Economics, 11, 295–329.CrossRefGoogle Scholar
Ou, J. A., & Penman, S. H. (1990). Accounting measurement, price-earnings ratio, and the information content of security prices. Journal of Accounting Research, 27, 111–144.CrossRefGoogle Scholar
Penman, S. H., & Yehuda, N. (2009). The pricing of earnings and cash flows and an affirmation of accrual accounting. Review of Accounting Studies, 14, 453–479.CrossRefGoogle Scholar
Pfeiffer, R. J., Elgers, P. T., Lo, M. H., & Rees, L. L. (1998). Additional evidence on the incremental information content of cash flows and accruals: The impact of errors in measuring market expectations. The Accounting Review, 73, 373–385.Google Scholar
Rayburn, J. (1986). The association of operating cash flow and accruals with security returns. Journal of Accounting Research, 24, 112–133.CrossRefGoogle Scholar
Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, I. (2005). Accrual reliability, earnings persistence and stock prices. Journal of Accounting and Economics, 39, 437–485.CrossRefGoogle Scholar
Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71, 289–315.Google Scholar
Srivastava, A. (2014). Why have measures of earnings quality changed over time? Journal of Accounting and Economics, 57, 196–217.CrossRefGoogle Scholar
Wilson, G. P. (1986). The relative information content of accruals and cash flows: Combined evidence at the earnings announcement and annual report release date. Journal of Accounting Research, 24, 165–200.CrossRefGoogle Scholar
Wilson, G. P. (1987). The incremental information content of the accrual and funds components of earnings after controlling for earnings. The Accounting Review, 62, 293–322.Google Scholar

Copyright information

Authors and Affiliations

Mary E. Barth
- 1
Email author
Greg Clinch
- 2
Doron Israeli
- 3

1.Graduate School of BusinessStanford UniversityStanfordUSA
2.University of MelbourneParkvilleAustralia
3.Arison School of Business, Interdisciplinary Center (IDC) HerzliyaHerzliyaIsrael

What do accruals tell us about future cash flows?

Abstract

Keywords

JEL Classifications

Notes

Acknowledgments

References

Copyright information

Authors and Affiliations

Personalised recommendations

Cite article