ijcrb.webs.com INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS JULY 2013 VOL 5, NO 3

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1 Accruals and Cash Flows- A case of Jordan Dr. Mohammad Fawzi Shubita Assistant Professor, Accounting Department Amman Arab University, Amman Jordan PO Box Code Amman Jordan Abstract The aim of this research is to empirically study the fundamental issues in Jordan, when it comes to the use of accounting information, such as earnings, is the base of Jordanian capital market since there is a lack of other information sources, in the current emerging markets The findings are founded on a sample of Jordanian shareholders companies and based on Barth et al. (2001) of cash flow prediction models. The results expose that both current cash flows and earnings have a forecasting ability instead of the futureoperating cash flow. The findings also show that accruals main constituents varies in change of accounts payable, inventory and in accounts receivable, depreciation, and other accruals. This causes a significant enhancement in the forecasting ability of earnings for future operating cash flows. Keywords: Accruals, Cash Flow forecasting, Accruals components, Amman Stock Exchange. 1. Introduction Expenses, gains, loss and revenues are all important factors in earnings components that users can use to analyze prior performance and gain insights, into how to get to a certain level of cash flows. This is possible because earnings help estimate future cash flows and they also reflect several assumptions, such as income statement users, must be aware that there are certain restrictions connected with the information found in earnings. For the preparation and presentation of financial statements, International Accounting Standards Board (IASB) authorized accrual net income to be used in its framework. The main goal of financial accounting reports is that it gives information assists creditors, investors and other external users in measuring the future operating cash flows. An underlying question that has engaged researchers is if current earnings have a better ability in comparison to current cash flows, when it comes to predicting a company s future cash flow. This brings to mind the FASB s argument that accrual-based earnings are superior in COPY RIGHT 2013 Institute of Interdisciplinary Business Research 428

2 predicting future operating cash flows. Conversely, the current empirical evidence, on the superiority of earnings and cash flow is indecisive. Previous research assessment, on the forecasting ability of earnings and cash flows for future cash flows is large in developed markets but there is not enough empirical evidence known for emerging markets. Expansion of previous research findings in budding capital markets is not an easy task. In emerging capital markets a different set of characteristics is found in comparison to capital markets that are mature.in the case of emerging capital markets the different characteristics that govern it, make it difficult to take a broad view of it, so it is not safe to compare study findings in developed markets with emerging ones. The different characteristics include have fewer number of registrants, lack efficient ways to process information, less enforcement of established disclosures,fewer demanding disclosure requirements, and fewer mature investors. Thus, it is of great interest to assess the forecasting abilities of accrual earnings andcurrent operating cash flows for future operating cash flows, in emerging markets. Consequently, the chief objective of the research is to provide evidence that is Jordanian, on the important information content of accruals. The other main objective of this research is to also provide the future cash flow from operating activities. The forecasting ability is evaluated, along with the current cash flow from operations. After that is evaluated, the disaggregating of earnings into cash flow and the other main factors of accruals, such as the changes in accounts payable and receivable, along with the inventory, depreciation, and other accruals, all enhance the forecasting ability of the earnings for future operating cash flow. The whole of the research is structured in the following manner. First the researcher begins with pointing out the research problem. Then literature already available about the content of earnings and about operating cash flows are reviewed. Lastly, the methodology of the study is introduced and the empirical results along with the conclusions are reported. 2. Research Problem The research problem can be expressed in the following questions:- Can aggregate earnings forecast future operating cash flows? Cancurrent operating cash flowpredict future cash flow from operation? Canaccrual components enhance forecasting ability of earnings for future operating cash flows? COPY RIGHT 2013 Institute of Interdisciplinary Business Research 429

3 3. Literature Review The function of studying the information content of accrual earnings in forecasting future operating cash flows is an important topic that is fundamental to financial accounting reporting (Barth et al., 2001(. It should be noted that previous research that tackles this subject shows varied and inconsistent findings. Bowen et. al, (1986) tested 1289 firms during the time period of It explained the empirical relationships that are found between accrual earnings and cash flow. The result of this test group revealed that the correlations of the alternative measures of cash flow have a low correlation with earnings, while the traditional measures of cash flows have a high correlation with earnings. Kim and Kross (2005) explored the capacity of accrual earnings to forecast future cash flows from operations, during the time period of 1973 to They investigated the forecasting ability of earnings of future cash flows over a period of time. It implied that the capacity of current accrual earnings to forecast future operating cash flows has improvedduring time.theseresults aren t consistent with the value relevance literature exemplified by Francis and Schipper (1999) and Ryan and Zarowin (2003).Our study is different than this study because our study evaluates the forecasting power of the earnings for the futureoperating cash flows. Burgstahler, et. al, (2006) used a large sample of firms that were operating during the time period of In an assortment of contextual settings it was found that the study showed that cash flows presented considerably more explanatory power than the aggregate earnings in forecasting future cash flows. Lorek and Willinger (2009) examine the ability of previous operating cash flows and previous accrual earnings to produce forecasts of future operating cash flows during the period of 1990 to The study found that cash flow from operations has incremental information content comparing with accruals. Waldron and Jordan (2010) explore and compare the information content of accrual earnings and current operating cash flows as forecasters of future operating cash flows during economic boom and economic duress. Employing data during the period of , it is found that the current operating cash flows outdo accrual earnings in forecasting future cash flows. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 430

4 Dechow (1994) shows that the length of the operating cycle is an important determinant in explaining variation in cash flow from operations. Dechow et al. (1998) model accrual earnings and operating cash flow that is associated to accounts receivable,inventory, andaccounts payable, reveal that current accrual net income is a far better forecaster of future operating cash flows than currentcash flows from operations. Barth et al. (2001) magnify this work by examining the role of accrual net income in forecasting future operating cash flows. They discover that disaggregating accrual accounting into main parts(i.e change in accounts payable, change in accounts receivable, and change in inventory, amortization,depreciation, and other accruals) pointedly improves the forecasting ability of current earnings to forecast future operating cash flows and is betterthan current operating cash flows. Barth et al. (2001), first estimate of the comparative relationship that is found between the future operating cash flows, past earnings or operating cash flows, along with the test of differences in explanatory power. That is the standard comparison of the forecasting ability of the both summary measures. They both estimate the relationship that is found between future operating cash flows, current operating cash flows, along with past earnings. That is after disaggregating the earnings into aggregate accruals and cash flows. The test is done to see the impact of the coefficients on the entire earnings component. The tests are repeated after disaggregating the accrual component of earnings into its key components. In emerging markets, Ragab and Omran (2006) assess the value of net income in stock valuation. They discovered thataccounting earnings in Egypt had incrementalinformationcontent about a firm s value in comparison tostock prices. They propose that the finding may indicate that different competing information sources, e.g., financial analystsstudies and earnings forecasts. All of these methods are not as relevant in comparison to accounting earnings that are more reliable because the financial reporting is of a higher quality. In Palestine Daraghma (2010) studied the relative and the incremental information content of earnings and operating cash flows. His study sample includes 23 firms on the Palestinian Stock Exchange from and finds that there is incremental information content for earnings comparing with operating cash flow. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 431

5 Ebaid, (2011) assess the relative capability of current period cash flows and earnings, along with its components, to forecast the future cash flow from operations in Egypt, for one year. In his study, the cash flow prediction models that were worked out by Barth, et. al. (2001), were used to study the forecasting abilities of earnings and cash flows for up-coming cash flows, along with the disaggregating accruals into its main components, notably increasing the forecasting ability of earnings. 4. Research Method 4.1StudySample The research sample contains all shareholders industrial firms found on the Amman Stock Exchange, from The required information that is to be used must at least include two successive years. After applying the needed criteria, the study sample included 66 companies and the number of observations was 419 company-years measures but this is after deleting the outliers observations. 4.2 Study Hypotheses H 01 : Aggregate earnings cannot predict cash flows from operation. H 02 : current operating cash flow cannot predict future operating cash flows. H 03 : Disaggregating earnings into accrual components and operating cash flow cannot enhance the forecastingability of accrual earnings to predict future operating cash flows. 4.3 Study Models and Variables The research uses Barth et al., (2001) four models to forecast the relationship that is found between earnings and operating cash flow measures. Model 1 is used to test the first hypothesis, by assessing the relationship that is found between future operating cash flow and current earnings. CFO it+1 = α 0 + α 1 EARNS it + e it (1) Where: α 0, α 1: Coefficients; i: firm; t: year; EARNS: earnings is defined as net income after tax; CFO: net cash flow from operating for one year ahead; e = Error term. Model 2 is used to test the second hypothesis, by assessing the explanatory power of accruals by evaluating the result of this model with model (1). CFO it+1 = α 0 + α 1 CFO it + e it (2) COPY RIGHT 2013 Institute of Interdisciplinary Business Research 432

6 Where: CFO: net cash flow from operating In model 3 the earnings are disaggregated into the key components of accruals and cash flow from operations. This is done in order to assess if this will enhance the capacity of earnings, to forecast operating cash flow. This is used with model 4to test the third hypothesis. Where: CFO it+1 = α 0 + α 1CFO it +α 2 Accruals it + e it (3) Accruals: Accruals= Net income- Cash flow from operations. Model 4 expands upon model 3 by disaggregating accruals into key components. This is done to study if the accrual components will advance the ability of earnings to forecast cash flow from operations. Where: CFO it = α 0+ α 1CFO it-1 + α 2 ΔAP+ α 3 ΔAR+ α 4 ΔINV+ α 5 DEPR+ α 6 OTHER+ e it (4) ΔAP = accounts payable this year- accounts payable previous year. ΔAR = accounts receivablethis year- accounts receivable previous year. ΔINV = Inventory level this year- inventory level previous year. DEPR = depreciation. OTHER = other accruals=earn - (CFO+ΔAR+ΔINV-ΔAP- DEPR). All the variables in the four modelsdeflated by average total assets like Barth et al., (2001). Table (1) displays the descriptive measures of the key variables. Comparable to Barth et al. (2001), EARN, CFO, ΔAR, ΔINV, ΔAP and DEPR means and medians are all positive. This is comparable to Ebaid, (2011) study but the only difference is the ΔAP was negative. It should be noted that themedianand mean of ACCRUALS were also negative becausecontaining depreciation. It should be noted that when it comes to the amortizable assets and acquisition of depreciable it is an investing activity not an operating activity. The standard deviation of cash flow from operations is fewer than earnings. This advocates that earnings in Jordan are unstable, in comparison to cash flow from operations and agrees with accruals improving cash flow changes. This is in harmony with Barth et al. (2001), accruals components, which are ΔAR, ΔINV, and ΔAP, that they are all lesser in magnitude than depreciation. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 433

7 The table displays that the mean value of EARNS is less than the average cash flow from operations. Since the average cash flow from operations is greater than the value of EARNS. The increase can be justified because some non-cash expenses were added to the net income, in order to reach the cash flow from operations. Table (1): Descriptive Measures (66 Industrial firms listed on Amman Stock Exchange (ASE), , 419 company-year observations) Variable Percentile 1 Minimum Mean Median Percentile 99 Maximum Std. Deviation Kurtosis CFOt CFOt EARNt ACCRUALSt Δ APt ΔARt Δ INVt DEPRt OTHERt Notes: The table describes descriptive statistics for the main variables in the research after deleting outliers defined as the bottom and top 1% of the observations on the study variables. Variable definitions: CFOis cash flow from operating, EARNS is earnings after tax but before extraordinary items. ACCRUALS areaccruals. ΔAP = accounts payable this year- accounts payable previous year. ΔAR = accounts receivable this year- accounts receivable previous year.δinv = Inventory level this year- inventory level previous year.depr = depreciation and amortization expense.other = other accruals. All variables are scaled by average total assets. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 434

8 5. Analysis and results 5.1 Correlation Analysis Observing the Pearson correlations coefficients that is found in the study measures in table (2), it is observed that there is a significant positive relationship found between EARNS and CFO it-1. There is also a significant positive relationship found between EARNS and its own components. The greatest and clearest correlation coefficient is found between CFO and ACCRUALS and CFO and it should be noted that there is a negative relationship between the two.. It is sensible to accept that there is a noteworthy relationship found between accruals and its component. The relationship found between them is positive for ΔAP, ΔAR and ΔINV but negative with DEPR. It should be noted that there is no relationship between Accruals and OTHER. Table (2): PearsonCorrelation Variable CFOt+1 EARNt ACCRUALSt ΔAPt ΔARt ΔINVt DEPRt OTHERt CFOt 0.334** 0.406** ** ** ** 0.230** CFOt ** ** EARNt 0.387** ** 0.255** * ACCRUALSt 0.133** 0.370** 0.449** ** ΔAP 0.103* 0.184** ** ΔARt ΔINVt ** DEPRt Notes: The table shows Pearson correlation coefficients for the variables in the study after deleting outliers defined as the bottom and top 1% of the observations on the study variables. Variable definitions: CFOis cash flow from operating, EARNS is earnings after tax but before extraordinary items. ACCRUALS are accruals. ΔAP = accounts payable this year- accounts payable previous year. ΔAR = accounts receivable this year- accounts receivable previous year.δinv = Inventory level this year- inventory level previous year.depr = depreciation and amortization expense.other = other accruals. All variables are scaled by average total assets. ** Correlation is significant at the 0.01 level (2-tailed). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 435

9 5.2 Regression analysis Table (3) states the outcome of the regression models in the report. The objective of model 1 is to observe the explanatory power of the earnings. The findings reveal that coefficient of EARNS is That is statistically important at the 0.01 level and it should be noted that the adjusted R 2 of that model is 10.9%. Model 2 studies the explanatory power of cash flow from operations. The results reveal that the coefficient for the CFO t is That is statistically significant at the 0.01 level and it should be noted that the adjusted R2 of this model is 11%. Table 3, displays both the current cash flows and current earnings are positive. They are also vital forecasters of future operating cash flows. Conversely, the explanatory power of the current accrual earnings which is adjusted R 2 =10.9% in model 1, is roughly the same as the explanatory power of the current operating cash flows that are adjusted R 2 =11% in model 2. The outcomes of Vuong (1989), Z -statistic test reveal that the difference in the two adjusted R 2 is not noteworthy at all because there is only a Z -statistic of 0.93 between them. The findings results point out that they will reject the first two null hypotheses. Instead the results accept the alternative hypotheses, meaning aggregate earnings are able to forecast cash flows from operation. It also accepts that the current cash flow from operations has the ability to forecast the future cash flows from operations. On the other hand, these findings cannot signal any superior forecasting ability for future operating cash flow, to the current aggregate earnings nor for the current operating cash flows. Table (3) also reveals the impact of disaggregating current earnings into accrual components and cash flow from operations, on the capacity of earnings when it comes to forecasting future operating cash flows. The table reveals, that the disaggregating of net income into operating cash flow and aggregate accruals points to an improvein the adjusted R 2, initial from 10.9% to 17%. The outcomes of Vuong (1989), Z -statistic test, show that the distinction in the two adjusted R 2 is significant at the 0.01 with a Z -statistic of Barth et al. (2001) assert that every key accrual reveals different information about the future cash flows. The outcome of this is that it results in a different weight when it comes to forecast when it comes to future cash flows. On the other hand, aggregate earnings unreservedly show the same weight on each earnings part and masks information that is related to forecasting future operating cash flows. Consequently, disaggregating total accruals COPY RIGHT 2013 Institute of Interdisciplinary Business Research 436

10 into its key constituents has lead to an improve in the predictive ability of earnings, the adjusted R 2, from 10.9% to 16% as seen in table 3. VuongZ-statistic test show that the difference in these two adjusted R 2 is noteworthy at the 0.01 level, with a Z -statistic of On the other hand, according to Barth et al. (2001), change in accounts payable, changes in accounts receivable and others accruals have no significant relationship with future operating cash flows and the accrual components that do relate significantly with future operating cash flows and in change in inventory and depreciation. The assessment of Adj-R 2 outcomes revealed in model 1 and model 3 in comparison to model 4, support the rejection of the third null hypothesis found in the study. That means disaggregating the earnings intoaccrual components andoperating cash flow and improves the ability of earnings to forecast the future operating cash flow. All in all, the results proposed that the current operating cash flows and the current aggregate earnings have forecasting ability for the future operating cash flow within Jordan. All of these findings are uniform with findings that were documented in previous studies (see Kim and Kross, (2005); and Ebaid, (2011)). The outcome of the third hypothesis is consistent with previous research in the developed markets (see Barth et al., (2001) Al-Attar and Hussain, 2004 and Ebaid, (2011)). The findings show that after disaggregating earnings of the components of accrual earnings and disaggregating earnings into its components increases earnings forecasting ability that is relative to aggregate earnings for forecasting future operating cash flow in Jordan. Properties of accounting earnings are affected by the international institutional factors. Those factors affect the timeliness, in which the economic income is accepted, and respected as accounting income. The economic income that is being discussed is the variations in probable future cash flows by the fiscal year change in the market value equity. In countries where the country is has market oriented, shareholders model usually, gives governance rights exclusively to the shareholders. Since, there is a large and varied center of individual bondholders and shareholders, all the information is competently and professionally resolved through revealing this information to the public (Lange et al., 2006). That reflects that there is a high request for including the COPY RIGHT 2013 Institute of Interdisciplinary Business Research 437

11 economic income in the stated accounting earnings and there is a call for a higher quality of public financial reporting and for disclosure. On the other hand, in the case of Jordan, the average setting and implementation are primarily functions of the public sector. Politicization has led to a stakeholder model where the main groups contracting with the firms. It includes the likes of providers of capital which are not surprisingly banks, labor, main customers or suppliers, and the likes of the government. All of these different segments are all represented in having an accounting code for the firms in general, along with an accounting code within their own individual corporations. In the case of accruals information, since they have a horizon of one period, information can be impounded for the next time intervals cash flow. While accruals to can provide a large amount of information for the cash flow that will be arriving within the next period, it will also limit the information related to the next period's cash flows. Table (3): Regression analysis Results Model 1 Model 2 Model 3 Model 4 EARNt 0.374** CFOt 0.313** ACCRUALSt ΔAP ΔARt ΔINVt DEPRt 0.504** ** ** ** ** OTHERt Constant 0.028** 0.022** 0.023** Adjusted R % 11% 17% 16% Vuong Z-statistic Notes: Variable definitions: CFOis cash flow from operating, EARNS is earnings after tax but before extraordinary items. ACCRUALS are accruals. ΔAP = change in accounts payable and accrued liabilities.δar = change in accounts receivable.δinv = change in inventory.depr = depreciation and amortization expense.other = other accruals. All variables are scaled by average total assets. ** Correlation is significant at the 0.01 level (2-tailed).* Correlation is significant at the 0.05 level (2- tailed). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 438

12 6. Conclusion and Recommendations The research examines the capacity of accruals to forecast future cash flows. Definitely, the capacities of cash from operations and earnings to forecast future cash from operations are compared. In this study the predictions are based on Barth et al., (2001) models of future operating cash flows. In the study it has been found that permitting the coefficients on the assorted accrual components of earnings, to differ, is the cause of pointed enhancement in the forecasting ability of earnings of future cash flows and this is consistent with the predictions, which the study was based upon. It has also been found that long-term accruals, which are depreciation of fixed assets, have a significant forecasting ability when it comes to future cash flows. FASB insists that information about current cash flows provide a less accurate indication of a firm s future cash flow. Instead, insisting that information about a firm's net income and its modules calculated by accrual net income delivers a better forecasting of firm's future operating cash flows. Though, previous research that examined this empirically insists upon mixed results, in accordance to these claims. Additional studies might analyze the forecasting ability of cash flows several years into the future, along with the use of stock returns as a representation of future cash flows. This additional research can also analyze the effect of corporate governance and the effect of company size, on the forecasting abilities of earnings and operating cash flows for operating future cash flows. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 439

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