The Power of Investment and Accruals for Return and Earnings Prediction

Transcription

1 The Power of Investment and Accruals for Return and Earnings Prediction Keyhan Maham 1 Samaneh Morsali 2* 1 Assistant Professor, Department of Accounting, Islamic Azad University, Qazvin Branch 2 MA in Accounting, Islamic Azad University of Qazvin, Science and Research Branch ABSTRACT The purpose of the study is to test whether we are able to explain the anomalies by decomposing firm s total into working-capital, long-term investment and non-transaction (e.g. depreciation and asset writedown, etc.). To achieve the purpose of the research the study sample consists of 100 companies listed on the Tehran Stock Exchange and the essential data of the research were extracted based on data of sample firms for the The research is an applied research by purpose, in which a correlation method was used. Similarly, by time, it is kind of ex post facto research. Statistical analysis of data was conducted by Eviews statistical software and for testing hypotheses Husman and Limer test and linear regression were used. The results indicated that there is a negative correlation between total and its components (working-capital long-term investment and nontransaction ) and future earnings and stock returns. KEYWORD earnings persistence,, investment, stock returns, anomaly E INTRODUCTION arnings report and components of earnings have always garnered attention both in the course of historical progress and financial reporting. Professional accountants, financial analysts, and academic researchers often forecast future earnings and cash flow using components of current earnings. Accounting earnings is measured under an accrual basis. Thus there seems to be a difference between accounting earnings and reported operating cash flow if there is cash flow. The difference suggests the presence of and their on firm s operating earnings. Unlike cash items, are associated with a degree of subjectivity by which the possibility of manipulation is provided. *Corresponding Author: samaneh morsali Telephone Number: Fax. Number: According to Sloan (1996), manipulation and management of derive from change in the extent to which profitability and cash flows persist. Accrual anomaly is one of the most sever anomaly ever in asset pricing. Sloan (1996) found that are strongly negatively related to future stock returns (after controlling for size, beta and other specific features of a company) [1]. He called this negative relationship accrual anomaly, and inexperienced investors were found to be causes of such anomaly. Interpretation of accrual anomaly is still conceived of as an important constant challenge. In this respect, two different and competing accounts are discussed in this literature. The first stresses the relationship between and earnings, as the second stresses the relationship between and investment. Recognition of the distinctions is important in two respects; the one, clarification of economic forces of anomaly infrastructure, andthe other, better understanding of proper or occasionally improper use of accounting information. Sloan[1], emphasizing the relationship between and earnings, hold that investors direct their focus toward firm s total earnings, and they would have difficulty appreciating the fluctuation of accrual and cash flows persistence. Sloan indicated that firms with greater, after controlling for firm s total earnings would have lower earnings in forthcoming years, but investors fail to understand the issue. Fierfield et al [2] lay emphasis on the second account, i.e. the relationship between and growth investment. They indicated that change in long-term operating asset has the same predictive power as working-capital, saying that a combined criterion, change in firm s total net operating assets, has the ability to predict short-term and long-term simultaneously. Therefore, Fairfield et al came to the conclusion that accrual anomaly is suggestive of growth in total. They assert that investors fail to appreciate the final declining return of investment. An alternative interpretation of the research result, companies tend to increase their investment and when their stocks are overvalued. The third postulation is put by Fama and French [3] and Wu et al [4]; investment reacts to logical fluctuation of cost of equity. The lower the cost of equity, the more current investment and the less future stock returns will be. From

2 now on, the interpretations are generally referred to as investment, because it illustrates the relationship between and investment. The main challenge that exists in differing aspects of focus on earnings by Sloan and investment hypotheses by Fairfield et al is related to the robust relationship between and investment. Indeed, represents a method of investment registration at accounting system and most of investment expenditure will have an individual urgent on on a historical cost system basis. The relation makes it difficult to conclude whether market s reaction to represent investment expenditure or the method of expense registration in financial statements of a business unit. However, investment and are not fully linked. Some investments such as costs of research and development are made in favor of the costs of the current rather than being reflected in assets, while some have implications for change in the book value of investments made in prior s, rather than new investments of business unit. The items include amortization of tangible and intangible fixed assets, asset write-down, and dividends receivable from incorporated subsidiary companies. The main purpose of the research is to test whether disaggregation of (change in firms netoperating assets) into working-capital (change in non-cash working-capital), long-term investment (implicating new costs paid for long-term net assets), and non-transaction can explain the power of the accrual anomaly? THEORETICAL FOUNDATION AND RESEARCH BACKGROUND One of the most important information available to investors as they react to its variation is reported earnings on the part of firms. Investors can predict future stock returns of companies through reported earnings and examining components of earnings, namely and operating cash flow. In this forecast, there are some inexperienced investors who failed to consider contributing factors in the accurate prediction of future returns, including the role of accrual persistence, or they might have made wrong estimate, for which they showed inappropriate reaction as a result of it[5]. Khajavi and Nazemi [6]found some evidence that we cannot acknowledge the firm s returns influenced by small or large quantity of. Ghaemi et al [7]demonstrated that company s stock returns are influenced by the amount of and their related components. The results of Ebrahimi et al [8]revealed that there is a positive relationship between firms first year current discretionary and long-term performance of stock price for three-year-ahead. Kurdestani and Rudneshin [9]showed that cash components of accounting earnings have the predictive powerof firm s market valuation, while earnings do not have the power to predict and explain variation in firm s market valuation. Since somehow represent cash flow adjustment as their aggregate is zero in the entire life of a company, extreme in one lead the items to be reversed in future s; consequently, future earnings will decline with reversibility of, given the fact that accounting earnings are composed of two components cash and accrual [10]. Khodamipour and Pourahmad [11]investigated the power of, operating earnings, and operating cash flows to forecast operating cash flows by considering specific time intervals. The results showed that there is a significant relationship between future operating cash flows and operating earnings during the years Mashayekhi et al [12]examined the accrual anomaly (accrual on stock returns), anomaly of capital expenditures (capital expenditures on stock returns), and the improvement of stock performance with simultaneous application of both anomalies in Iran s capital markets. The results indicated thatcapital expense anomalies and accrual anomaly are seen and disaggregated in Iran s capital market, though related possibly in one way or another. After controlling for the three risk factors of Fama and French, investors can acquire higher returns byconcurrently employing two anomalies rather than using one anomaly. The results of Dastgir and Rastegar [13] indicated quality of earnings (earnings persistence) are directly related to quality of ; similarly, as quality of decline and the amount of increases, stock returns increase. Mahmoudabadi and Mansouri [14]investigated the role of discretionary and non-discretionary in predicting future cash flows. They studied 69 companies during the years Their approach to test was cross-sectional. The results indicated that variables of discretionary and non-discretionary do not have the predictive power of future cash flows. Foroughi et al [15]examined the relationship between and future stock returns. The results showed that there is an inverse negative relationship between and future stock returns ( anomaly). Eteemadi et al [16]concluded that the optimal amount of earnings feature will diminish as the amount of discretionary increase. In this respect, quality of is influenced by earnings management more than other features. Furthermore, increase in the amount of discretionary is related to decrease in the quality rate of company s earnings. The results of Vadiee and Azimifar [17]demonstrated that companies with higher valuation will report more current discretionary in the current year than companies with lower valuation; moreover, despite the fact that the inverse relationship between future operating cash flow and current discretionary is stronger in companies with higher valuation than those with lower valuation, the difference is no significant at 5%. Chan et al [18], in the research earnings quality and future stock returns, investigated the relationship between and future stock returns. They demonstrated that companies with large will experience a decrease in

3 their stock returns in the next of financial information reporting. Cooper et al [19]examined the relation between investment and future stock returns, and they saw a negative relation between investment and future stock returns. They perceived investor overreaction to accrual investment change to be the reason for such relationship. They also argue that investors described asset growth as a positive sign to company, predicting firm future earnings optimistically and decrease of asset as a negative sign for company, on the other hand; in which case, they predicted firm future earnings pessimistically. Fedyk et al [20]examined and tested for fixation. The results indicated that there is a negative relationship between and future stock returns, in that the negative relationship is corrected when discretionary reverse in future s. Resutek et al [21]demonstrated that all three components of contribute to the prediction of future earnings and stock returns with the most negative slope for nontransaction. RESEARCH HYPOTHESES 1. working-capital andfirm future earnings are negatively related 2. Long-term investment and firm future earnings are negatively related 3. Non-transaction and firm future earnings are negatively related. 4. Working-capital and firm s future cash flow 5. Long-term investment and firm s future cash flow are negatively related 6. Non-transaction and firm s future cash flow are negatively related 7. Total and firm future earnings are negatively related 8. Total and firm s future cash flow are negatively related. RESEARCH MODELS 1. NI t= b 0 + b 1 NI t-1 + b 2 wc t-1 + e t 2. NIt = b 0 + b 1 NIt- 1 + b 2Inv Acc t-1 + e t 3. NIt= b 0 + b 1 NI t-1 + b 2 NT Acc t-1 + e t 4. Ret = b 0 + b 1 NI t-1 + b 2 wc t-1 +b 3 ln size t-1 + b 4 B t -1 /M t-1 + e t 5. Ret = b 0 + b 1 NI t-1 + b 2 Inv Acc t-1 + b 3 ln size t-1 + b 4 B t- 1/M t-1 + e t 6. Ret = b 0 + b 1 NI t-1 + b 2 NT Acc t-1 + b 3 ln size t-1 + b 4 B t- 1/M t-1 + e t 7. NI t= b 0 + b 1 NI t-1 + b 2 NOA t-1 + e t 8. Ret = b 0 + b 1 NI t-1 + b 2 NOA t-1 + b 3 ln size t-1 + b 4 B t- 1/M t-1 + e t EXPLANATION OF RESEARCH IMPLEMENTATION The present research is an experimental and ex-post facto research in the field of accounting. Based on purpose, it is an applied research, and a correlational research in terms of nature and method, which was conducted to gain knowledge about the relationship between variables, though causal relationship is not necessarily concerned. By data collection, it is a library research, in that relevant information about research background and financial data of companies were gleaned through referring to libraries, domestic and foreign databases, using documentation technique, and referring to companies financial statements and official websites of the Tehran Stock Exchange, as well as related software programs (e.g. RahavardNovin and TadbirPardaz). STATISTICAL POPULATION AND SAMPLE The population of the study included all the companies listed on the Tehran Stock Exchange, for which the study sample was chosen with respect to the following conditions; The end of companies fiscal year should be on March 29. The companies should not have changed their financial year during the study. The companies should not be division of banks, financial mediating institutions (investment firms, leasing and holding companies). Complete information of all studied companies should exist during Considering the above terms, 100 companies were chosen as sample. INTRODUCTION AND MEASUREMENT OF RESEARCH VARIABLES Tab.1. research variables row Variable Variable name symbol type 1 Depended Net income NIt 2 variable Return RETt 3 Independent Net income in the previous NIt-1 variable year 4 Total NOA 5 Working-capital WCt-1 6 Investment Inv Acct-1 7 Non-transaction NT Acct-1 8 Control Firm s size Ln size 9 variable Firm s Book-to- market value ratio b/m NI t :Firm s operating (loss) earnings according to income statement and audited loss RET t :Stock returns, icompany return percentage in year t, for the purpose of the study NI t-1 :Net income divided by total assets NOA: Non-cash assets minus operating debt WC t-1 :Changes in current assets minus the changes in current liabilities minus cash

4 Inv Acc t-1 :Changes in long-term operating assets minus non-transaction NT Acc t-1 :Negative of total depreciation expenses of fixed assets and costs of employees end of service benefits and bad debt expenses and expenses of investment write-down and expenses of inventory devaluation Ln size :Obtained from natural logarithm of firm market valuation. b/m :Obtained by dividing firm s book value in the previous year by firm s market value in the previous year *to homogenize, all variables, except return and control variables, are divided by total assets. The method was first employed by Sloan (1996) to better compare companies at the same point in time. The item marked in the variable table are explained as follows; 1. Non-cash assets are equal to total assets minus cash balance 2. Operating debt is equal to total debt minus short-term and long-term receivable facilities and payable stock dividends 3. Changes in net operating assets are equal to changes in non-current assets minus changes in long-term operating liabilities 4. Long-term operating liabilities are equal to long-term debt minus long-term financial facilities DESCRIPTIVE STATISTICS To provide an overview of the major characteristics of measured variables in table 4.1, some descriptive concepts of the variables are introduced, namely mean, standard deviation, minimum, maximum, and the number of observations. Tab.2. Descriptive statistics of research variables variables Variabl e symbol mean media n Standard deviation skewne ss Kurto sis min max Net income NI Change in workingcapital Change in net income WC NOA Non-transaction Long-term investment NTAC C INVA CC Market valuation B/M Firm size LnMV Stock returns RET Given the results reflected in table 4.1, the mean of net income index is equal to 15% unit; the mean of change in net assets variable is about 8%. Skewness and kurtosis of most variables stand at a normal level. INFERENTIAL STATISTICS To analyze the research, a set of combined data were used, because a few companies will be analyzed and addressed over time. In the combined data, F-Limer test was used to choose between mixed method and fixed- method in the first place; the rejection of null implies the significance of fixed- and the use of fixed- method. Once fixed is selected, the next step is to use Hausman test for making-decision on the fixed or random. Models. In Hausman, if null cannot be rejected, random method is preferred to fixed-, chosen as more suitable and ive procedure; otherwise, fixed is ive. Tab.3. hypotheses about Limer and Hausman tests Hausman test To test the choice between random and fixed methods H0: assumption of incoherence between individual, random method H1: assumption of coherence between individual, fixed method F-Limer test To test the choice between mixed method and fixed method H0: assumption of intercept equality, mixed methos H1: intercept difference, fixed method

5 Tab. 4. results of F-Limer test and Hausman test Test stati stic Prob abili ty amo unt Test resul t test First hypothes is Second Third Fourth Fifth Six Sevent h hypoth esis Eight hypothesi s Hausma 1 /48 1 / 48 1 / 11 1 / 78 1 / 75 1 / / 511 / n Limer 84 / / / / / / 77 / / 58 Hausma 5 /555 5 / / / / / / 5 / 5558 n Limer 5 / / / / / / / / 555 Hausma n Limer Effective ness of fixed Effectiv eness of fixed Effectiv eness of fixed Effectiv eness of fixed Effectivene ss of fixed Effectiveness of fixed Effecti veness of fixed Effectiven ess of fixed RESULTS OF RESEARCH HYPOTHESES TEST AND HOW TO PERFORM IT The research hypotheses are examined using data collected from sample companies and administration of multiple linear regression test, and decisions thus will be made based on observed indexes concerning hypotheses. To examine if the variables and s are static, we use Fisher s exact test. As it seems notable, the significance level of Fisher s test was less than 1% in all the s. Thus, we can assert that the s are significant with 99 percent probability. To put differently, the s are highly reliable. The numbers of determined and adjusted coefficient in the s revealto what percentage a dependent variable can be linearly explained by explanatory variables. It should be noted that thevalue of Durbin-Watson test lay between 1.5 and 2.5 in all s, which means that there is no autocorrelation between the components of the error. Considering the research s, if b2 coefficient is negative, then the entire hypotheses will be confirmed. TESTING THE FIRST HYPOTHESIS The first : working-capital are negatively related to firm s future earnings Thus, the administration of F-Limer test and Hausman test is used to examine the and the fitness of the following. Tab.5. Results of the fitness and estimation of the first research NI t = b 0 + b 1 NI t-1 + b 2 Δ WC t-1 + e t Variables Variable symbol coefficient Standard error T Prob. intercept C Net income of previous NI t Working-capital accrual Δ WC t Coefficient of determination 0.81 Adjusted coefficient of determination 5.88 Durbin-Watson statistic 1.17 F-statistic F-probability Considering the results of table ( 7 (, it can be concluded that: The variable coefficient of working-capital is negative (-24%), and probability value is 0.029, which is less than 0.05, so it is significant at 0.05 level; that is, there is a negative relationship between the variable and net income. As a result, the first is confirmed working-capital is negatively related to firm s future earnings. TESTING THE SECOND HYPOTHESIS The second : long-term investment are negatively related to firm s future earnings.

6 Tab.6. Results of the fitness and estimation of the second research NI t = b 0 + b 1 NI t-1 + b 2Inv Acc t- 1+ e t intercept C Net income of previous NI t long-term investment Inv Acc t Coefficient of determination 0.89 Adjusted coefficient of 0.88 Durbin-Watson statistic 1.19 determination F-statistic F-probability Considering the results of table (8), the variable coefficient long-term investment is negative and significant at 0.05 level; that is, as the variable increases, net income will decrease. This confirms the second long-term investment are negatively related to firm s future earnings. Tab.7. Results of the fitness and estimation of the third research TESTING THE THIRD HYPOTHESIS The third : non-transaction are negatively related to firm s future earnings. NI t = b 0 + b 1 NI t-1 + b 2 NT Acc t-1+ e t intercept C Net income of NI t previous Non-transaction NT Acc t Coefficient of determination 0.81 Adjusted coefficient of determination 0.88 Durbin-Watson statistic F-statistic F-probability Considering the results of table 7, the variable coefficient of non-transaction is negative and significant at 5% level; that is, as the variable increases, net income will decrease. This confirms the third non-transaction are negatively related to firm s future earnings. TESTING THE FOURTH HYPOTHESIS The Fourth : working-capital are negatively related to firm s future cash flow. Tab. 4. Results of the fitness and estimation of the fourth research Ret t = b 0 + b 1 NI t-1 + b 2 Δ WC t-1 + b 3ln size t-1 + b 4 B t-1 / M t -1+ e t Variables Variable symbol coefficient Standard error T Prob. Intercept C Net income of previous NI t Δ WC t Change in non-cash working-capital Firm size ln sizet Market value B t-1 / Mt Coefficient of determination 0.55 Adjusted coefficient of determination 0.14 Durbin-Watson statistic 2.55 F-statistic 2.15 F-probability 0.000

7 Considering the results of table (8), we can conclude that: The variable coefficient of working-capital is negative and significant at 0.05 level; that is, as the variable increases, net income will decrease. This confirms the fourth working-capital are negatively related to firm s future cash flow. TESTING THE FIFTH HYPOTHESIS The fifth : long-term investment are negatively related to firm s future cash flow. Tab. 1. Results of the fitness and estimation of the fifth research Ret t = b 0 + b 1 NI t-1 + b 2Inv Acc t-1 + b 3ln size t-1 + b 4 B t-1 / M t -1+ e t intercept C Net income of previous NI t Long-term investment Inv Acc t Firm size ln size t Market value B t-1 / M t Coefficient of determination 0.54 Adjusted coefficient of determination 0.14 Durbin-Watson statistic 2.57 F-statistic 2.15 F-probability TESTING THE SIXTH HYPOTHESIS The sixth : non-transaction are negatively related to firm s future cash flow. Tab. 10. Results of the fitness and estimation of the sixth research Ret t = b 0 + b 1 NI t-1 + b 2 NT Acc t-1 + b 3ln size t-1 + b 4 B t-1 / M t -1+ e t intercept C Net income of previous NI t Non-transaction NT Acc t Firm size ln size t Market value B t-1 / M t Coefficient of determination 0.53 Adjusted coefficient of determination 0.17 Durbin-Watson statistic 2.51 F-statistic 2.09 F-probability Considering the results of table ) 15(, it can be concluded that: The variable coefficient of non-transaction is TESTING THE SEVENTH HYPOTHESIS negative and significant at 0.05 level; that is, as the variable The seventh : total are negatively increases (decreases), net income will decreases (increases). related to firm s future earnings. In conclusion, the sixth is confirmed non- To examine the, the following is fitted, if transaction are negatively related to firm s future b 2 coefficient is negative, the is confirmed. cash flow. Tab. 11. Results of the fitness and estimation of the seventh research NI t = b 0 + b 1 NI t-1 + b 2 Δ NOA t-1+ e t Intercept C Net income of previous NI t Change in net Δ NOA t operating asset Coefficient of determination 0.79 Adjusted coefficient of determination 0.74 Durbin-Watson statistic 1.92 F-statistic F-probability 0.000

8 Considering the results of table 11, it can be concluded that: The variable coefficient of change in net operating assets is negative and significant 0.05 level; that is, as the variable increases, net income will decrease. As a consequence, the seventh is confirmed total is negatively related to firm earnings. TESTING THE EIGHTH HYPOTHESIS The eight is confirmed total are negatively related to firm s future cash flow. Tab. 12.Results of the fitness and estimation of the eighth research Ret t = b 0 + b 1 NI t-1 + b 2 Δ NOA t-1+ b 3ln size t-1 + b 4 B t-1 / M t -1+ e t intercept C Net income of previous NI t Change in net Δ NOA t operating assets Firm size ln size t Market value B t-1 / M t Coefficient of determination 0.34 Adjusted coefficient of determination 0.18 Durbin-Watson statistic F-statistic 2.12 F-probability Considering the results of table 12, it can be concluded that: The variable coefficient of change in net operating assets is negative and significant at 0.05; that is, as the variable increases, net income will decrease. As a result, the eight is confirmed total are negatively related to firm s future cash flow. CONCLUSION The preset research aimed to account for the question whether we are able to explain the accrual anomaly by decomposing company s total into working-capital, long-term investment, and non-transaction (e.g. depreciation and asset write-down, etc.), examining the relationship between total and decomposed by income and returns. The results of fit confirmed all hypotheses; the negative relationship between and its components and future earnings and stock returns. Furthermore, given the results of the research, comparison of R2coefficient in s, we found that prediction of total, compared to its decomposition, is equal to working-capital, longterm investment and non-transaction ; however, total and their components have greater power to predict earnings than returns. REFERENCES [1] Sloan, R., Do stock prices fully reflect information in and cashflows about future earnings?, TheAccounting Review, Vol.71,1996, pp [2] Fairfield, P., Whisenant, J., and Yohn, T., Accrued earnings and growth: Implications for future profitability and market mispricing,the Accounting Review,Vol. 78, 2003,pp [3] Fama, E., and French, K., Profitability, investment, and average returns. Journal of Financial Economics,Vol. 82, 2006,pp [4] Wu, Jin., Zhang, Lu.,and Zhang, X. F., The q-theory approach to understanding the accrual anomaly,journal of Accounting Research,Vol. 48, 2010, pp [5] Haghighat, H., and Iranshahi, A., A study of investors response to the aspects of accrual stability in the Tehran Stock Exchange, Financial Accounting Research Journal, No. 5,2010, PP [6] Khajavi, Sh., And Nazemi, A., Role of in explaining and analyzing quality of earnings, Auditing and Accounting Investigation journal, No. 40,2005, PP [7] Ghaemi, M., Livani, J., and Barzegar, S.,Quality of earnings and firms stock returns, Audit and Accounting Investigations, No. 52,2008, PP [8] Ebrahimi-Kordlar, A., and Hassani-Azardariani, A., A study of earnings management in time of the initial public stock offering in companies listed on the Tehran Stock Exchange, Auditing and Accounting Investigation,2006, PP [9] Kurdestani, Gh., and Rudneshin, H., A study of the amount of relativeness of cash and accrual components of accounting profit to companies market valuation, Auditing and Accounting Investigations, No. 45,2006, PP [10] Zhang X.F., Accruals, Investment and Accrual Anomaly. The Accounting Review,Vol. 82,2007, pp [11] Khodamipour, A., and Pouraham, R., A study of the power of financial variables to predict operating cash flows, considering particular time intervals, Financial Accounting Research,No. 3,2010, PP [12] Mashayekhi, B., Fadaeenejad, M., and Kalateh-Rahmani,

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