The Relationship between Operational Cash Flows and Accruals to Predict Future Earnings

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1 Applied mahemaics in Engineering, Managemen and Technology 2 (6) 2014: The Relaionship beween Operaional Cash Flows and Accruals o Predic Fuure Earnings Maryam Rahimi 1 *, Abbas Eseghlal Molagh 2 1-Maryam Rahim M.A. Suden, Deparmen of Accouning, Qeshm Inernaional Branch, Islamic Azad Universy, Qeshm,Iran. 2- Abbas Eseghlal Molagh, Deparmen of Accouning, Faculy of Economic, Shiraz Universy, Shiraz, Iran. ABSTRACT The presen sudy aimed o explore he relaionship beween operaional cash flows and accruals o predic fuure earnings of lised companies in Tehran Sock Exchange. Jones adjused model was used o assess and calculae accruals. Accordingly, accruals were divided ino discreionary and non-discreionary accruals. The sudy was conduced in he ime period of 2007 o 2012 on a sample including 123 companies lised in he Tehran Sock Exchange. Three hypoheses were developed o address he problem under sudy and hey were esed using regression analysis echnique. In his sudy, discreionary accruals (DA), nondiscreionary accruals (NDA), and operaing cash flow (OCF) were used as he independen variables and he fuure operaing prof was manipulaed as he dependen variable. The resuls suggesed discreionary and non-discreionary accruals and operaing cash flow are significanly correlaed o operaing earnings in fuure. Keywords: Accruals, Discreionary Accruals (DA), Non-Discreionary Accruals (NDA), Operaing Cash Flow (OCF), Operaional Earnings 1.INTRODUCTION Repored earnings and earnings componens have always received much aenion in he hisorical developmen and in financial reporing as well. Professional accounans, financial analyss and academic researchers ofen use he componens of curren earnings o predic fuure earnings and cash flows. Since in economic heories, he firm value is based on he presen value of s fuure cash flows and earnings are used as a subsue for cash flows, he predicion of earnings is of val imporance. Accordingly, one of he objecives of financial reporing is o help invesors and credors o predic fuure earnings. In addion, he Iranian Accouning Sandards Commee in he heoreical conceps of financial reporing secion saed ha Economic decisions made by users of financial saemens require an assessmen of an eny o generae cash and he cerainy of doing so. Besides, he assessmen of he power o creae cash is facilaed by focusing on he financial posion, financial performance, and cash flows of he eny and using hem o predic he expeced cash flows and he assessmen of financial flexibily (Auding Organizaion, 2002). The presen sudy explores he relaionship beween accruals and operaing cash flows o predic fuure earnings. In summary, his sudy followed research conduced by previous researchers such as Sloan (1996) o predic fuure earnings and o find ou wheher he accuracy of accruals and operaing cash flows in predicing earnings can improve he predicion of earnings and if can explain earnings sabily and he relaionship beween earnings, accruals, and cash flows. The use of accruals o predic fuure profs and presen cash flows has some economic implicaions. The relevance of curren accruals and cash flows o fuure earnings may indicae he exen o which managemen inends o demonsrae he firm economic value wh honesy (Modares & Abbas Zadeh, 2008). 2.STATEMENT OF THE PROBLEM Making good earnings and conribuing o he promoion a counry s economy is one of he social and economic aspiraions of any sociey. The suable conex o do so has been provided by esablishing and 60

2 developing he Tehran Sock Exchange. However, o direc and encourage invesors o make invesmens in his regard requires he provision of more ransparen and reliable informaion o hem. Among he mos imporan facors ha will encourage invesors o inves are operaing earnings. Therefore, a sound knowledge of how earnings behave using a reliable crerion is he prerequise for making a successful invesmen. So, he idenificaion of a crerion relaed o operaional earnings is of umos imporance. Several economic and accouning creria have been proposed in his regard including he accouning indices such as cash from operaional acivies and accruals. Many financial analyss and invesors sae ha cash flow measures such as operaing cash flows are highly imporan when assessing a firm s financial healh and prospecs. Operaing cash flows are very significan in he sense ha hey allow managers o seek opporunies ha increase he firm s socks value. Whou having cash is impossible o develop new producs, making business earnings, paying cash dividends o shareholders, and deb relief (Goldberg and Kim, 2001). Based on wha was menioned, he presen sudy aims o find ou wheher accruals and operaing cash flows are able o predic fuure earnings or no. Dechow e al. (2004) sudied he persisence and pricing of he cash componens of earnings. They divided hese componens ino hree caegories of cash balances, cash paymens o credors, and paymen of cash dividends o shareholders. They found ha more durable componens of dividends i.e. paymens o shareholders were significanly correlaed o sock prices. Farshadi and Monemi (2013) examined he usefulness operaing cash and accruals in improving earnings predicion. They came o he conclusion ha componens of operaing cash and accruals ogeher are more useful han earnings, operaional cash, oal accruals, and he sum of operaing cash and accruals in predicing fuure operaing cash flows. Barh e al. (2001) and Subramanyam and Venkaachalam (2007) showed ha operaing cash flows are sronger han earnings in predicing fuure operaing cash flows. Decou e al. (1998) proposed he firs heoreical models using operaing cash flows and accruals o find if earnings have a higher predicive abily han operaing cash flows o accoun for fuure operaing cash flows. Following Barh e al (2001), Barh e al (2001) showed ha operaing cash flows and major accruals (i.e., changes in accouns receivable, accouns payable, prepaymens, advance paymens received, expenses before depreciaion, and oher accruals) significanly increase predicive abily of earnings compared o operaing cash flows and individual earnings whin he cash flows and general accruals. Khodadadi and Janjani (2010), sudied invesors reacion o earnings predicion, cash flows, and accruals on a sample of 230 firms lised in in he Tehran Sock Exchange from 2000 o The resuls indicaed ha invesors appropriaely reaced o some exen o earnings predicion, of course no as much accuraely as o cash flows. In addion, heir reacions o cash flow predicions were o a grea exen reliable. I was also noed ha cash flows provide a more reliable basis for decision-making han earnings and accruals. Sadeqbayan (1998) explored he relaionship beween cash flow from operaing acivies and operaing earnings and found ha here is no significan relaionship beween cash flow from operaing acivies and operaing earnings. Jana Rosami (1999) examined he role and poenials of earrings in predicing fuure earnings and fuure cash flow o inves in shares of he companies lised in he Tehran Sock Exchange. The resuls showed a significan correlaion beween hisorical earnings, fuure earnings and he beween hisorical earnings and cash flows and fuure cash flows. Modars (2001) examined he relaionship of curren asses and liabilies wh operaing cash flows using accouning informaion including 1) operaing cash flows, 2) accouning earnings, 3) operaing cash flows and accouning earnings, and 4) hisorical operaing cash flows and accouning earnings as well as curren asses and liabilies. The resuls show ha operaing cash flow forecasing using hisorical operaing cash flows is no possible, bu is possible by using hisorical operaing earnings. Besides, he combined use of operaing cash flows and hisorical operaing earnings improves he predicion model. I was also found ha he inclusion of componens of working capal ino he model will enhance s predicive power. Thaqafi and Hashemi (2004) sudied he relaionship beween fuure operaing cash flows and componens of hisorical operaing earnings using hisorical accruals and concluded ha accouning earnings are able o predic fuure cash flows. Besides, earnings divided ino cash flows and accruals are more powerful in predicing fuure cash flows. 3.SIGNIFICANCE OF THE STUDY The significance of earnings, operaing cash flows, and accruals o invesors is clear o anyone. Earnings are among he mos imporan indicaors for measuring he performance of a business eny. Researchers have illusraed differen approaches o earnings in erms of scienific findings, measured heir srenghs and weaknesses, and made effors o add o he accuracy and poenials of hese approaches. Invesors give a special 61

3 weigh o accouning earnings as a predicion ool. In addion, sock reurns are lined o he expeced cash flows and invesors usually hold or sell shares based on heir expecaions of he firm s profs and hus dividends. Dividends are he mos commonly used mehod of disribuion of reurns o by he firm among shareholders, bu firms do no operae similarly when disribuing dividends and so hey ake differen policies. These policies may range from paying dividends o paying all he firm s revenues. Since prof acs a ool for he managemen and he ne prof is a direc variable available o he managemen in calculaing he salary and compensaions, is herefore subjec o manipulaion. As such, he availabily of sufficien cash flow o mee he needs of managemen and invesors is dependen on posive operaing cash flows. In addion, he cash flows will increase he predicive power of earnings hrough operaing cash flow and accruals. 4.RESEARCH HYPOTHESIS - H1: There is a significan relaionship beween curren discreionary accruals and fuure operaing earnings. - H2: There is a significan relaionship beween curren non-discreionary accruals and fuure operaing earnings. - H3: There is a significan relaionship beween curren operaive cash and fuure operaing earnings. 5.RESEARCH METHODOLOGY The presen sudy is an applied research as s resuls can be used by capal marke analyss and invesors in evaluaing he firms performance. The sudy aims o invesigae he relaionships beween independen and dependen variables hrough regression models. Therefore, is a correlaional-causal sudy in erms of he naure and he correlaional mehod employs. In fac, a correlaional sudy deals wh relaionship beween variables and in an ex pos faco research, he researcher ries o sudy and idenify he poenial causes of he dependen variable hrough s effecs. 6.Research Variables The variables manipulaed in his sudy are as follows: 7.Independen Variables A. Accruals: Discreionary accruals (DA) were used based on he Jones adjused model o divide accruals. The following seps were aken o calculae discreionary accruals: I. The oal accruals (TA) for a given firm were calculaed for a given year. The Jones adjused model was employed calculae accruals in his sudy as follows (Dechow e al. 1995): TA E OCF Where, E is operaing earnings of he firm i in year, OCF is he ne operaing cash flows of he firm i in year, and TA represens he oal accruals in he same period. II. Parameers α1, α2, and α3 were calculaed as he firm-specific parameers using he leas squares echnique hrough Excel and SPSS sofware packages o esimae non-discreionary accruals (NDA) according o he following equaion: TA 1 REV PPE A i ( 1) A i ( 1) A i ( 1) A i ( 1) Where, TA represens he oal accruals, A i(-1) is he oal asses of firm i in year -1, REV is he changes in he ne revenues of he firm i in years and -1, and PPE represens properies, machineries, and equipmen of firm i in year. 62

4 III. Non-discreionary accruals (NDA) were calculaed using he parameers esimaed in he above secion as follows: NDA 1 REV REC PPE A i ( 1) A i ( 1) A i ( 1) Where, REC shows changes in ne accouns and rade receivables, A i(-1) sands for he oal asses of firm i in year -1, REV is he changes in he ne revenues of he firm i in years, NDA is non-discreionary accruals (NDA), and -1, and PPE represens properies, machineries, and equipmen of firm i in year. IV. Afer obaining he non-discreionary accruals, he Jones adjused model was employed o esimae discreionary accruals as follows: DA TA A i ( 1) NDA B. Cash from Operaions: Cash flow saemen reporing changes in cash of he firm is one of he basic financial saemens, which could represen he performance of he managemen. Cash from operaions as he mos imporan em in cash flow saemen shows he amoun of cash impored ino he firm hrough he operaional acivies. I is used as an accounings index by he decision-makers o measure he managemen performance. Dependen Variable The dependen variable in his sudy was assessed using he Sloan Predicion as done in previous research. 8.The Sloan Predicion Earning y0 y1 Accruals y2 Cashflows Vi, In order o esimae he model parameers for he sample of firms, he above model was divided ino Modal I and II depending on heir parameers as follows: Earning 1 y0 y1 Earnings ( y2 y1) Cashflows Vi, ( I) Where, Earning +1 is fuure operaing earnings for firm Earnings shows operaing earnings of firm i in period, Cashflows shows operaing cash flows (cash componen of operaing earnings) of firm i in period, and V is he error erm (residual of firm i in period ). Ernings 1 y0 y1 Earnings y2 y1 Accruals Vi, ( II) Where, Earning +1 is operaing earnings for firm I in period, Earnings shows he oal accruals (he accrual componen of operaional earnings) of firm i in period, and V is he error erm (residuals of firm i in period ). The dependen variable in he above models was he firm s operaing prof in period + 1 ha was esimaed based on oal operaing earnings of he firms by including cash dividends (operaing cash flows) in one sage and in he oher sage by including non-cash ems (oal accruals). 1. Earning Predicion Using Cash Flow Earning Cashflow i Where, Earning +1 is fuure cash earnings of he form Cashflow is operaing cash flows of he firm i in period, and ɛ i is he model error. 2. Earning Predicion Using Accruals 63

5 Earning i, accrual i, i Where, Earning +1 is fuure cash earnings of he form Cashflow is operaing cash flows of he firm i in period, and ɛ i is he model error. 9.Daa Collecion Procedure Variables used in his sudy were operaing earnings, ne cash generaed or used in operaing acivies, oal accruals, and oal asses. Operaing earnings were direcly esimaed from he firms income saemens. Besides, ne cash from operaions were derived from in he saemen of cash flows of he firms and oal accruals were calculaed as follows: Toal Accruals in Operaing Acivies = Ne Cash Generaed or Used Operaing Earnings 10.Populaion and Sampling The populaion under sudy included he firms lised on he Tehran Sock Exchange in a five-year period from 2007 o The sampling was performed using eliminaion echnique. Accordingly, he research populaion consised of all firms wh he following requiremens: 1. Firms oher han invesmen firms, financial inermediaries, and insurance companies. 2. Firms whose capal included common socks no preferred socks. 3. Firms whose financial years ended a he lae March. 4. Firms whose socks were raded from he early 2007 o he lae According o he above condions, 125 firms were included in he research sample. 11.RESULTS 11.1.Tesing he Firs Hypohesis The firs hypohesis saes ha here is a significan relaionship beween curren discreionary accruals and fuure operaing earnings. Saisically, his hypohesis is saed as follows: H0: There is no significan relaionship beween curren discreionary accruals and fuure operaing earnings. H1: There is a significan relaionship beween curren discreionary accruals and fuure operaing earnings. Table 1: Summary b R R Adjused R Sd. Error of Esimae Durbin- Wason A a. Predicors: (Consan), DA b. Dependen Variable: Earning Sum of s Table 2: ANOVA b df 64 Mean Regression 1.265E E Residual 6.740E E10 Toal 6.866E a. Predicors: (Consan), DA b. Dependen Variable: E F Sig..002 A

6 As shown in ables 1 and 2, he adjused coefficien of deerminaion (R 2 ) is 0.017, indicaing ha abou 1.7% of he response variaions (fuure operaing earnings) can be explained by he independen variable ha is he curren discreionary accruals (DA). The probabily of he null hypohesis which indicaes here is no linear relaionship beween he independen variables and he response variable is equal o ha is smaller han Therefore, he null hypohesis (H0) is rejeced a 95% confidence level. So, here is a significan linear relaionship beween wo variables and hus he alernaive hypohesis (H1) is confirmed. The fed model is presened as follows: Earning DA 0 12.Tesing he Second Hypohesis The second hypohesis suggess ha here is a significan relaionship beween curren non-discreionary accruals and fuure operaing earnings. Saisically, his hypohesis is saed as follows: H0: There is no significan relaionship beween curren non-discreionary accruals and fuure operaing earnings. H1: There is a significan relaionship beween curren non-discreionary accruals and fuure operaing earnings. Table 3: Summary b R R Adjused R Sd. Error of Esimae Durbin- Wason a a. Predicors: (Consan), DA b. Dependen Variable: Earning Table 4: ANOVA b Sum of Mean df s F Sig. Regression 7.160E E E3.000a 1 Residual 1.039E E10 Toal 8.200E a. Predicors: (Consan), DA b. Dependen Variable: E As shown in he above ables, he adjused coefficien of deerminaion (R 2 ) is 0.873, showing ha abou 87.3% of he response variaions (fuure operaing earnings) can be explained by he curren non-discreionary accruals (DA). The probabily of he null hypohesis which saes ha here is no linear relaionship beween he independen variables and he response variable is equal o ha is smaller han Therefore, he null hypohesis (H0) is rejeced a 95% confidence level. So, here is a significan linear relaionship beween wo variables and hus he alernaive hypohesis (H1) is confirmed. The fed model is presened as follows: Earning NDA 0 65

7 13.Tesing he Third Hypohesis The hird hypohesis saes ha here is a significan relaionship beween curren operaing cash and fuure operaing earnings. Saisically, his hypohesis is saed as follows: H0: There is no significan relaionship beween curren operaing cash and fuure operaing earnings. H1: There is a significan relaionship beween curren operaing cash and fuure operaing earnings. Table 5: Summary b R R Adjused R Sd. Error of Esimae Durbin-Wason a a. Predicors: (Consan), DA b. Dependen Variable: Earning 1 Table 6: ANOVA b Sum of Mean df s F Sig. Regression 4.714E E a Residual 2.969E E9 Toal 7.683E a. Predicors: (Consan), DA b. Dependen Variable: E As can be seen in he above ables, he adjused coefficien of deerminaion (R 2 ) is 0.613, showing ha abou 61.3% of he response variaions (fuure operaing earnings) can be explained by he curren operaing cash ems. The probabily of he null hypohesis which saes ha here is no linear relaionship beween he independen variables and he response variable is equal o ha is smaller han Therefore, he null hypohesis (H0) is rejeced a 95% confidence level. So, here is a significan linear relaionship beween wo variables and hus he alernaive hypohesis (H1) is confirmed. The fed model is presened as follows: Earning OCF 0 66

8 14.CONCLUSION The resuls of his sudy concerning he relaionship beween operaing cash flow and accruals o predic fuure earnings indicaed ha curren discreionary accruals, curren non-discreionary accruals, and operaing cash flow, and fuure operaing cash are posively and significanly associaed wh fuure operaing earnings. 15.Limaions - The general limaion of his sudy was relaed o he marke srucure and how ransacions are performed in. The socks of some firms are raded inermenly while hose of oher firms are raded less frequenly in a year. However, variables are calculaed in a way similar for boh ypes of firms. This makes he firms sock performance is no shown correcly. - The effecs of oher variables on he resuls based on he condion of he exchange marke, skyrockeing sock prices, he effecs of hese facors on he firms variables, and he effecs of changes in economic condions on he findings of he sudy were among oher shorcomings. 16.Suggesions 1. Our findings indicaed ha operaing cash flows have more informaion conen han oher variables o predic fuure earnings. On he conrary, when predicing fuure earnings, curren discreionary accruals and nondiscreionary curren accruals have less informaion conen compared o operaing cash flows. Accordingly, when esimaing fuure earnings, invesors and financial analyss are recommended o ake ino consideraion hese facors in addion o heir desired indexes. 2. As was menioned earlier, accruals and cash flows conain sufficien informaion for predicing fuure earnings. Therefore, when predicing earnings, invesors are recommended o pay aenion o oher facors such as general economic condions, supply and demand, and relevan accouning variables. They are also required o run a comprehensive analysis when esimaing fuure earnings and do no suffice only o he cash ems and accruals of he business eny. 17.Suggesions for Fuure Research 1. The presen sudy was performed on acive firms in differen indusries lised in he Tehran Sock Exchange wh he excepion of invesmen firms and financial inermediaries. Given he differences in operaions aken invesmen firms and he firms in he research sample, is recommended ha he relaionship beween accruals and cash flows be aken ino accoun in predicing fuure earnings in invesmen firms. 67

9 2. To explore he associaion beween accruals and cash flows in predicing fuure earnings, is recommended ha such relaionship be analyzed in he form of a correlaional ime series research (by reviewing daa from a period of a leas en years). 3. The relaionship beween accruals and cash flows in predicing fuure earnings may also be explored by indusry. References 1. Thaqaf A. & Hashem S. A. (2004). Analyical sudy of he relaionship beween operaing cash flows and accruals o develop an operaing cash flow forecasing model. Review of Accouning and Auding, No. 38, Jana Rosam M. T. (1999). The role and poenials of earnings for predicing fuure profs and invesmen cash flows in firms lised in he Tehran Socks Exchange. M.A Thesis: Deparmen of Managemen and Accouning, Shahid Beheshi Universy. 3. Khodadad V. & Janjan R. (2010). Invesors reacions o he predicion of earnings, cash flows, and accruals in The Tehran Sock Exchange. Sock Exchange Quarerly, 8: Sadeghbayan, M. (1377). Relaionship beween cash flow from operaing acivies and operaing earnings. Maser s Thesis in Accouning, Faculy of Humanies, Tehran Universy. 5. Modares, A. (2001). Applicaion of mulivariae ime series models in forecasing operaing cash flows, comparing heory and empirical evidence. PhD Thesis, Universy of Allameh Tabaabai. 6. Modares & Abass Zadeh (2008). The impac of accruals and cash flow componens o predic he qualy of he prediced earnings. Journal of knowledge and Developmen, 15(24): Barh, ME, DP Cram, and KK Nelson, 2001, Accruals and he predicion of fuure cash flows, The Accouning Review 76, Dechow, P. M, Sco, A. R and Richard, G. S. (2004). The Pricing of he Cash Componen of Earning Goldberg, SR, Kim, M.-S., Barov, E., The valuaion-relevance of earnings and cash flows: an inernaional perspecive. Journal of Inernaional Financial Managemen and Accouning, 12 (2), Jones, J, Earning managemen during impor relief invesigaions journal of Accouning Research, 29, Farshad Farshadfar A, Reza Monem The usefulness of operaing cash flow and accrual componens in improving he predicive abily of earnings: a re-examinaion and exension Accouning and Finance 53 (2013): Sloan, R., (1996); Do Sock Prices Reflec Informaion in Accruals and Cash Flows abou Fuure Earnings? The Accouning Review, 71 (July): Subramanyam, KR, and M. Venkaachalam, 2007, Earnings, cash flows, and ex pos inrinsic value of equy, The Accouning Review 82,