«Leif Atle Beisland University of Agder Dissertation submitted to the Department of Accounting, Auditing and Law at the Norwegian School of Economics ...»
There are several reasons why short term cash flow and earnings prediction tests may differ from value relevance studies. First, while the prediction studies typically analyse very short time horizons, company value is a function of all future cash flows/earnings. For instance, transitory earnings items may introduce noise (compare Kim et al., 2007) in current cash flow and earnings that render them unrelated to future cash flow and earnings even if they are statistically associated with stock return. Second, cash flow or earnings may be defined differently in empirical studies than in equity valuation models. For instance, the traditional cash flow model computes value as a function of free cash flow to equity. Equity value can also be expressed as a function of net financial assets and free cash flow from operations.
Nevertheless, most research focuses on cash flow from operations before investments. This research tradition uses another cash flow definition than the models that constitute the theoretical foundation of the empirical studies. Whether a change in cash flow definition towards free cash flow would materially alter the conclusions of prior research is an issue left for future research.
Aboody, D., Hughes, J., & Liu, J. (2002). Measuring Value Relevance in a (Possibly) Inefficient Market. Journal of Accounting Research, 40(4), 965-986.
Ali, A., & Lee-Seok, H. (2000). Country-Specific Factors Related to Financial Reporting and the Value Relevance of Accounting Data. Journal of Accounting Research, 38(1), 1Ball, R., & Brown, P. (1968). An Empirical Evaluation of Accounting Income Numbers.
Journal of Accounting Research, 6(2), 159-178.
Ball, R., & Shivakumar, L. (2006). The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition. Journal of Accounting Research, 44(2), 207-242.
Banghøj, J., & Plenborg, T. (2006). The value relevance of voluntary disclosure in the annual report. Working Paper.
Barth, M. E., Beaver, W. H., Hand, J. R. M., & Landsman, W. R. (2005). Accruals, Accounting-Based Valuation Models, and the Prediction of Equity Values. Journal of Accounting, Auditing & Finance, 20(4), 311-345.
Barth, M. E., Cram, D. P., & Nelson, K. K. (2001). Accruals and the Prediction of Future Cash Flows. The Accounting Review, 76(1), 27-58.
Barth, M. E., & Kallapur, S. (1996). The Effects of Cross-Sectional Scale Differences on Regression Results in Empirical Accounting Research. Contemporary Accounting Research, 13(2), 527-567.
Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings.
Journal of Accounting & Economics, 24(1), 3.
Ben-Hsien, B., & Da-Hsien, B. (2004). Income Smoothing, Earnings Quality and Firm Valuation. Journal of Business Finance & Accounting, 31(9/10), 1525-1557.
Bernard, V. L., & Stober, T. L. (1989). The Nature and Amount of Information in Cash Flows and Accruals. Accounting Review, 64(4), 624.
Biddle, G. C., Seow, G. S., & Siegel, A. F. (1995). Relative versus Incremental Information Content. Contemporary Accounting Research, 12(1), 1-23.
Bowen, R. M., Burgstahler, D., & Daley, L. A. (1986). Evidence on the Relationships Between Earnings and Various Measures of Cash Flow. Accounting Review, 61(4), 713.
Bradshaw, M. T., & Sloan, R. G. (2002). GAAP versus The Street: An Empirical Assessment of Two Alternative Definitions of Earnings. Journal of Accounting Research, 40(1), 41-66.
Brown, S., Kin, L., & Lys, T. (1999). Use of R² in accounting research: measuring changes in value relevance over the last four decades. Journal of Accounting & Economics, 28(2), 83-115.
Brown, W. D., He, H., & Teitel, K. (2006). Conditional Conservatism and the Value Relevance of Accounting Earnings: An International Study. European Accounting Review, 15(4), 605-626.
Callen, J. L., & Segal, D. (2004). Do Accruals Drive Firm-Level Stock Returns? A Variance Decomposition Analysis. Journal of Accounting Research, 42(3), 527-560.
Chen, K., Sommers, G. A., & Taylor, G. K. (2006). Fair Value's Affect on Accounting's Ability to Predict Future Cash Flows: A Glance Back and a Look at the Potential Impact of Reaching the Goal. Working Paper - Available at SSRN.
Christensen, P., & Feltham, G. A. (2003). Economics of Accounting, Volume I: Information in Markets. Springer.
Christie, A. A. (1987). On Cross-Sectional Analysis in Accounting Research. Journal of Accounting and Economics, 9(3), 231-258.
- 127 Collins, D. W., & Hribar, P. (2000). Earning-based and accrual -based market anomalies: one effect or two? Journal of Accounting & Economics, 29(1), 101-123.
Collins, D. W., Kothari, S. P., Shanken, J., & Sloan, R. G. (1994). Lack of Timeliness and Noise as Explanations for the Low Contemporaneous Return-Earnings Association.
Journal of Accounting and Economics, 18(3), 289-324.
Collins, D. W., Maydew, E. L., & Weiss, I. S. (1997). Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting & Economics, 24(1), 39.
Cornell, B., & Landsman, W. R. (2003). Accounting Valuation: Is Earnings Quality an Issue?
Financial Analysts Journal.
Davis, A. K. (2002). The Value Relevance of Revenue for Internet Firms: Does Reporting Grossed-up or Barter Revenue Make a Difference? Journal of Accounting Research, 40(2), 445-477.
Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance:
The role of accounting accruals. Journal of Accounting & Economics, 18(1), 3-42.
Dechow, P. M., & Ge, W. (2006). The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly. Review of Accounting Studies, 11.
Dechow, P. M., Kothari, S. P., & Watts, R. L. (1998). The relation between earnings and cash flows. Journal of Accounting & Economics, 25(2), 133-168.
Easton, P. D., & Sommers, G. A. (2003). Scale and the Scale Effect in Market-based Accounting Research. Journal of Business Finance & Accounting, 30(1/2), 25-55.
Edwards, E. O., & Bell, P. W. (1961). The Theory and Measurement of Business Income University of California Press Fama, E. F., & French, K. R. (2000). Forecasting Profitability and Earnings. Journal of Business, 73(2), 161.
FASB. (1978). Financial Accounting Standards Board. Objectives of Financial Reporting by Business Enterprises. Statement of Financial Accounting Concepts No. 1.
Feltham, G. A., & Ohlson, J. A. (1995). Valuation and Clean Surplus Accounting for Operating and Financial Activities. Contemporary Accounting Research, 11(2), 689Feltham, G. A., & Ohlson, J. A. (1996). Uncertainty Resolution and the Theory of Depreciation Measurement. Journal of Accounting Research, 34(2).
Finger, C. A. (1994). The Ability of Earnings to Predict Future Earnings and Cash Flow.
Journal of Accounting Research, 32(2), 210-223.
Francis, J., LaFond, R., Olsson, P. M., & Schipper, K. (2004). Costs of Equity and Earnings Attributes. Accounting Review, 79(4), 967-1010.
Francis, J., & Schipper, K. (1999). Have Financial Statements Lost Their Relevance? Journal of Accounting Research, 37(2), 319-352.
Francis, J., Schipper, K., & Vincent, L. (2003). The Relative and Incremental Explanatory Power of Earnings and Alternative (to Earnings) Performance Measures for Returns.
Contemporary Accounting Research, 20(1), 121-164.
Francis, J., & Smith, M. (2005). A Reexamination of the Persistence of Accruals and Cash Flows. Journal of Accounting Research, 43(3), 413-451.
Freeman, R. N., & Tse, S. Y. (1992). A Nonlinear Model of Security Price Responses to Unexpected Earnings. Journal of Accounting Research, 30(2), 185-209.
Gjerde, Ø., Knivsflå, K. H., & Sættem, F. (2007a). The Value-Relevance of Adopting IFRS:
Evidence from 145 NGAAP Restatements. Working Paper - The Norwegian School of Economics and Business Administration.
- 128 Gjerde, Ø., Knivsflå, K. H., & Sættem, F. (2007b). The Value Relevance of Financial Reporting in Norway 1965-2004. The Norwegian School of Economics and Business Administration - Working Paper.
Gu, Z. (2007). Across-Sample Incomparability of R2s and Additional Evidence on Value Relevance Changes Over Time Journal of Business Finance & Accounting, 34.
Hair, J. F., Black, W. C., Babin, B. J., Anderson, R. E., & Tatham, R. L. (2006). Multivariate Data Analysis, Sixth Edition. PEARSON Prentice Hall.
Hassel, L., Nilsson, H., & Nyquist, S. (2005). The value relevance of environmental performance. European Accounting Review, 14(1), 41-61.
Hayn, C. (1995). The information content of losses. Journal of Accounting & Economics, 20(2), 125-153.
Hellstrøm, K. (2006). The Value Relevance of Financial Accounting Information in a Transition Economy: The Case of the Czech Republic. European Accounting Review, 15(3), 325-349.
Holthausen, R. W., & Watts, R. L. (2001). The relevance of the value-relevance literature for financial accounting standard setting. Journal of Accounting & Economics, 31(1-3), 3Hope, O.-K. (1999). Value Relevance Effects of the Introduction of Interperiod Tax Allocation: The Case of Norway. In Advances in international accounting. Volume 12 (pp. 157-191).
Hope, O.-K. (2004). Variations in the Financial Reporting Environment and Earnings Forecasting. Journal of International Financial Management & Accounting, 15(1), 21Joos, P., & Plesko, G. A. (2005). Valuing Loss Firms. The Accounting Review, 80(3).
Junttila, J., Kallunki, J.-P., Karja, A., & Martikainen, M. (2005). Stock market response to analysts' perceptions and earnings in a technology-intensive environment.
International Review of Financial Analysis, 14(1), 77-92.
Kim, M., & Kross, W. (2005). The Ability of Earnings to Predict Future Operating Cash Flows Has Been Increasing — Not Decreasing. Journal of Accounting Research, 43(5).
Kim, O., Lim, S. C., & Park, T. (2007). The Value Relevance of Earnings and the Prediction of One-Year-Ahead Cash Flows. Working Paper - Available at SSRN.
King, R. D., & Langli, J. C. (1998). Accounting Diversity and Firm Valuation. International Journal of Accounting, 33(4), 529-567.
Klein, A., & Marquardt, C. A. (2006). Fundamentals of Accounting Losses. The Accounting Review, 81(1).
Konan Chan, A., Jegadeesh, N., & Sougiannis, T. (2004). The Accrual Effect on Future Earnings. Review of Quantitative Finance & Accounting, 22(2), 97-121.
Kormendi, R., & Lipe, R. (1987). Earnings Innovations, Earnings Persistence, and Stock Returns. Journal of Business, 60(3), 323-345.
Landsman, W. R., Miller, B. L., & Yeh, S. (2007). Implications of Components of Income Excluded from Pro Forma Earnings for Future Profitability and Equity Valuation.
Journal of Business Finance & Accounting, 34(3/4), 650-675.
Lev, B. (1989). On the Usefulness of Earnings and Earnings Research: Lessons and Directions from Two Decades of Empirical Research. Journal of Accounting Research, 27(3), 153-192.
Lev, B., Li, S., & Sougiannis, T. (2005). Accounting Estimates: Pervasive, Yet of Questionable Usefulness. Working Paper.
Lev, B., & Nissim, D. (2006). The Persistence of the Accruals Anomaly. Contemporary Accounting Research, 23(1), 193-226.
- 129 Lev, B., & Zarowin, P. (1999). The Boundaries of Financial Reporting and How to Extend Them. Journal of Accounting Research, 37(2), 353-385.
Lianzan, X., & Cai, F. (2005). The Valuation of High-Tech 'New Economy" Companies.
Journal of Global Competitiveness, 13(1/2), 1-8.
Liu, J., Nissim, D., & Thomas, J. (2007). Is Cash Flow King in Valuations? Financial Analysts Journal, 63(2).
Nikkinen, J., & Sahlstrøm, P. (2004). Impact of an accounting environment on cash flow prediction. Journal of International Accounting, Auditing & Taxation, 13(1), 39-52.
Næs, R., Skjeltorp, J. A., & Ødegaard, B. A. (2008). Liquidity at the Oslo Stock Exchange.
Working Paper - Available at www.norges-bank.no.
Ohlson, J. A. (1995). Earnings, Book Values, and Dividends in Equity Valuation.
Contemporary Accounting Research, 11(2), 661-687.
Penman, S. H. (2001). Financial Statement Analysis and Security Valuation. McGraw-Hill.
Ramakrishnan, R. T. S., & Thomas, J. K. (1998). Valuation of Permanent, Transitory, and Price-Irrelevant Components of Reported Earnings. Journal of Accounting, Auditing and Finance, 13(3), 301-336.
Rayburn, J. (1986). The Association of Operating Cash Flow and Accruals with Security Returns. Journal of Accounting Research, 24(3), 112-133.
Sloan, R. G. (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? Accounting Review, 71(3), 289-315.
StataCorp. (2005). Stata Statistical Software: Release 9. College Station, TX: StataCorp LP.
Subramanyam, K. R., & Venkatachalam, M. (2007). Earnings, Cash Flows, and Ex Post Intrinsic Value of Equity. Accounting Review, 82(2), 457-481.
Williams, J. (1938). The Theory of Investment Value. Harvard University Press, Cambridge.
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(3), 165-200.
Company value is the present value of future cash flows generated by the company. Several versions of the cash flow valuation model exist. However, regardless of the cash flow model used, company value is generally a function of future free cash flows. Still, when prior research analyses cash flows’ predictive ability and value relevance, the focus is almost exclusively on cash from operations before investments (Barth et al., 2001; Biddle et al., 1995; Dechow, 1994; Dechow et al., 1998; Finger, 1994; M. Kim & Kross, 2005; O. Kim et al., 2007; Rayburn, 1986; Subramanyam & Venkatachalam, 2007). This may seem like a paradox, particularly since the research maintains that it focuses on cash flows because they
are important drivers of company value; see the following statements from prior studies:
This study investigates the role of accruals in predicting future cash flows. A firm's ability to generate cash flow affects the values of its securities (Barth et al., 2001, p. 28).
Various explanations for the prominence of accounting earnings and the reasons for its usage have been offered.