Quarterly Earnings, Operating Cash Flow, and Accruals in Future Performance Assessment.
| Autor | Pimentel, Rene Coppe |
| Cargo | Research Article |
INTRODUCTION
One of the main issues and challenges for investors, analysts, and other market practitioners and participants is to forecast future financial outputs in a world in which firms' future performance and their associated probabilities are not completely known and the markets are neither perfect nor complete (i.e., there is information asymmetry and barriers to fair and efficient markets) (Scott, 2015). These challenges are corroborated by empirical literature, documenting that professional analysts and investors have been failing in providing accurate estimations of future performance (Bradshaw, Drake, Myers, & Myers, 2012; Hou, Van Dijk, & Zhang, 2012; Lacina, Lee, & Xu, 2011; Olsen, 1996).
While Fama and French (2000) suggest that security analysts should exploit and scrutinize the time series process of earnings during the forecast process, Chen (2013) shows that these analysts and investors fail to fully recognize the time series process of earnings and cash flows. In this regard, estimation of future earnings and cash flows are key aspects in financial analysis and firm valuation. Linking accruals included in accounting earnings measurements with future operating cash flow is important for assessing the relevance of accruals and earnings for firm valuation (Farshadfar & Monem, 2019). However, due to natural uncertainty about the future and the context specificity of financial outputs, the literature has struggled to develop universal forecast models to understand the behavior of financial indicators, especially with regard to earnings, operating cash flows, and accounting accruals (Ball, Gerakos, Linnainmaa, & Nikolaev, 2016). Hence, no outperforming model or pattern is consensually considered the best in all situations and environments (Dechow, Ge, & Schrand, 2010).
In this regard, Livnat and Santicchia (2006) claim that careful financial statement users such as financial analysts, investors, and creditors should closely scrutinize a firm's quarterly accruals for the possibility of future reversals. Specifically, accruals are the non-cash component of earnings, representing adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash (Ball et al., 2016).
Hence, by reflecting a wide variety of corporate decisions, accruals are assumed to be the key output of the financial reporting system, encompassing everything that drives a wedge between earnings and cash flow, including a firm's sales, production, investment, accounting, and cash management choices (Lewellen & Resutek, 2019). If investors are fixated only on earnings and ignore information in cash flows from operation and accruals, stock prices may not accurately reflect the economic situation of the firm, leading to market anomalies, such as mispricing and accruals anomaly (Livnat & Santicchia, 2006).
Different from the existing literature, this paper addresses this issue by analyzing quarterly data of earnings, cash flow from operations--reported in the statement of cash flows--, and accruals, and their assessment of future performance using a sample of 270 Brazilian non-financial firms listed on B3 (Sao Paulo Stock Exchange) from 2005 to 2018 (10,792 firms--quarterly observations). This sample includes non-financial firms that account for around 98% of the market capitalization and comprises all available cash flow statement information.
The analysis is conducted by controlling the estimations for accounting accruals methodologies and processes (i.e., controlling the effects of negative performance, extreme values, decreasing performance, volatility of accounting components, and IFRS adoption). The accruals processes have practical importance since they significantly affect future earnings and operating cash flow estimations, by increasing or reducing the accuracy of future performance forecasts by market agents. Overall, extreme accruals, reducing earnings, negative earnings, and more volatile financial performance reduce earnings and cash flows persistence parameters, making forecast even more challenging. In this regard, this paper also provides alternative assumptions for the time series process of earnings, operating cash flows, and accruals.
The relevance of quarterly analysis relies on the fact that market agents tend to revise earnings forecasts after quarterly earnings announcements. Hence, to ignore the fact that comprehensive annual earnings and operating cash flows are anticipated mainly in quarterly reporting might be regarded as incomplete from an efficient market perspective. Considering that 3/4 of annual earnings and operating cash flows are already known when annual measures are reported, careful consideration of quarterly earnings, operating cash flows, and accruals is likely to be extremely important for improving forecasts (Livnat & Santicchia, 2006).
The informative content of earnings, cash flow, and accruals is not a closed subject, since studies show conflicting evidence and environment specificity for the role played by each measure. Bartov, Goldberg, and Kim (2001), for instance, demonstrate that the superiority of earnings over cash flows is not universal. Rather, it depends on the national reporting regime and attendant institutional factors. In this regard, to the best of our knowledge, no paper combines the analysis of quarterly earnings data, operating cash flow, and the role of quarterly accruals information in the forecast of future values of earnings and operating cash flows in the Brazilian market. Moreover, none of the previous papers controls persistence estimation for the effect of accounting accruals methodology.
Overall, results in this paper show that accounting earnings and accruals contained in earnings have incremental information content on operating cash flows in accessing future financial performance measured by both earnings and cash flow from operations. Firstly, earnings have higher persistence parameters and capture a longer-term perspective of time series components than cash flows from operations, showing that earnings, under the accrual accounting regime, are more predictable than operating cash flows when using their past information. Secondly, the magnitude of accruals is associated positively with the persistence of earnings. Thirdly, as a component of earnings, operating cash flows are more persistent than the accruals component. Fourthly, high accruals levels are associated with lower future earnings. Finally, earnings have incremental informative power to explain future operating cash flows. The study contributes to the literature by providing evidence of the information content of quarterly performance measures (earnings, operating cash flows, and accruals) with regard to future performance and an incremental tool for forecasting future performance of firms by analyzing the Brazilian market. This is an emerging capital market with a low level of investor protection, low analyst coverage, and restricted enforcement mechanisms. Due to the recent legal requirement for reporting the statement of cash flows (from 2005), the time series length can now provide valuable and robust analysis comparable to other developed economies.
In line with Call, Hewitt, Shevlin, and Yohn (2016), this study also provides an incremental tool for forecasting future performance of firms (in terms of earnings and operating cash flows) by improved understanding of the time series dynamics of quarterly earnings and cash flows. This aspect has practical relevance since analysts' forecasts have been providing disappointing accuracy and estimation biases (Olsen, 1996), have been less accurate than a naive and simple time series process (Bradshaw et al., 2012; Gatsios, Lima, & Magnani, 2018; Lacina, Lee, & Xu, 2011; Hou et al., 2012), and have been failing in fully recognize the time series process of earnings and cash flows (Chen, 2013). In this regard, more persistent earnings and operating cash flows are better inputs to valuation models (Call, Hewitt, Shevlin, & Yohn, 2016) and the high or low persistence and predictability are related to the pattern of earnings, operating cash flows, and, in particular, accruals: financial performance with different accruals processes and anomalies have different predictability power.
The remainder of this paper is organized as follows. Section 2 reviews the relevant literature, presents specificities of the Brazilian market, and formulates the hypotheses. Section 3 presents the empirical models and variables. Section 4 presents the sample and description of the variables. Section 5 introduces the empirical findings and discusses the results. Section 6 provides additional tests and assumptions for the empirical study. Finally, the last section offers concluding remarks and suggestions for future research.
LITERATURE OF INTEREST AND HYPOTHESIS DEVELOPMENT
Persistence of performance measures: earnings vs. operating cash flows
The financial performance of a firm--measured on earnings (accruals) and operating cash flows basis--has permanent and transitory components (Easton & Zmijewski, 1989). The permanent portion of performance indicates that new information in current performance will affect expected future outputs while the transitory portion will not help explain expected future performance as its effects will not persist over time. Hence, persistence is related to the continuation of an effect if a series receives an external shock: shocks tend to persist for a long time in high persistent series, while they tend to return to their historical average trajectory in low persistent series (Baginski, Lorek, Willinger, & Branson, 1999; Baginski, Branson, Lorek, & Willinger, 2003). Knowing the level of persistence in the series (and comparing them, as done in this paper) provides important information to potential decision-making, especially if the two series--earnings and operating...
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