The differential pricing of cash flows and total accruals

Abstract

PurposeRecent studies on the securities market's differential pricing of earnings components indicate that cash flows from operations are valued more highly than extreme total accruals. However, no previous study has examined whether cash flows from operations have a higher valuation than moderate total accruals. Therefore, this study examines the securities market's differential pricing of cash flows from operations and both moderate and extreme total accruals.Design/methodology/approachThe study's sample is divided into two sub-samples: a moderate total accruals sub-sample; and an extreme total accruals sub-sample. To evaluate whether cash flows have a higher valuation when compared to total accruals, for the entire sample and for each of the two sub-samples, the study examines the statistical significance of the difference between slope coefficients of cash flows and total accruals for regression of returns on both unexpected cash flows from operations and unexpected total accruals.FindingsConsistent with prior research, results from the entire sample show a differential higher valuation of cash flows when compared to total accruals. Another finding, consistent with recent studies, is that cash flows from operations have a higher valuation when compared to extreme total accruals. However, there is no higher differential valuation of cash flows over moderate total accruals. These findings support the decomposition of earnings into the components of cash flows from operations and total accruals only when total accruals are extreme (rather than moderate).Practical implicationsA possible explanation for these results is that since accruals predict cash flows, total accruals – when moderate (i.e. not extreme) – are priced similarly to cash flows. These results reveal that when total accruals are moderate, earnings are a better proxy for the underlying cash flows (over the entire future horizon, not just the current period) than is cash flows. However, since total accruals are unlikely to persist in a permanent way over the years, these results indicate that the decomposition of earnings into the components of cash flows from operations and total accruals is consistent with the information set used to value equity securities. Therefore, separate disclosure of cash flows is value relevant. In addition, users of financial statements certainly need the cash flows information as an ex-post validation of the prior earnings.Originality/valueThis study's contribution stems from its determination of the preferred level of disaggregation of earnings components (i.e. operating cash flows and total accruals). This is expected to help investors in their attempt to enhance the outcome of their informed investment and credit decisions.