Abstract
Purpose
Recent studies on the securities market’s differential pricing of earnings components have shown that cash flow from operations is more highly valued than total accruals and that moderate cash flow from operations has higher valuation than extreme total accruals. An interesting question that follows is whether these findings hold regarding the differential valuations of cash flow and current accruals. This study aims to extend prior research by addressing this issue in two ways. First, the authors examine the incremental information content of cash flow from operations beyond working capital from operations. Second, the authors assess the effect of extreme working capital from operations on the incremental information content of cash flow from operations. This study aims to extend prior research by addressing this issue in two ways.
Design/methodology/approach
This study adopts market-based accounting research to test its hypotheses and to achieve its objectives. Specifically, this study uses statistical associations between accounting data and stock returns to examine the incremental information content (value relevance) of cash flow and working capital from operations and the effect of extreme working capital from operations on the incremental information content of cash flow.
Findings
The results show that cash flow from operations is not more highly valued than current accruals (both being valued equivalently). However, moderate cash flow from operations has higher valuation than extreme current accruals (each is valued differently). Overall, these research findings indicate that cash flow becomes more important for valuation as accruals get “extreme”.
Practical implications
As accruals are unlikely to persist to be permanent across the years, these results can be interpreted as indicating that cash flow and accruals information are used jointly by investors, with one being more important than the other depending on the relative “extremeness” of each. Therefore, both are of value to the investor and both should be reported.
Originality/value
The paper contributes to the UK research on determining the preferred level of disaggregation of earnings components, i.e. operating cash flow, current accruals and non-current accruals. This would help investors to improve their investment and credit decisions.
Subject
General Economics, Econometrics and Finance,Finance,Accounting
Reference40 articles.
1. The value relevance of cash flows, current accruals, and non-current accruals in the UK;International Review of Financial Analysis,2011
2. Ali, A. and Pope, P.F. (1994), “The incremental information content of earnings, funds flow and cash flow: the U.K. evidence”, Working Paper Version, The Management School, Lancaster University, pp. 1-32.
3. The incremental information content of earnings, working capital from operations, and cash flows;Journal of Accounting Research,1994
4. The incremental information content of earnings, funds flow and cash flow: the UK evidence;Journal of Business Finance and Accounting,1995
5. A the role of earnings levels in annual earnings-returns studies;Journal of Accounting Research,1992