Accruals and the prediction of future cash flows

Abstract

PurposeThe purpose of this paper is to examine the comparative abilities of current period cash flows and earnings (and its components) to predict one‐year‐ahead cash flow from operations in Egypt.Design/methodology/approachThe study uses the cash flow prediction models developed by Barth, Cram, and Nelson to examine the predictive abilities of earnings and cash flows for future cash flows. The first set of prediction models uses cross‐sectional regression to compare the predictive abilities of cash flows and aggregate earnings for one‐year‐ahead cash flow from operations. The second set of prediction models tests whether disaggregating earnings into cash flows and the major components of accruals enhances the predictive ability of earnings for one‐year‐ahead cash flow from operations.FindingsThe findings of the study reveal that aggregate earnings have superior predictive ability than cash flows for future cash flows. Also, the results reveal that disaggregating accruals into major components – changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals – significantly enhances predictive ability of earnings.Research limitations/implicationsThe study provides empirical evidence on the superiority of earnings in predicting future cash flows. The findings of the study should be considered in explaining the results of value relevance research Egypt. However, owing to relatively small sample size, given the thinness of the Egyptian capital market, these findings should be interpreted with caution.Originality/valueThe paper contributes to the limited body of research on the superiority of earnings and cash flows in predicting future cash flows by examining the predictive abilities of earnings and cash flows for future cash flows in Egypt as one of many emerging markets.

Comparative Predictive Abilities of Earnings and Operating Cash Flows on Future Cash Flows: Empirical Evidence from Ghana

“…These different estimation methods could also be a contributory factor to the conflicting findings emanating from the use of actual operating cash flows from the cash flow statement as against estimated operating cash flows. In line with the accounting standards setters, studies (Dechow et al, 1998;Ebaid, 2011;Greenberg et al, 1986;Kim and Kross, 2005;Krause, 1989 and1990;Pae, 2005) conducted in the US confirm that historical earnings demonstrate higher predictive ability compared to historical operating cash flows. Contrarily, employing panel data from Australia, New Zealand and Thailand, Arthur, Czernkowski and Chen, (2007), Barth et al (2001), Seng (2006) and Chotkunakitti (2005) reveal that historical operating cash flows predicts future operating cash flows better than historical earnings.…”

“…Listed firms without published financial statements within the period of analysis were removed from the analysis for consistency. Following Barth et al (2001), Al-Altar and Hussain (2004), Chotkunakitti (2005), Habib (2010), Ebaid (2011), Chong (2012 we use Ordinary Least Squares to estimate the likely influence of the three-lags of operating cash flows and earnings ratios on future operating cash flows of the listed firms. The variables were scaled by the average total assets of the firms to eliminate the effects of size and heteroskedasticity problems (Anderson, Woodhouse, Ramsay and Faff, 2007;Hollister, Shoaf, and Tully 2008;Ebaid, 2011;Chong, 2012).…”

“…Prior studies on the predictability of both earnings and operating cash flows on future operating cash flows are well documented (Barth, Cram and Nelson, 2001;Dechow, Kothari and Watts, 1998;Ebaid, 2011;Habib, 2010;Pae, 2005;Waldron and Jordan, 2010;Chotkunakitti 2005;Chong 2012). Yet, empirical findings are inconclusive on the comparative predictive abilities of earnings and operating cash flows on future operating cash flows.…”

“…Despite these, existing literature on the comparative predictive abilities of earnings and operating cash flows on future operating cash flows are inconsistent and inadequate. Some earlier studies (such as Finger, 1994;Charitou and Vafeas, 1998;Kim and Kross, 2005;Pae, 2005;Ebaid, 2011;Chong, 2012) reveal that historical earnings have more predictive power than operating cash flows. Others (Farshadfar, Ng and Brimble 2008;Penham and Yehuda, 2009;Habib, 2010;Waldron and Jordan, 2010) document that historical operating cash flows are superior to historical earnings in forecasting future operating cash flows.…”

“…Moreover, most of these studies are emanating from developed economies with few studies on emerging markets. For example Egypt (Ebaid, 2011), Indonesia (Supriyadi, 1998), Thailand (Chotkunakitti, 2005) and Malaysia (Chong, 2012).…”