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09.10.2023

Are earnings better than cash flows at predicting future cash flows? Evidence from apples-to-apples comparisons

verfasst von: Ryan J. Casey, George W. Ruch

Erschienen in: Review of Accounting Studies

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Abstract

We compare the abilities of earnings and cash flows to predict future cash flows. We take a novel approach in that we perform apples-to-apples comparisons of five earnings components measured on an accrual basis with their equivalents measured on a cash basis. On the one hand, we find that the operating profit component (sales net of cost of goods sold and SG&A expense) outperforms its cash-basis equivalent in predicting future cash flows. On the other hand, we find that the depreciation expense and non-operating income components underperform their cash-basis equivalents in predicting future cash flows. Additionally, we fail to find significant differences between the predictive abilities of the interest expense and income tax expense components and their cash-basis equivalents. The inconsistent findings across earnings components suggest that unequivocal all-or-nothing conclusions on the relative predictive abilities of earnings and cash flows are unwarranted.

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2
See paragraphs 37–43 in Statement of Financial Accounting Concepts No. 1 (FASB 1978) and OB3-OB4 and OB14-OB15 in Statement of Financial Accounting Concepts No. 8 (FASB 2010).
 
3
Research finds that this balance sheet approach measures operating cash flows with error (e.g., Drtina and Largay 1995; Hribar and Collins 2002; Shi and Zhang 2011). Relatedly, Chen et al. (2020) find that measurement error in surrogate measures of cash flows using changes in balance sheet accounts causes an understatement (overstatement) in the ability of cash flows (accruals) to predict future cash flows.
 
4
See Dechow et al. (2022), Casey et al. (2017), Barth et al. (2016), Dechow et al. (2008), Dechow and Ge (2006), Richardson et al. (2020), and Lipe (1986).
 
5
We use the word “arbitrarily” because operating cash flows lack a conceptual definition under U.S. GAAP. For instance, the operating, investing, and financing classifications for cash flows are largely defined with lists of examples rather than with concepts (“ASC 230-10-45”; ASC 230-10-45–10 through 17). Operating cash flows receive the additional definition as cash flows “that do not stem from transactions defined as investing or financing activities” (“ASC 230-10-45”; ASC 230-10-45-16 and 17). Note, too, that the use of the term “operating” on the statement of cash flows is inconsistent with its use on the income statement, as operating earnings generally exclude the interest and income tax expenses.
 
6
Ball and Nikolaev (2022) acknowledge the inconsistency between operating cash flows and their operating earnings measures. In a sensitivity test (reported in their Table 8), they adjust cash flows by removing cash paid for interest and cash paid for taxes on capital gains. Ball and Nikolaev (2022) find that the results are “somewhat more pronounced than” (p. 19) those using operating cash flows. This is generally consistent with what we find when we shift from operating cash flows in Table 3 to the alternative cash flow measures in Table 4. Ball and Nikolaev (2022) also consider the prediction of free cash flow, which includes capital expenditures, instead of operating cash flows (reported in their Table 9). However, their results are not comparable to any analysis we perform because they include capital expenditures as a separate regressor in both the earnings and cash flow specifications of their model, thus precluding comparison of depreciation expense with its cash-basis equivalent.
 
7
Nallareddy et al. (2020) include a table in their Appendix C comparing 12 combinations of various earnings and cash flow measures. They find that cash flows beat earnings in predicting future cash flows for each of the 12 combinations. However, none of the 12 combinations of earnings and cash flow measures matches any of combinations we analyze here.
 
8
To be clear, Ball and Nikolaev (2022) raise legitimate questions about the appropriateness of using bottom-line earnings to compare the abilities of earnings and cash flows to predict future cash flows, and, in our view, it is reasonable to consider the use of alternative earnings measures. However, concerns about bottom-line earnings do not justify limiting comparisons of earnings and cash flows to sales, cost of goods sold, and SG&A expense.
 
9
We also estimate Eqs. (1) and (2) as firm-specific time-series regressions and compare the mean coefficient and incremental R2 estimates across all sample firms. We report these results in Tables 7 and 8 and discuss them in Section 5.2.
 
10
OPE is equivalent to the Compustat earnings variable “Operating Income before Depreciation” (Compustat: OIBDP).
 
11
Appendix 1 provides Compustat definitions for each earnings component and their cash-basis equivalent components.
 
12
This order is based on the traditional order in which components are included in bottom-line earnings on the income statement. Our inferences are unaffected by the order in which the components are included in the summary measures.
 
13
EBIN is equivalent to the Compustat earnings variable “Operating Income after Depreciation” (Compustat: OIADP).
 
14
EBTX is equivalent to the Compustat earnings variable “Pre-Tax Income” (Compustat: PI).
 
15
EBL is equivalent to earnings before extraordinary items and noncontrolling interest (Compustat: IBMII). Most studies, however, use the Compustat variable IB, which includes a deduction for noncontrolling interest (Compustat: MII). The inclusion of MII in our bottom-line earnings variable has no effect on our inferences, and therefore, to keep our definitions simple, we choose not to include it as an additional earnings component.
 
16
We calculate the incremental R2 for the earnings and cash flow components as the difference between the R2 obtained from estimating the disaggregated regression models in Eqs. (3)-(10) and the R2 obtained from estimating regression models that exclude the components. For example, the incremental R2 for depreciation expense is the R2 obtained from estimating Eq. (3) less the R2 obtained from estimating a regression model that includes only the OPE variable.
 
17
Nallareddy et al. (2020) winsorize all continuous variables at the top and bottom percentiles, whereas Ball and Nikolaev (2022) trim all continuous variables at the top and bottom percentiles. Our inferences are unaffected if we winsorize instead of trim.
 
18
We derive our conclusions by performing multiple empirical comparisons of earnings and cash flows. As a result, we consider the possibility that our results suffer from a multiple testing problem, which arises when multiple statistical inferences are considered simultaneously (Farcomeni 2008). In short, as the number of comparisons increases, so does the likelihood of observing spurious correlations and, in turn, of drawing erroneous inferences. Note that, while we make multiple comparisons, we draw inferences from these comparisons individually rather than jointly. For example, we consider the comparison of operating profit with its cash-basis equivalent separate from the comparison of bottom-line earnings from its cash-basis equivalent. Nevertheless, to alleviate concerns that our results stem from a multiple testing problem, we perform a Bonferroni correction in which we reduce our α levels of significance in proportion to the number of comparisons made (Dunn 1961). Conservatively, we assume that each set of tests is comprised of 10 comparisons (i.e., five summary measures compared once on R2 and once on slope coefficient). This requires that we divide α by 10, resulting in a significance threshold of α level 0.01 for each test. In other words, only the comparisons that are significant at α level 0.01 are considered significant under the Bonferroni correction. However, note that most of our inferences are based on comparisons that exceed this threshold. Therefore the Bonferroni correction does not meaningfully affect our inferences, and we consider it unlikely that a multiple testing problem explains our results.
 
19
While we observe a statistically significant difference in the slope coefficients between interest expense and cash paid for interest in Table 5, this result is not supported by the incremental R2 comparison. Additionally, we fail to observe a statistically significant difference between the coefficients in alternative regression specifications (e.g., firm-specific time-series regressions). Therefore we conclude that the coefficient difference observed in Table 5 does not constitute reliable evidence that cash paid for interest better predicts future cash flows than does interest expense.
 
20
EBITDA and many of its variants are commonly labeled “non-GAAP” or “pro forma” measures. See Black et al. (2017) for a comprehensive review of this literature.
 
21
This definition is consistent with Compustat’s variable (Compustat: EBITDA) and is equivalent to its “Operating Income before Depreciation” variable (Compustat: OIBDP).
 
22
This definition conforms to the Securities and Exchange Commission’s (SEC’s) interpretation of EBITDA. In a non-GAAP financial measures Q&A on its website, the SEC’s Division of Corporation Finance explicitly states that “earnings” – the “E” in EBITDA – refers to GAAP net income and that EBITDA should be reconciled to net income rather than operating income (See questions 103.01 and 103.02: https://​www.​sec.​gov/​corpfin/​non-gaap-financial-measures).
 
23
Penman and Yehuda (2009) theoretically define free cash flow as the difference between cash from operations (C) and cash investment (I). We define C as the sum of cash-basis operating profit and cash-basis non-operating income less cash paid for taxes (OPCF + NOCF − TXCF) and I as capital expenditures (DPCF). This is consistent with definitions in some finance textbooks (e.g., Ross et al. 2021). Others, however, define I as additionally including net cash purchases of investments (e.g., Palepu and Healy 2013) and even net cash retained in the firm’s cash account (e.g., Lundholm and Sloan 2023). We exclude net cash purchases of investments and net cash retained from our definition of free cash flow because they are not components of firm performance and therefore do not differ in how they are accounted for under accrual- and cash-basis accounting. See Bhandari and Adams (2017) for a review of the variety of free cash flow definitions.
 
24
Our measure of free cash flow reflects free cash flow available to all claimants rather than free cash flow available to shareholders, and therefore we exclude cash paid for interest. To obtain free cash flow available to shareholders, we would additionally subtract cash paid for interest and net repayments of debt (cash paid to repay debt less cash received from debt issuance). We do not examine this measure of free cash flow because repayments and issuances of debt are not components of firm performance and therefore do not differ in how they are accounted for under accrual- and cash-basis accounting. Our cash-basis bottom-line earnings summary measure (CFBL) closely approximates free cash flow available to shareholders.
 
25
Nallareddy et al. (2020) estimate firm-specific regressions on firms with at least 12, 16, 20, 24, and 27 years of data. Ball and Nikolaev (2022) estimate firm-specific regressions on firms with at least 15 years of data. Our inferences are the same if we apply these alternative restrictions.
 
26
We confirm these results with respect to the individual components in firm-specific time-series specifications of the disaggregated regressions in Eqs. (3)-(10). In other words, depreciation expense and non-operating income exhibit less incremental predictive ability than do capital expenditures and cash-basis non-operating income. In the interest of brevity, however, we do not tabulate these results.
 
27
We do not present graphs for the interest and income tax components because their incremental R2 values approximate zero and lack statistical significance across the sample period.
 
28
These increases may understate the actual trends in the predictive abilities of accrual- and cash-basis operating profit. Specifically, we observe a significant decrease in the adjusted R2 values after 2018, which may stem from the onset of the COVID-19 pandemic in early 2020. Specifically, the adjusted R2 for OPE (OPCF) was 59.1% (55.0%) in 2018.
 
29
Following Nallareddy et al. (2020), we test the difference in prediction errors by calculating the Diebold-Mariano statistic from Diebold and Mariano (1995), which compares the mean squared prediction error of each model.
 
30
We additionally find that the reduction in predictive ability from the inclusion of non-operating income in earnings recedes over longer horizons. However, we do not find any evidence that non-operating income improves the predictive ability of earnings over any horizon.
 
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Metadaten
Titel
Are earnings better than cash flows at predicting future cash flows? Evidence from apples-to-apples comparisons
verfasst von
Ryan J. Casey
George W. Ruch
Publikationsdatum
09.10.2023
Verlag
Springer US
Erschienen in
Review of Accounting Studies
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-023-09805-5