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Discretionary Accruals and the Predictive Ability of Earnings in the Forecast of Future Cash Flows: Evidence from Australia

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Discretionary Accruals and the Predictive Ability of Earnings in the Forecast of Future Cash Flows: Evidence from Australia Corporate Ownership & Control / Volume 9, Issue 1, 2011, Continued - 6 DISCRETIONARY ACCRUALS AND THE PREDICTIVE ABILITY OF EARNINGS IN THE FORECAST OF FUTURE CASH FLOWS: EVIDENCE FROM AUSTRALIA Shadi Farshadfar*, Reza Monem** Abstract We examine whether discretionary and non-discretionary accruals improve the predictive ability of earnings for forecasting future cash flows in an Australian context. Using both within-sample and out- of-sample forecasting tests, we demonstrate that discretionary accruals improve the predictive abilty of earnings in the forecast of future cash flows. Further, discretionary and non-discretionary accruals and direct method cash flow components together are more useful than (i) aggregate earnings, (ii) aggregate cash flow from operations and total accruals, and (iii) aggregate cash flow from operations, discretionary accruals and nondiscretionary accruals. Keywords: Discretionary Accruals, Nondiscretionary Accruals, Cash Flow, Earnings, Future Cash Flows, Australia JEL Classification: M41 *Corresponding Author, Ted Rogers School of Management, Ryerson University, 350 Victoria Street, Toronto, ON, M5B 2K3, Canada Tel: 1-416-9795000 Fax: 1-416-9795266 Email: [email protected] ** Griffith Business School, Griffith University, Brisbane, Australia 1. Introduction discretionary and non-discretionary accruals, most of the previous studies have used stock returns as a We investigate whether decomposing accruals into surrogate of future cash flows, rather than using future discretionary and non-discretionary components cash flows directly. improves the predictive ability of earnings for The forecasting of future cash flows is forecasting future cash flows. There are two fundamental to a firm‘s valuation and its investment perspectives in positive accounting theory about the analysis (e.g., Krishnan and Largay, 2000); as well, role of discretionary accruals in the usefulness of accounting standard-setters argue that forecasting earnings: signaling and opportunism. According to the future cash flows is one of the prime objectives of signaling hypothesis, discretionary accruals can financial reporting [1]. Thus, any investigation to improve the information content of earnings by identify models that improve forecasting of future allowing managers to signal their private information cash flows should be of interest to preparers, users about future cash flows. However, according to the and regulators of financial reporting. Further, Sloan opportunism hypothesis, discretionary accruals can be (1996) and Xie (2001), inter alia, show that the used opportunistically, and thus can distort the differential persistence of the accrual and cash flow information in earnings (e.g., Watts and Zimmerman, components of earnings is not accurately priced by 1986). There is substantial empirical evidence that the market. This casts doubt on the application of managers may manipulate earnings due to various share prices in assessing the relevance of cash flow incentives, such as earnings-based management and accruals. compensation schemes (e.g., Healy, 1985; Guidry et Subramanyam (1996) provides the first evidence al., 1999) or executive stock options (e.g., Bartov and on this issue by investigating the association of cash Mohanram, 2004; Bergstresser and Philippon, 2006). flow from operations, discretionary accruals, and However, there is relatively scarce evidence (e.g., nondiscretionary accruals (as earnings components) Subramanayam, 1996; Xie, 2001; Tucker and with future cash flows. He employs the Jones (1991) Zarowin, 2006) on whether on average managerial model to separate total accruals into discretionary and discretion is used to distort earnings‘ informativeness nondiscretionary accruals. Subramanyam assumes or to convey useful information to investors. In that if discretionary accruals can predict future cash addition, in evaluating the relative usefulness of flows, managers use discretionary accruals to signal 597 Corporate Ownership & Control / Volume 9, Issue 1, 2011, Continued - 6 their private information rather than using them material measurement errors when estimating cash opportunistically. His results show that both flow components. More importantly, Orpurt and Zang discretionary and nondiscretionary accruals (2009) find that the association of estimated CFO incrementally enhance the predictive ability of components and future cash flows are affected by the earnings for future cash flows over cash flow from degree of these measurement errors. Therefore, this operations. Subramanyam‘s results, however, are not study avoids aggregagation bias, estimation errors, conclusive about the relative importance of and possible model misspecification, as suffered by discretionary and non-discretionary accruals in most previous studies in this area, in particular predicting future cash flows for three reasons. Subramanyam (1996). In addition, during the period First, the reliability of Subramanyam‘s (1996) of this study, Australian companies were allowed to results has been questioned by Bernard and Skinner re-evaluate non-current accruals, capitalise research (1996), and Hribar and Collins (2002). Bernard and and development expenditures, and were not allowed Skinner (1996) argue that the mismeasurement of to use the LIFO method. Prior research indicates that discretionary accruals can be an alternative the non-current asset revaluations and the explanation for Subramanyam‘s (1996) findings. In capitalisation of research and development costs are particular, the Jones (1991) model employed by value relevant in the Australian capital market (e.g., Subramanyam (1996) sysmatically misclassifies Barth et al. Clinch 1998; Jones 2003). Furthermore, nondiscretionary accruals into discretionary accruals Materials and Energy industries with a high degree of and thereby, may falsely indicate that discretionary heterogeneity in accounting method choices (e.g., accruals are value relevant. Furthermore, Hribar and Defond et al.; Hung, 2003) constitute a larger portion Collins (2002) find that total accruals estimated by the of the Australian capital market compared to the US balance sheet approach, as in Subramanyam (1996), market. These differences affect the level of are subject to substantial measurement errors; informativeness of discretionary accruals in the discretionary and nondiscretionary accruals embed Australian context. some (or all) such errors, as opposed to the cash flow To address the research question, a sample of approach. Hribar and Collins (2002) further show that 340 Australian firms over 1992-2004 is analysed. To the coefficients on discretionary and nondiscretionary separate accruals into discretionary and non- accruals reported in Subramanyam (1996) are affected discretionary components, the forward-looking model by errors in total accruals and are therefore biased. proposed by Dechow et al. (2003) is employed. To Second, Subramanyam‘s results are based on a evaluate the forecasting performance of the regression model in which earnings are disaggregated into models, both within-sample and out-of-sample aggregate cash flow from operations, discretionary forecasting tests are used. First, the explanatory power accruals, and nondiscretionay accruals. However, it is of the models is evaluated via the adjusted R2 for the unclear whether the results would hold if the direct within-sample period of 1992-2001. The forecast method cash flow components were incorporated accuracy of the models is then examined by instead of aggregate cash flow from operations in his estimating Theil‘s U-statistic and its proportions for cash flow prediction model. In particluar, cash flow the out-of-sample period 2002-2004. In addition, components provide different information in given Hribar and Collins‘s (2002) findings, this study predicting future cash flows (e.g., Krishnan and uses the cash flow approach to estimate total accruals. Largay, 2000; Cheng and Hollie, 2008; Orpurt and This study contributes to the literature in two Zang, 2009); hence, constraining coefficients on cash ways. First, by using Australian data, this study flow from operations to be equal, as per provides the first evidence on the role of discretionary Subramanyam (1996), may bias the explanatory accruals in the predictive ability of earnings for future power of the model as well as the estimated cash flows using actual cash flow components instead coefficients on discretionary and nondiscretionary of aggregate cash flow from operations. This study accruals. Finally, to the extent the level of managers‘ also extends the methodology used in Subramanyam discretions and constraints for earnings recognition (1996). To mitigate the limitations of the Jones (1991) differs across countries (Bartov et al., 2001), the model, this study uses both the modified Jones model generalisability of Subramanyam‘s findings (premised and the forward-looking model, an alternative model on the US setting) to other settings is questionable. proposed by Dechow et al. (2003). Dechow et al. In light of the above discussion, this study (2003) provide evidence that this model is more addresses the following research question: do effective than the Jones (1991) model in estimating discretionary and nondiscretionary accruals, on discretionary and nondiscretionary accruals. average, enhance the predictive ability of earnings to Second, this study relates to a growing body of forecast future cash flows in an Australian context? accounting literature on the relevance of accounting
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