Abnormal Accruals and the Predictive Ability of Future Cash Flows: Evidence in China

AbstractThis paper examines the information contents of discretionary (abnormal) accruals under Chinese evidence during 2008 to 2012, whether they could provide superior insight into future cash flows beyond that conveyed through traditional earnings components (current cash flows and accruals items). In particular, this research extends Subramanyam's34 study to estimate abnormal accruals using modified Jones model, which focused on working capital accruals and developed Barth et al's6 model to disaggregate total accruals into components to identify a measure for unexplained future cash flows. These represent the portion of future cash flows that may be considered 'abnormal' in the sense that it is not explained by current earnings components.The results reveal that disaggregation of total accruals can improve the prediction of reported earnings and present a significant positive association between current values of abnormal accruals and one-year-ahead values for unexplained future cash flows. This suggests that abnormal accruals contain information regarding the unexplained part of future cash flows and may provide a rationale for the pricing of abnormal accruals by the market.34,35 It also finds that firms with extreme positive abnormal accruals exhibit positive abnormal cash flows in the following year, possibly indicating that managers may use accruals to signal future performance.Keywords: Abnormal accruals, future cash flow, working capital accruals, earnings components.(ProQuest: ... denotes formulae omitted.)IntroductionThe valuation of a firm can be affected by the aggregate value of future cash flows, so the forecasting of future cash flows is an essential issue of corporate valuation and investment analysis. The Financial Accounting Standards Board (FASB) maintains that financial reporting should provide investors and creditors with information that can help them assess a firm's prospect as proxy for future cash flow, meanwhile, the use of accmal accounting to constmct accounting earnings is intended to give a superior insight into future cash flows than could be gleaned from current cash flow data alone1.The reason is due to timing and mismatching problems inherent in measuring cash flows over short intervals can be mitigated through accmal accounting13. Previous literature has verified this opinion.Bernard8 concluded that earnings provide incremental information content for cash flow forecast. Ali and Pope4 analyzed and drew conclusions about existence of relationship between earnings components: operating cash flows, normal and abnormal accmals and found accruals are more informative for explaining future cash flows than current operating cash flows using UK data. Additionally, Dechow et al15 have developed the model to measure relationship between earning, accmal and cash flows and indicated that accmal is capable to predict future cash flows under US evidence.However, managers may use accmals to manage earnings opportunistically and thereby adversely affect the quality of reported earnings with regard to conveying information on future cash flows. Even in the absence of deliberate manipulation by managers, large accmals may be associated with a reduced quality of reported earnings due to increased measurement errors in managers' accmals estimates: this point has been noted in studies by Dechow and Dichev14, Richardson31, Bharath et al10 and Malacrida et al27. Indeed, many comment that high degree of subjectivity and flexibility involved in accmal adversely influence its forecasting ability and more often discretionary earning management would take place.6,24 Dechow and Dichev14 hypothesize that if abnormally large accmals are associated with high levels of estimation error then such accmals will not map into realized future cash flows to the extent that would normally be expected of accmals data.Different with the above perspective, some researches support that abnormal accmals are capable of enhancing information content for predictability of future cash flows. …