Accounting Earnings, Change in Market Value and Cash Flows

Abstract

Our analyses are based on the observation that the portion of change in enterprise value captured in earnings differs according to the source of value change. These sources are: (1) cash flows to/from debt holders, equity holders, and/or cash reserves; and, (2) changes in value of assets in place (i.e., enterprise returns). We demonstrate that the effect on earnings of each source of growth captures distinct aspects of accounting conservatism. Although the effect of cash flows on earnings has received little attention in the extant literature, we show that it explains more of earnings than is explained by enterprise returns. We show that the difference in the portion of negative cf. positive enterprise returns captured in current earnings is similar to the portion of negative cf. positive equity returns reported in the extant literature. We also demonstrate an interaction between the sign of returns and cash flows.