The incremental value relevance of cash flows and earnings affected by their extremity

Abstract

Purpose In contrast to earlier studies, the most recent studies on the incremental value relevance of earnings and cash flows from operations find that both earnings and cash flows have incremental value relevance beyond each other. An interesting question that follows is whether these findings hold after controlling the extremity of earnings and cash flows. This study, therefore, aims to examine the incremental value relevance of earnings and cash flows in the following four cases: moderate earnings and moderate cash flows, moderate earnings and extreme cash flows, extreme earnings and moderate cash flows and extreme earnings and extreme cash flows. Design/methodology/approach To evaluate the incremental value relevance (information content) of earnings and cash flows for each of the four cases mentioned above, we examine the statistical significance of the slope coefficients for regression of returns on both unexpected earnings and unexpected cash flows from operations. Findings The results show that (i) both moderate and extreme earnings have incremental value relevance beyond both moderate and extreme cash flows, (ii) moderate cash flows have incremental value relevance beyond both moderate and extreme earnings and (iii) extreme cash flows lack incremental value relevance beyond moderate earnings; however, they (extreme cash flows) have incremental value relevance beyond extreme earnings. These results suggest that earnings and cash flows have incremental value relevance. However, only in cases when cash flows are extreme and earnings are moderate, cash flows do not possess incremental value relevance. In further analysis, we find that the value relevance for cash flows and earnings decreases when they are extreme and transitory. Moreover, the value relevance for cash flows increases when they are moderate (not extreme) and the other competing measure (earnings) is transitory and extreme. Practical implications The results support the idea that earnings and cash flows from operations complement each other in explaining variation in returns. However, when cash flows are extreme and less informative, investors rely more on earnings in firm valuation, especially when earnings are moderate. Because earnings are unlikely to persist to be permanent across the years, these results can be interpreted as indicating that cash flows and earnings information are used jointly by investors. Originality/value In contrast to previous studies, we control for the extremity of earnings and cash flows when evaluating the incremental value relevance of earnings and cash flows from operations.