The value‐relevance of earnings and operating cash flows during mergers

Abstract

This paper examines the value relevance of operating cash flows in consideration of potential weaknesses in earnings quality in the context of a merger. When two firms merge, the earnings stream is altered reflecting the new entity that is created thus, making the prediction of future earnings challenging due to weaknesses in the quality of earnings. The quality of generally accepted accounting principle (GAAP) earnings, has recently been questioned by investors, analysts, and regulators. The difficulty with merged firm earnings has been exacerbated because, prior to June 2001, generally accepted accounting principles (GAAP) allowed firms to account for a merger using either the purchase or the pooling method of accounting. While the pooling method has been eliminated, this paper hypothesizes that difficulties arising from the purchase method of accounting will still exist and will continue to reduce the role of earnings in explaining security returns, and, consequently, the value‐relevance of operating cash flows is expected to increase as investors search for additional means to explain security returns. This paper finds that in the year of the merger, operating cash flows provide valuerelevant information beyond earnings. This finding supports the hypothesis that the quality of earnings in the year of the merger is difficult to interpret, and given this weakness, cash flows can aid in the explanation of abnormal security returns. Additional analyses indicate that the value‐relevance of operating cash flows is positively associated with the purchase method of recording the merger. This result is consistent with operating cash flows assuming a more important role in firm valuation when the difficulties in estimating the merged firm’s earnings are more severe. These findings also suggest that earning’s quality is more value relevant in a non‐merger year than in a merger year.