Incremental Information Content Research Articles

The Valuation‐relevance of Earnings and Cash Flows: an International Perspective

We investigate which variable, earnings or cash flows, provides greater information for equity valuation within the United States, the United Kingdom, Canada, Germany, and Japan. We regress returns on earnings and cash flow metrics. We generally find earnings developed in three Anglo‐Saxon countries—where capital is traditionally raised in public markets and reporting rules are unencumbered by taxation requirements—to have greater explanatory power for stock returns than cash flow metrics. Conversely, in two non‐Anglo‐Saxon countries—where capital is traditionally raised from private sources—earnings are generally not superior to cash flows for equity valuation, except in Japan, non‐consolidated sample. While sensitivity analyses generally support the conclusions of our primary tests, in some of the additional analyses, earnings were superior to cash flows for samples from all countries. As expected, in all countries earnings have incremental information content over cash flows in explaining returns. Collectively, our findings provide two contributions. First, we generalize the findings of prior US research by showing that earnings are more important than cash flows for equity valuation in other Anglo‐Saxon countries. Second and more importantly, our findings demonstrate that the superiority of earnings over cash flows is not universal. Rather, it depends on the national reporting regime and attendant institutional factors.

Accounting‐based Valuation of Polish Listed Companies

This study examines the value relevance of the new accounting system in Poland. Using a model derived from the Edwards‐Bell‐Ohlson valuation framework, the relation of current earnings and lagged book values with the stock prices of Polish listed companies is tested. The accounting data are derived from the financial statements prepared under The Act on Accounting of 1994, which assured a full compliance of the Polish accounting standards with the European Union directives. The results show that both current earnings and lagged book values are positively and significantly related to prices, and the magnitude of this relation is comparable to that reported in more advanced markets. Also, the incremental information content of lagged book value is greater than that of current earnings.

Accounting Practices and the Market Valuation of Accounting Numbers: Evidence from Indonesia, Korea, Malaysia, the Philippines, Taiwan, and Thailand

This study examines the relation between stock prices and accounting earnings and book values in six Asian countries: Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. The analysis is based on a residual earnings model that expresses the value of the firm in terms of book value and residual income. The model holds for any clean surplus accounting system. However, for finite time horizons, biased accounting may affect model estimates. The six countries examined in this study differ in faithfulness to clean surplus accounting as well as bias (conservatism). The study addresses two questions. First, are there systematic differences across countries in the value relevance of accounting, and are these differences related to accounting differences? Second, are there systematic differences in the incremental and relative information content of book value per share (BVPS) and abnormal (residual) earnings per share (REPS) across the countries, and are such differences related to accounting differences? We find differences across the six countries in the explanatory power of BVPS and REPS for firm values. Explanatory power for Taiwan and Malaysia is relatively low while that for Korea and the Philippines is relatively high. These differences are generally consistent with differences in accounting practice; however, since Korean accounting practice is strongly influenced by tax law, we did not expect the high association for Korea. Second, with respect to the incremental and relative explanatory power of BVPS and REPS, we find BVPS to have high explanatory power in the Philippines and Korea but little in Taiwan. In all six countries REPS has less explanatory power than BVPS in most years. Again, the evidence may be interpreted as suggesting accounting practice affects valuation (with Korea again as the exception). Finally, we provide evidence on the sensitivity of the timing of comparisons of stock prices and accounting values. We find that comparing prices at year-end (even though annual accounting information has not been released at that time), in general, provides the highest correlation between market and accounting numbers.

Earnings, cashflows and returns: Functional relations and the impact of firm size

The relation between stock returns, earnings and cashflows is of importance because it directly addresses the issue of whether accounting data provide value relevant information. The empirical evidence to date, however, has documented low explanatory power for earnings and inconclusive incremental information content for cashflows. This research re‐evaluates the incremental information content debate using Australian data. Our research is motivated by: recent innovations in research design, including the specification of nonlinear functional relations between accounting variables and prices, and the fact that differences in firm size characteristics may influence the relative information content of the accounting variables. We observe that: (i) a nonlinear functional relation provides greater explanatory power for both earnings and cashflows;(ii) the results are consistent with more transitory earnings components for smaller firms; and (iii) contrary to received theory, cashflows add greater incremental explanatory power for large firms.

Cash Flows vs. Earnings in the Valuation of Equity REITs

Executive Summary. This article examines the incremental information content of net income and cash flows for equity real estate investment trusts (REITs). REITs provide a natural setting for investigating which measure, earnings or cash flows, provides a better summary statistic of corporate value. No formal empirical analysis has been conducted for REITs however, and existing research for public firms in general provides mixed results.Using three alternative models, we find funds from operations (FFO) has a higher information content than net income, and contains incremental information beyond that contained in net income. Our results support the usefulness of the FFO measure for REITs.

The Incremental Information Content of SEC 10-K Reports Filed under the EDGAR System

This paper examines the incremental information content of disclosures in the 10-K reports filed with the SEC through the EDGAR system with a research design that explicitly controls for cross-sectional differences in the informativeness of current and prior disclosures. More specifically, we investigate (1) whether stock returns exhibit abnormal behavior when the 10-K reports are filed with the SEC through the EDGAR system and (2) whether there exist preemptive and delayed market responses to disclosures in these reports. We also run tests for the pre-EDGAR 10-K reports submitted through the paper filing system to compare our results with those of prior studies. Our empirical results indicate that the 10-K report filed through the EDGAR system contains incremental information while the 10-K report filed through the prior paper filing system does not. This provides empirical evidence in support of the advantage of the EDGAR system over the previous paper filing system in disseminating information to investors in a timely fashion.

An examination of the information content of Danish earnings and cash flows

This study examines the information content of earnings and cash flows on the basis of Danish data. The study is motivated by the recent implementation of the Danish cash flow standard RV 11. No prior studies have examined the information content of Danish cash flows. In addition, the results of non-Danish cash flow studies are not consistent. Thus, there is no clear evidence as to whether cash flows have incremental information content beyond that of earnings. Finally, most cash flow studies focus only on cash flow from operations (CFO). This study also examines the information content of cash flow after investments (CFAI) and net cash flow (NCF). The results of the various tests are generally consistent with the following statements: (1) earnings are relatively more informative than cash flows; (2) the aggregated effect of cash flows has incremental information content beyond that of earnings; (3) after controlling for the effect of earnings, CFO (NCF) is negatively (positively) associated with the contemporaneous annual stock return at conventional significance levels. The coefficient on CFAI is not statistically different from zero; (4) over longer return intervals, the incremental information content of cash flows beyond earnings is maintained.

THE IMPACT OF THE QUALITY OF EARNINGS ON THE VALUATION RELEVANCE OF CASH FLOW DISCLOSURES

This study investigates whether the ‘quality of earnings’, defined as the relationship between profitability and cash generating ability, is a conditioning factor with regard to the valuation relevance of cash flow disclosures. The study is performed on a sample of 197 British firms employing data over a 23-year period. The results of the study support the contention that the valuation relevance of cash flow disclosures is conditional upon the ‘quality of earnings’, as previously defined. Specifically, the decomposition of unexpected earnings into its cash flow and accruals components provides incremental information content to earnings when the firm-specific time-series correlation between earnings and cash flows is low. Furthermore, the cash flow ‘surprise’ is valued more than the accruals ‘surprise’ when the firm-specific time-series correlation between earnings and cash flows is low.

Trends In Earnings, Book Value And Stock Price Relationships: An International Study

Prior international studies that investigate the relative usefulness of accounting information have focused either on the incremental information content of earnings reconciliation, or the relative information content of accounting numbers across countries. Using a sample of 13 countries, this paper extends the literature by providing empirical evidence on whether the value relevance of accounting numbers in different countries has changed over time and whether the patterns of changes differ across countries. In particular, the study analyzes factors that may cause the differences among countries. The study finds that there are differences in value relevance of accounting information across countries, and that these differences may be explained by disclosure practices and market efficiency.

Evidence on the Incremental Information Contained in the Components of Restructuring Charges

In response to the dramatic increase in corporate restructurings and perceived abusive accounting practices, the Emerging Issues Task Force (EITF) released Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring (EITF 94-3), in 1994. Among the new disclosures required by EITF 94-3 is the requirement that firms disclose the nature and amounts of the material components of a restructuring charge. Implicit in this requirement is the EITF's assumption that such disclosure provides incremental information to financial statement users. The usefulness of these disclosures, however, is subject to an ongoing debate. Recent Securities and Exchange Commission (SEC) staff comments suggest that the inadequacy of restructuring disclosures render the disclosures uninformative. The purpose of this paper is to assess whether one requirement of EITF 94-3 is informative to financial statement users. Specifically, this study empirically investigates whether the reporting of material components of a restructuring charge provides incremental information to financial statement users beyond that contained in the aggregate charge. This study measures incremental information content in the form of differences among the components of the restructuring charge as they relate to analysts' earnings forecast revisions. The hypothesis (stated in alternative form) is that the components of the restructuring charge convey differential information to analysts on firms' future prospects. This study evaluates this hypothesis with full (reduced) form regressions of analysts' forecast revisions on the reported components of (aggregate amount of) restructuring charges. The primary empirical findings of this paper suggest that the components of restructuring charges are informative. The results suggest that the EITF was justified in mandating that the material components of the charge be disclosed. Further analysis indicates that the quality of the restructuring disclosure and/or the motive of management for taking the charge has an effect on the informativeness of the restructuring charge components. Thus, the results also provide support for the SECs stance that further regulatory guidance is necessary with respect to restructuring disclosures.

The Accuracy and Incremental Information Content of Audit Reports in Predicting Bankruptcy

A series of corporate failures in which auditors failed to warn about impending bankruptcy led to widespread criticism of the UK auditing profession during the last recession. For a sample of 976 quoted companies (1987–94), this paper shows that there are two reasons why audit reports were not accurate or informative indicators of bankruptcy. First, audit reports poorly reflected publicly available information about the probability of bankruptcy. Secondly, strong persistence in audit reporting reduced the accuracy of audit reports

Earnings, Cash Flows and Security Returns Over Long Return Intervals: Analysis and UK Evidence

The aim of this paper is to provide a fuller understanding of the process linking security returns and accounting data by focusing on the effect of long return intervals on the association between security returns and earnings and cash flow variables. First, we develop a theoretical basis for empirical analysis of the relationship between security returns and cash flow data over long return intervals. Second, we carry out empirical analysis of both the information content of cash flow variables and the incremental information content of accounting earnings and cash flows using UK data over the period 1985–92 for annual, two year and four year return intervals. Our results provide strong evidence of the valuation relevance of cash flow information for the dataset examined.

The information content of funds from operations (FFO) for real estate investment trusts (REITs)

This paper examines the information content of alternative summary performance measures, using stock returns as the benchmark, for 138 REITs during 1994–1996. This paper tests for both incremental and relative information content of FFO (a voluntarily disclosed, accounting-based performance measure that is the industry standard for REITs) compared to GAAP net income (EPS), cash from operations, and earnings before interest, taxes, depreciation and amortization. Results indicate that both FFO and EPS consistently provide incremental information content with only weak evidence that EPS has greater relative information content and no evidence for the other summary performance measures.

The Value Relevance of Accounting Information in Thailand around the 1997 Decline in the Value of the Baht

This study examines the value relevance of financial accounting in Thailand prior to and during the decline in the value of the Baht in July 1997. The study examines the association between security prices from the Stock Exchange of Thailand and accounting book values and earnings from first quarter 1992 through third quarter 1997. Our results show that Thai earnings and book values are positively and significantly related to security prices although to a lessor extent than for United States and British firms. Thai book values and earnings each have incremental information content relative to the other. We find that the value relevance of book values in Thailand are increasing significantly over time, particularly after the decline in the value of the Baht in July 1997. However, the number of Thai firms reporting losses increased in the second and third quarters of 1997. Thus, our evidence that the value-relevance of Thai book values increased is consistent with evidence from US firms that value relevance shifts from earnings to book values when earnings are negative. We find no evidence, however, of change in the value relevance of earnings.

Dividend Reductions and Interim Effect: UK Evidence

Short-term price reactions to dividend reductions of UK firms that did not reduce their dividends in the previous three-year period are studied. Price reactions to interim and final dividend reductions are found to be significantly negative and stronger for interim dividend reductions. Though market reacted negatively around final dividend reduction announcements it bounced back to its prior level within one month of announcements. The magnitude of price reactions to dividend reductions is found to be statistically related to the size of the dividend reduction, the post-announcement effect from day 2 to day 20, the gearing ratio and dummy variable interim versus final dividend reduction. Interim dividend reductions were found to have incremental information about future annual earnings changes. No incremental information content was found for the final dividend reductions; however, they have information content when included as the only independent variable.

The Relation of Firm Market Values with Book Values and Residual Accounting Earnings in Six Asian Countries

We examine the relation between stock prices and accounting numbers across six Asian countries: Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. Accounting practice in the six countries differs in faithfulness to clean surplus accounting and in bias (conservatism). We address two questions. First, are there systematic differences across the countries in the value relevance of accounting? Second, are there systematic differences in the incremental and relative information content of book values and abnormal (residual) earnings per share (REPS) across the countries? We also examine whether differences are related to accounting differences. We find differences across the six countries in the value relevance of accounting numbers. Explanatory power for Taiwan and Malaysia is relatively low while that for Korea and the Philippines is relatively high. Second, we find book value to have high explanatory power in the Philippines and Korea but little in Taiwan. REPS had less explanatory power than book value (and less than EPS) in all six countries.

The usefulness of earnings in explaining stock returns in an emerging market: the case of Cyprus

The paper presents evidence that earnings levels as well as changes in earnings are important in explaining stock returns in an emerging stock market. The study employs data on all listed firms in the Cyprus Stock Exchange over the ten-year period 1985-1994. Operating cash flows have no incremental information content beyond earnings. Earnings is more informative for larger firms consistent with the notion that accounting information by larger firms is perceived as being more reliable. Moreover, the earnings–returns relationship is not linear, being stronger for positive earnings levels and changes than for negative. Finally, the usefulness of earnings is statistically higher in the later half of the sample period. Overall, the results suggest that investors price earnings information in this emerging market.

Portfolio aspects of segment identification

Despite the enactment of accounting standards on segmental reporting around the globe, the question of segment identification still remains unresolved. The current debate between the FASB and IASC on whether a managerial or risk-return approach is most beneficial to users underscores the importance of the issue. In this paper a measure of firm diversification is developed which provides a clear and unambiguous measure of the potential incremental information content of segmental data over consolidated disclosure. The analysis shows how this measure can be utilised to guide decisions as to the most appropriate and informative categorisation of operational units into reportable segments for external users.

Distortion effects and extreme observations in empirical research: An analysis of the incremental information content of cash flows

AbstractLinear regression models are used in a number of studies examining the presence or absence of incremental information content in cash flows. The results of these studies are not consistent. This paper provides evidence of the impact that extreme observations can exert on parameter estimates in a regression model. Two techniques commonly used to address the problem of extreme observations are considered. These techniques, winsorising the data and trimming the data, are compared to a regression diagnostic technique, Cook's distance. The comparison of these techniques provides evidence that the choice of technique can determine the significance or otherwise of regression results. This paper concludes that the inconsistency in reported results examining the incremental information content in cash flows may be attributed to the techniques adopted to address the issue of extreme observations.

The Incremental Information Content of Accruals: Evidence Based on the Exponential Smoothing of Levels and Trends in Pre‐Tax Earnings, Funds Flow and Cash Flow

By arranging the accrual accounting identity as a hierarchy of market response models, this paper investigates whether current and noncurrent accruals have incremental information content beyond earnings. The results indicate that the increase in explanatory power attributable to funds flow and cash flow disclosure can be improved upon by estimating the surprises in reported numbers by exponentially weighting prior values. The unexpected information simplifies to the weighted sum of deviations from the estimated level and estimated trend. Further improvements are obtained by allowing components of the error to vary with time and by company in a non‐autoregressive, homoscedastic pooling scheme which takes account of the joint presence of time series disturbance and cross sectional disturbance.