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The Relationship between Earnings before Interest and Tax and Operating Cash Flow and Stock Return in Information Asymmetry Conditions at Pharmaceutical Companies of Abidi and DarouPakhshApplying Markov-switching Approach Hossein Parsian M.A in accounting, Raja university Amir Shams Koloukhi Department of Accounting, Torbat-e-Jam Branch, Islamic Azad University, Torbat-eJam, Iran SajadAbdipour M.A in accounting, USB university MojtabaAkbarpour M.A in accounting, USB university Abstract One of most fundamental economic issues is optimal resource allocation towards productive investment with rational risk-taking. In doing so, there is a need to performance evaluation indices, some of which emphasize upon cash flow variables and some others upon information contents of accounting earning. Therefore, it is tried to consider the relationship between earnings before interest and tax and operating cash flow and shareholders return at pharmaceutical companies of Abidi and Daroupakhsh. Then this relationship was tested in conditions of information asymmetry. In order to test hypotheses, nonlinear Markovswitching was applied. Results obtained from experimental tests using relating information from 2002 to 2011 indicate that independent variable of earnings before interest and tax has no significant relationship with stock returns of two companies. In other words, earnings before interest and tax have information content toward operating cash flow. Also by increasing information asymmetry it was observed that variable of earnings before interest and tax have more correlation with companies stock return towards variable of operating cash flow. In other words, in conditions of information asymmetry, accrual variables have more information content towards variables of cash flow. Key words: INFORMATION ASYMMETRY, ACCRUALS, CASH FLOW, TOTAL SHAREHOLDERS RETURN, MARKOV-SWITCHING APPROACH Introduction In terms of presence in the path of economic development and regarding privatization, it seems that in our country size of investment will have growing trend during future periods, while regarding information asymmetry investors need some indices to assess companies performance to make appropriate economic decisions through following them. To do so, some performance evaluation indices may be required, some of which emphasize upon variables of cash flow and some others upon information content of accounting earnings.
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Studies by Aston et al (1992)and Dichev et al (1998),Haw et al (2001), and Stephen Rapp (2010) indicate that earnings (due to additional information content in its accrual components) has more information content towards cash flows. Also at international level, Bartov et al (2001) examined earnings information content and cash flows for assessing equities in countries of US, England, Canada, Germany, and Japan. Results showed that earnings have more importance towards cash flows. However, respecting asymmetric distribution of information among people, it seems that variables of cash flow have more information content for explaining performance of companys market towards accounting earnings. Hence, it is tried in present study to examine the relationship between earnings before interest and tax and operating cash flow and shareholders return in pharmaceutical companies of Abidi and Daroupakhsh. Research theoretical considerations In opinion of most of financial statements users, accounting earning provided by using accrual system is a tool measuring performance of a company. The mean by measuring companies performance is to assess financial statements and operations results to making rational decisions.in statement no.6 for financial accounting concepts; financial accounting standards board necessitates applying accrual method in accounting. Based on this, to reflect effects of transactions and events of company doesnt mean necessarily entry and exit of cash. In other words, in accrual method, some principles such as realization and matching are applied to reflect incomes and costs and computing accounting earnings (financial accounting standards board, 1985). On the other hand, operating cash flow is one of main indices for assessing performance based on view of internaland external users of organization, especially investors and creditors. In theoretical framework, financial accounting that determines objectives of financial reporting takes special consideration to cash flows and possibility of its prediction. In statement no.1 of financial accounting concepts of financial accounting standards board it is states: One of financial reporting objectives is to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are affected by an enterprise's ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise's securities. (FASB, 1978: par.37)
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Accounting Standard no.7:

Also International Accounting Standards Committee (IASC) states in International Information about the cash flows of an entity is useful in providing users of financial statements with a basisto assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilize those cash flows. The economic decisions that are taken by users require an evaluation of the ability of anentity to generate cash and cash equivalents and the timing and certainty of their generation (IASC, 1993). Iranian Accounting Standards Committee states in the part of theoretical concepts of financial reporting: Taking economic decisions by users of financial statements require an evaluation of the ability of an entity to make cash and certainty of their generation. Evaluating the ability of generating cash is facilitated through focusing upon financial status, financial performance, and cash flows of an entity and utilizing them in predicting expected cash flows and measuring financial flexibility (Technical committee of Audit Organization,2002: 49). There are some differences between accounting earning and operating cash flows due to effect of the following factors: 1. First factor is non-cash costs (such as depreciation costs) that reduces net profit, however causes no reduction in cash value of company. 2. Second factor is time difference of income realization and receiving its payment and also to bear cost and to pay its payment. 3. Third factor refers to non-operating gain and loss resulted from sale of fixed assets,securities, and other types of investment taken into account in loss statements and may cause transition in net profit, however have no effect upon activities of cash flows statements. Figure.1 shows different states that accrual and cash systems may have towards each other. Each figure shows information available for market per moment. First state is when both gain (earning) and operating cash flow contain important information. Second one is state in which both gain (earning) and cash flow have important information but none of them contains incremental information content towards the other. Ultimately, the last state is when one of variables (for example earning (gain)) has incremental information content, but its reverse is not true(Bowen et al, 1987). In other words, it is tried in present study to consider the relationship between earning and operating cash flows and stock return, then this

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has stronger relation with shareholders returns.

relationship would be tested in information asymmetry conditions to signify that which one

Figure.1: Possible results of the study about incremental information content of cash flows and accrual flows (Bowen et al., 1987)

Accrual basis

Cash basis

Accrual basis Cash basis

Accrual basis Cash basis

ThirdstatestateSecond Literature review

First state Market information

Gambula and Ketz (1983) in their study examined the relationship between figures obtained from accrual earning and cash flows. The results of their study indicate that cash flow lack information importance compared with accounting earning (Gambula and Ketz, 1983). Rayburn (1986) in his study examines the relationship between unexpected accrual components and cash flows with stock return. The results of this study show that both components, accounting earning and cash flows, have information content (Rayburn, 1986). Wilson (1987) in a study examined the role of information content of earning components towards the values of earning itself through dividing cash and accrual components of earning. The results indicate that earnings accrual components contain incremental information content towards its cash components (Wilson, 1987). Bowen et al (1987) studied incremental information content of cash and accrual figures. The results of their study show that information related to earning and cash flows contain incremental content towards each other. Also, information related to cash flows has incremental information content towards earning (Bowen et al., 1987). Easton in his research examined relative information content of earning and cash flows. The results of this study reveal that earning has higher information content compared with cash flows (Easton et al., 1992). Dechow (1924) in his study considered accounting earning and cash flows as an index of performance evaluation. The results of this study indicates that as firm has less fluctuations in supplying its required funds, cash flows have better conditions for measuring performance. In his opinion, during short time periods (form example; three months or a year), firm;s earning has more relationship with return and cash flows. (Dechow, 1994). Hodgson and Stevenson (2000) in their research studied the relationship between earning and cash flows with stock return affected by firms size. The results of this study indicate that
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cash flows provide more additional information for firms with big size towards firms with small size. Also, smaller firms contain more unstable earning components towards bigger ones. In addition, non-linear relation between earning and cash flows has higher descriptive strength compared with when this relationship was examined as linear (Hodgson and Stevenson, 2000). Club et al. (2000) in their research examined the relationship between earning and operating cash flows with stock return in Japan from 1985 to 1993. The results of this study reveal that when earning has more unstable state, cash flows have more significant role for determining return (Club et al., 2000). Bartov et al (2001) in their study examined information content of earning and cash flows for evaluating equities interest in Us, England, Canada, Germany, and Japan. The results indicate that in US, England, and Canada earning has more significance towards cash flows but in Germany and Japan it is not as such. In other words, national method in factor reporting that effects upon information content of earning and cash flows (Bartov, 2001). Haw et al. (2001) in a study examined information content of operating cash flows, earning, and accruals in Chinas stock market. The results show that earning contains more information content towards operating cash flows and also incremental information content of discretionary accruals against non-discretionary accruals was conformed (Haw et al., 2001). Chan et al. (2006) in their study examined the relationship between accrual figures (accounting) (difference between earning and cash flows) with stock return. The results of this study indicate that stock return of firms with high accrual accounting (figures) is reduced during next period of financial information reporting (Chan, 2006). Subramanyam and Venkatachalam (2007) examined the relative significance of earning and cash flows in equity evaluation. The results show that earning may have better performance in explaining intrinsic realized value compared with cash flows (Subramanyam and Venkatachalam, 2007). Arthur et al. (2009) in their research studied information content cash flow and accruals. The results of their study indicate that earning cash components contain information content for investors and dividing earning into cash flows and accruals contains incremental information content towards disclosure of total earning figure (Arthur et al., 2009). Steffen Rapp in his research studied the relationship between accounting earning and cash flows with shareholders return in information asymmetric conditions. The results of this study show that in information asymmetric conditions, accounting earning contains more information content towards cash flows. However, through increasing information asymmetry cash flow indices are more relevant in explaining performance of stock market (Steffen Rapp, 2010).
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Analysis model

The current method for studying dynamic behavior of economic and financial variables is to use various models of time series. Among these time series models, linear models such as Auto Regression (AR) or a combination of these models(ARMA) are well known. A part of their currency may be because of easy estimation of these models through common econometric soft wares. Although they act in some cases successfully, they fail in describing non-linear behaviors such as asymmetry, etc. one of most famous non-linear time series models is Markov-switching model. This model was first introduced by Quant (1972),Quant and Goldfield (1973). Then it was developed by Hamilton (1989) to derive commercial cycles. Generally, it is assumed in non-linear models that behavior of a variable, upon which modeling has been done is different and transition in different states. In terms of speed of transition from one state to another, these non-linear models are divided into two main groups. In some of them, transition from one state to another state is slow and smooth (like model STAR3 and artificial network ANN4). In some others, the transition is done quickly that Markov-switching model is among them (Enders, 2004:404). In model of Markovswitching, probability are applied to divide time series variables, or relations between variables into two regimes or more. Method of Markov-switching is able to explain features of regimes information asymmetry because of being non-linear; hence it is more appropriate towards VAR and ARMIA. Used data in present study has been collected from audited financial statements. To do so, main part of information has been collected form software Rahavard Novin, and Tadbir Pardaz and other information has been gathered form center of research and Islamic studies management of organization of securities market and also from information bank of this organization. Software Ox Metrics Vol.6 used for statistical test. Research hypotheses Hypothesis.1: accounting variables have better performance towards variables of cash flows in explaining companies stock return performance (capital market) Hypothesis.2: by increasing information asymmetry, accounting variables play more significant role in describing companies stock return performance (capital market) compared with variable of cash flows.

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Research variables definition Research variable have been summarized in table.1

Table 1. Research variables definition

variables BETAit SIZEit Variable of size for firm at time (SIZE) is measured by logarithm of total assets MTBit The market-to-book ratio of equity of firm at time ETPit Earning per share to market stock price (firm at time ) Rit Return percentage of shareholders (firm at time ) EARit Earning before interest and tax (firm at time ) CFit Operating cash flow(firm at time ) LEVit Total dept to total asset ratio (firm at time ) For measuring information asymmetry, three virtual variables are applied as follows; MACPit: If value of companys market from the average market value of annual portfolio is greater than value of market capital, it is considered as 1, otherwise zero. INTANGit: If proportion of tangible fixed assets to total assets of company per year is greater than average value of the same proportion in annual portfolio, it is considered as 1, otherwise zero. DOMINATEDit: If floating shares of company is less than 50%, it is considered as 1, otherwise zero. Regression models related to research hypotheses are as follows; Hypothesis 1: Hypothesis 2: =0+1it+2CFit+1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy MACPit + =0+1it+2CFit +1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy INTANGit+ e0 =0+1it+2CFit +1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy DOMINATEDit+ e0 =0+1it+2CFit+

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Data analysis

First step for estimating the model in Markov-switching method is making sure that data model is non-linear. Therefore, LR test was applied and the results were presented in table.2. Table 2. Results of LR test Firm Statistics Probability Abidi 623.74 0.000 Daroupakhsh 579.04 0.000 As shown in results of the table above (by comparing value of statistic of LR test with critical value) considered variables follow a non-linear model. Therefore, linear method for estimating models parameters is not suitable and applying non-linear method is better for obtaining relation between variables. Therefore, in this study Markov-switching non-linear model has been applied. Results obtained from estimating model of hypothesis.1 in Markovswitching are provided in Table.3. Table.3: Results of estimating model of hypothesis.1 in Markov-switching method Abidi

coefficient statistics 24.5 0.0184 0.00145 0.00036 coefficient -0.0487 -0.0168

variables EAR CF variables EAR CF

Sig. 0.000 0.986 Sig. 0.042 0.667

Daroupakhsh

statistics -2.30 -0.475

Results of estimating model of hypothesis.1 for company of Abidi indicate that effect of independent variable of earning before interest and tax upon companys stock return, 0.00145 is positive and significant. In company of Daroupakhsh, effect of variable of earning before interest and tax upon stock return, -0.04872, was negative and significant in error level of 5%. In addition, operating cash flow has no significant effect upon stock return in both companies.

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table.4.
Table 4.Results of estimating model of hypothesis.1 in Markov-switching method When virtual variable Dominated added Abidi Variable Coefficient Sig. EAR 0.00225 0.000 CF -0.00112 0.000 When virtual variable Dominated added Variable EAR CF Coefficient -0.00227 0.00075 Sig. 0.000 0.000 When virtual variable Intang added Variable Coefficient Sig. EAR 0.002149 0.000 CF 0.0003 0.000 When virtual variable Intang added Variable EAR CF Coefficient -0.00222 0.00074 Sig. 0.000 0.000

Results obtained from estimating model of hypothesis.2 in Markov-switching are presented in

When virtual variable Macp added Variable Coefficient Sig. EAR 0.002289 0.000 CF -0.000326 0.000 When virtual variable Macp added Variable EAR CF Coefficient -0.00219 0.00073 Sig. 0.000 0.000

Darupakhsh

As shown in table.4, after adding virtual variables as representatives for information asymmetry, the relationship between independent variables with stock return changed for both companies, so that a significant relationship is observed between independent variable of earning before interest and tax and operating cash flow and companys stock return. Also, it is observed by comparing coefficients (factors) of earning before interest and tax and operating cash flow that in all cases, factor of earning before interest and tax is greater than factor of operating cash flow. In other words, in conditions of information asymmetry, variables of cash flow have more correlation with companies stock return towards accrual variables. In figure.2 probability of each regime per year is shown.

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2-1-1: company of Abidi- through adding virtual variable of Macp Fig.2: probability of each regime

2-1-2: company of Abidi- through adding virtual variables of Intang and Dominated.

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Dominated.

2-2: company of Daroupakhsh- through adding virtual variables of Macp, Intang, and

Respecting figure.2, years of study are categorized and summarized intable.5. Table 5. categorization of years of study by considering regime Abidi Years categorized in each regime Studied When virtual variable When virtual variable regime Dominated added Intang added Regime 1 2002, 2004, 2005, 2002, 2004, 2005, 2008, 2009 2008, 2009 Regime 2 2003, 2006, 2007, 2003, 2006, 2007, 2010, 2011 2010, 2011 Darupakhsh Years categorized in each regime Studied When virtual variable When virtual variable regime Dominated added Intang added Regime 1 2003, 2005, 2006, 2003, 2005, 2006, 2009, 2011 2009, 2011 Regime 2 2002, 2004, 2007, 2002, 2004, 2007, 2008, 2010 2008, 2010

When virtual variable Macp added 2002-2004, 2011 2003

When virtual variable Macp added 2003, 2005, 2006, 2009, 2011 2002, 2004, 2007, 2008, 2010

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time t+1 for each company is shown.

At the end, in table.6 probability of transition from a regime at time t to another regime at

Table6. probability of transition from a regime at time t to another regime at time t+1 Abidi Regime probability Regime 1 in period t + 1 Regime 2 in period t + 1 Darupakhsh Regime probability Regime 1 in period t + 1 Regime 2 in period t + 1 Regime 1 in period t 0.49951 0.50049 Regime 1 in period t 0.49976 0.50024 Regime 2 in period t 0.49951 0.50049 Regime 2 in period t 0.49976 0.50024

Table.6: probability of transition from a regime at time t to another regime at time t+1 Conclusions Research results show that in pharmaceutical company of Abidi and company of Daroupakhsh, independent variable of earning before interest and tax has a significant relationship with stock return of both companies. It is the case that variable of operating cash flow has no significant relationship with stock return of both companies.in other words,Results of adding these two variables are the same; therefore further representation of diagram is avoided. Results of adding these three variables are the same; therefore further representation of diagram is avoided.Interest and tax contain information content towards operating cash flow. By increasing information asymmetry it is observed that variable of earning before interest and tax has stronger relationship with companies stock return towards variable of operating cash flow. In other words, in conditions of information asymmetry, accrual variables have more information content compared with variables of cash flow. Results of this research are similar to those of studies by Gambula and Katz (1983), Easton(1992) and Haw et al (2001) indicating that accounting earning has more information content towards cash flow. However it has some contrast with research by Stephen Rapp (2010) indicating that through increasing information asymmetry, cash variables are more relevant towards accrual variables. Results of this research shows that earning (due to additional information content within its accrual components) contain more information content towards cash flows and investors should take this important point into consideration in their decisions.

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References

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