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Accruals and the prediction of future cash ows

Empirical evidence from an emerging market
Ibrahim El-Sayed Ebaid
Department of Accounting, Faculty of Commerce, Tanta University, Tanta, Egypt
Abstract
Purpose The purpose of this paper is to examine the comparative abilities of current period cash ows and earnings (and its components) to predict one-year-ahead cash ow from operations in Egypt. Design/methodology/approach The study uses the cash ow prediction models developed by Barth, Cram, and Nelson to examine the predictive abilities of earnings and cash ows for future cash ows. The rst set of prediction models uses cross-sectional regression to compare the predictive abilities of cash ows and aggregate earnings for one-year-ahead cash ow from operations. The second set of prediction models tests whether disaggregating earnings into cash ows and the major components of accruals enhances the predictive ability of earnings for one-year-ahead cash ow from operations. Findings The ndings of the study reveal that aggregate earnings have superior predictive ability than cash ows for future cash ows. Also, the results reveal that disaggregating accruals into major components changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals signicantly enhances predictive ability of earnings. Research limitations/implications The study provides empirical evidence on the superiority of earnings in predicting future cash ows. The ndings of the study should be considered in explaining the results of value relevance research Egypt. However, owing to relatively small sample size, given the thinness of the Egyptian capital market, these ndings should be interpreted with caution. Originality/value The paper contributes to the limited body of research on the superiority of earnings and cash ows in predicting future cash ows by examining the predictive abilities of earnings and cash ows for future cash ows in Egypt as one of many emerging markets. Keywords Earnings, Cash ows, Accruals, Cash ow prediction, Egypt Paper type Research paper

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Management Research Review Vol. 34 No. 7, 2011 pp. 838-853 q Emerald Group Publishing Limited 2040-8269 DOI 10.1108/01409171111146715

Introduction The predicting of rms future cash ows is a fundamental issue in accounting and nance given that the value of rms securities depends upon its ability to generate cash ows. For this reason, Financial Accounting Standards Board (FASB) (1978; paras 37-9) states in Statement of Financial Accounting Concepts No. 1 that the primary objective of nancial reporting is to provide information that help investors, creditors, and other users in assessing the amount and timing of future cash ows. FASB further asserts that information about rms earnings and its components measured by accrual accounting generally provides a better indication of rms future cash ows than does information about current cash ows (FASB, 1978; para 44). International Accounting Standards Board (IASB) has also endorsed accrual accounting in its framework for the preparation and presentation of nancial statements. The IASB states that the accrual-based nancial statements provide

the type of information about past transactions and other events that is most useful to users in making economic decisions. Since the FASBs contention of accrual-based earnings superiority in predicting future cash ows, one fundamental question that has occupied much of the researchers attention is whether current earnings has superior ability over current cash ows when predicting the rms future cash ows. However, the empirical evidence to date on the superiority of earnings and cash ows in predicting future cash ows remains inconclusive. A vast literature indirectly examines the FASBs assertion of the superiority of earnings in predicting future cash ows by examining the association between accounting earnings and stock prices (returns) and suggests that this association has been decreased over time (Ryan and Zarowin, 2003; Jones, 2003; Brown et al., 1999; Ely and Waymire, 1999; Francis and Schipper, 1999; Lev and Zarowin, 1999; Collins et al., 1997). One explanation of this deteriorated association between earnings and stock prices (returns) is the decreased ability of earnings to predict future cash ows since the stock price is the present value of future cash ows. In contrast, Kim and Kross (2005) investigate the relationship between earnings and one-year-ahead operating cash ows from 1973 to 2000 suggesting that while the explanatory power of return-earnings regression has decreased over last decades, the ability of current earnings to predict one-year-ahead operating cash ows has signicantly increased over the same period. Another stream of prior research directly examines the FASBs assertion that information in earnings has predictive power for future cash ows more than current cash ows by comparing predictive abilities of earnings and cash ows for future cash ows. However, the results of this research are also mixed. While some studies (Kim and Kross, 2005; Barth et al., 2001; Dechow et al., 1998; Murdoch and Krause, 1990; Greenberg et al., 1986) suggest that earnings have superior predictive ability than cash ows for future cash ows, other studies (Lorek and Willinger, 2009; Finger, 1994; Bowen et al., 1986) provide evidence that cash ows are better predictor of future cash ow from operations than earnings. While prior research examining the predictive abilities of earnings and cash ows for future cash ows is immense in developed markets (especially, the USA), little is empirically known about this issue in thin/emerging markets. Extension of prior research ndings to thin/emerging capital markets is not a straightforward task. Thin and emerging capital markets have different characteristics from those of mature capital markets. Thin and emerging capital markets have fewer numbers of registrants, less mature investors, less efcient processing of information, less demanding disclosure requirements, and less enforcement of established disclosures. In addition, local accounting rules are in a transition from serving national planning purposes to being useful for investment decisions. As a result of these differences in characteristics, one would be cautious in generalizing research ndings in developed markets to thin and emerging ones. Therefore, examining the predictive abilities of earnings and cash ows for future cash ows in emerging markets is of particular interest. The purpose of this study is to contribute to the literature by examining comparative predictive abilities of current period cash ows and earnings (and its components) for one-year-ahead cash ow from operations in Egypt as one of emerging markets that has not been examined before. In fact, Egypt is an interesting case where there are different predictions about accounting earnings as a superior measure of rm performance.

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In the 1990s, Egyptian Government introduced the economic liberalization to move the economy to free market economy. Privatization program was initiative and the Egyptian Stock Exchange reopened in 1992 in order to help rms raise capital for growth and investment opportunities and provides local investors with the opportunity to invest their savings and participate in the privatization process through ownership of stocks of listed rms. Another goal of the reopening of the Egyptian Stock Exchange was to attract foreign direct investment to help in the economic development and growth. In order to enhance the reliability of the market, the Egyptian Government issued the Capital Market Law 95/1992. The L95-1992 established the capital market authority (CMA), a controlling body resembling the Securities and Exchange Commission in the USA. The CMA controls the registration and disclosure of companies. CMA also oversees the behavior of security brokers and enforces transactions law. However, Egyptian capital market is characterized by a small number of listed rms, low trading volume, and the prominence of unsophisticated investors. Under the L95-1992, registrants are required to le their audited nancial statements (i.e. income statement, balance sheet, cash ow statement, and notes on accounts) with the CMA within three months from the scal year end and publish a summary of them in two newspapers at least one of them in Arabic. In fact, the nancial statements are the main source of information available to investors in Egyptian capital market. The nancial analysis industry is only at an early stage of development, and listed rms do not disclose earnings forecasts. Thus, most transactions in Egyptian capital market are made based on accounting data, especially, earnings. Therefore, the importance of earnings for market pricing is very high and functional xation on earnings is very common in stock pricing (Hassan et al., 2009; Ragab and Omran, 2006) in Egypt. The characteristics of Egyptian capital market mentioned above indicate to the high importance of earnings as a superior summary measure of rm performance. On the other hand, Egyptian Government, as a part of reform process, pursued a policy of harmonization between Egyptian Accounting Standards (EAS) and International Accounting Standards (IAS). The implementation of IAS was conceived as a gradual process. In October 1997, Decree No. 503 of the Minister of Economics was issued to establish 24 EAS based on IAS with some adaptation for local conditions. As from 1998, all listed companies in Egypt were required to comply with this new set of EAS. In the late 2006, a new set of EAS was issued pursuant to the Decree No. 243 of the Minister of Investment and, thus, replace the old set issued under the Decree No. 503/1997. This new set of EAS includes 35 EAS based on International Financial Reporting Standards (IFRS) (2005 version). As from 2007, all listed companies in Egypt were required to comply with this new set of EAS in preparing their nancial statements. However, prior research (Daske et al., 2008; Burgstahler et al., 2006; Bushman and Piotroski, 2006; Ball et al., 2000, 2003; Leuz et al., 2003) has documented that nancial reporting practice under a given set of standards is sensitive to the incentives of managers responsible for nancial statements preparation. These studies argue that IFRS, as principles-based standards, involves considerable judgment and provides managers with substantial discretion. The use of this discretion is likely to depend on their reporting incentives, which are shaped by the institutional structure of the country in which rms are domiciled including countrys legal/judicial system, securities laws, political economy, various market forces, and tax regime.

In fact, Egypt is a code-law country where accounting standards are established and enforced by government, nancial system of Egypt remain bank-oriented with a small number of banks providing the main part of rm nancing, there is a weak level of investor protection, and high conformity between nancial reporting and taxation. These attributes of the code-law countries give preparers incentive to issue low-quality nancial reports despite the mandating adoption of high-quality accounting standards (IFRS). Leuz et al. (2003) nd that rms in countries with weak investor protection engage in more earnings management. Ball et al. (2003) suggest that in weak regulatory environments, the mean level of nancial reporting quality tends to be driven by managers incentives rather than the strength of the countrys nancial reporting standards. The adoption of high-quality accounting standards does not confer benets upon users of nancial information unless managers comply with the new standards, which in turn may require that there is a strong system of enforcement in place (Tweedie and Seidenstein, 2005). Daske et al. (2008) nd that the capital market benets of IFRS adoption only arise in either markets with strict enforcement regimes or markets that have institutional environments which provide incentives for transparency. Emerging markets, such Egypt, tend to rank lower than developed markets in terms of the strength of their regulatory environments. Egyptian CMA does not have an effective mechanism for monitoring compliance with IFRS or for punishing registrants for violation; there is no effective regulatory mechanisms exist for imposing sanctions on audit rms who fail to comply with IFRS. Prior research (Samaha and Stapleton, 2008; Abd-Elsalam and Weetman, 2003; Dahawy et al., 2002) examining nancial reporting practice of Egyptian-listed rms has shown that the noncompliance with IFRS is the norm. In summary, Egypt has accounting standards (IFRS) that are generally viewed as high-quality, but it has institutional structures that give preparers incentive to issue low-quality nancial reports. Therefore, there are reasons to be skeptical about the quality of earnings as a measure of rm performance in Egypt despite the mandating adoption of IAS. Specically, to the extent earnings can be signicantly manipulated, earnings are expected to be relatively poor performance measure and, thereby, poor predictor of future cash ows. Based on a sample of Egyptian-listed rms for the period from 1999 to 2007 and based on the cash ow prediction models developed by Barth et al. (2001), the results reveal that current earnings have superior predictive ability than current cash ows for one-year-ahead cash ow from operations. Also, consistent with Barth et al. (2001), the results reveal that disaggregating earnings into cash ow and major accrual components changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals signicantly enhances predictive ability of earnings for future cash ows. The remainder of the study is organized as follows. Second section provides a summary review of prior literature and development of research hypothesis, third second provides details on the research design, fourth section contains the research results, and the nal section presents the research conclusion. Literature review and hypothesis development The role of accrual earnings in predicting future cash ows is a fundamental issue underlying nancial reporting (Barth et al., 2001; Francis and Schipper, 1999). However, prior research that addresses this issue presents mixed and contradictory results.

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The rst stream of prior research addresses the aggregate earnings predictability for future cash ows. Bowen et al. (1986) examine the ability of earnings compared to ve measures of cash ows to predict one- and two-periods ahead cash ow from operations. Depending on the data for the period 1971-1981, the results suggest that cash ow measures, especially, working capital from operations and net income before extraordinary items and discontinued operations plus depreciation and amortization, have superior predictive ability to predict cash ow from operations than earnings. Other studies (Quirin et al., 1999; Percy and Stokes, 1992; Arnold et al., 1991) use the prediction models developed by Bowen et al. (1986) and suggest similar results. Greenberg et al. (1986) examine predictive horizons of one to ve years and use up to three years of lagged predictor variables, depending on the data for the period 1963-1982, they nd that earnings have greater predictive ability than cash ows to predict cash ow from operations. Based on the data for the period 1966-1998, Murdoch and Krause (1990) nd that earnings is better predictor than operating cash ows for predicting of operating cash ows. They also nd that the primary predictive content of earnings is related to its current accruals component and that utilizing more than one year of predictive data improves the prediction accuracy. McBeth (1993) examines the relative predictive ability of net income versus cash ow from operations as predictors of cash ow from operations for the period 1988-1990 and nds mixed results. For 1989, McBeth nds that net income is a better predictor of future cash ow from operations, but that cash ow from operations is a better predictor of itself for 1990. Finger (1994) tests the ability of earnings to predict cash ow from operations one through eight years ahead, depending on the data for the period 1935-1987, the results indicate that cash ows have predictive ability superior to earnings for short horizons whereas earnings and cash ows are approximately equivalent for longer horizons. Lorek and Willinger (1996) develop a new multivariate, time-series prediction model that employs past values of earnings, short-term accruals and cash ows as independent variables in a time-series regression. They provide evidence that this model clearly outperforms rm specic and common structure autoregressive integrated moving average model for the period 1989-1991. Krishnan and Largay (2000) substitute cash receipts and payments for aggregate cash ow from operations in Lorek and Willinger (1996), cash ows prediction model and nd that cash ows components have higher predictive ability than aggregate cash ow from operation in predicting future cash ows. Kim and Kross (2005) investigate the ability of earnings to predict future operating cash ows from 1973 to 2000 suggesting that the ability of current earnings to predict future operating cash ows has been increased over time and that the predictions of operating cash ows generally show increasing forecast accuracy over time. However, Kim and Kross (2005) examine the predictive power of earnings for future cash ows over time. This issue is different from the issue in the current study. The current study compares the predictive power of current-year earnings for next-year cash ows relative to the predictive power of current-year cash ows. This relative comparison is way different from inter-temporal variations in the current-year earnings next-year cash ows predictability of Kim and Kross (2005). Lorek and Willinger (2009) investigate the ability of past operating cash ows and past earnings to generate predictions of operating cash ows from 1990 to 2004 nding that cash ow-based models provide signicantly more accurate predictions of operating cash ows than earnings-based models. Waldron and Jordan (2010) investigate the comparative

abilities of accrual basis net income and historical cash ows from operation as predictors of future cash ows during both the economic boom leading up to the IT Bubble and the period of economic duress following the burst of that Bubble. Using data for the period 1994-2004, they nd that historical cash ows outperform accrual net income in predicting future cash ows during these periods of economic turbulence. The second stream of prior research examine whether disaggregating earnings into cash ow and accruals improves the predictive ability of earnings for future cash ows. Dechow et al. (1998) model cash ow and the accrual process related to accounts receivable, accounts payable, and inventory and show that current earnings is better predictor of future cash ows than current cash ows because accruals exclude the contemporaneous one-year-ahead outows for working capital from current period s earnings and incorporate forecasts of future cash ows. Barth et al. (2001) expand the work of Dechow et al. (1998) by investigating the role of accruals in predicting future cash ows and nd that disaggregating accruals into major components changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals signicantly enhances the ability of earnings to predict future cash ows incremental to current cash ows. Hollister et al. (2002) extend the study of Barth et al. (2001) to examine rms in the USA, the UK, Germany, and Japan and nd results consistent with Barth et al. (2001) for each country. Al-Attar and Hussain (2004) also extend the work of Barth et al. (2001) to examine rms in the UK and conclude the same results. Cheng and Hollie (2008) extend the models of Barth et al. (2001) by decomposing cash ow components into core and non-core cash ow nding that the inclusion of cash ow components signicantly enhances cash ow prediction. Al-Attar et al. (2008) investigate whether abnormal accruals for the UK rms provide incremental insight into future cash ows and nd a signicant positive association between abnormal accruals and one-year-ahead operating cash ows. In Egypt, Ragab and Omran (2006) examine the usefulness of earnings in stock valuation nding that stock prices in Egypt have less information about rms value than accounting earnings. They suggest that this result may imply that competing information sources (i.e. earnings forecasts, rm research by nancial analysts, management conference calls, etc.) are far less relevant rather than implying that accounting earnings has higher value relevance because nancial reporting is of higher quality. Hassan et al. (2009) examine the value relevance of voluntary and mandatory disclosures in Egyptian capital market. They nd that, after controlling for factors such as asset size and protability, mandatory disclosure has a high signicant but negative relationship with rm value, while voluntary disclosure has a positive but insignicant association with rm value. In summary, empirical evidence as to which of accrual earnings or cash ow is superior in predicting future cash ow is limited and mixed. The purpose of this study is to contribute to the literature on the superiority of earnings and cash ows in predicting future cash ows as follows. First, prior research on superiority of earnings and cash ows in predicting future cash ows suggests mixed and contradictory results. Therefore, the superiority of earnings and cash ows in predicting future cash ows is a matter for empirical investigation. Second, prior literature examining the superiority of earnings and cash ows in predicting future cash ows is immense in developed markets (e.g. the USA and Europe). Little is empirically known about this issue in emerging markets such Egypt. The inconsistency of the ndings documented

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by prior research in developed markets in addition to the special attributes of Egyptian capital market create an opportunity to investigate the predictive abilities of current period cash ows and earnings (and its components) for one-year-ahead cash ow from operations. From prior research mentioned above, there is neither an empirical nor a theoretical basis to expect the superiority of earnings or cash ows in predicting future cash ows. Therefore, there is no expectation as to which of earnings and cash ows will be superior. Accordingly, the rst hypothesis of the study is that one of accrual earnings and cash ows will be superior in predicting one-year-ahead cash ow from operations. This leads to the rst hypothesis of the study, which is: Ha1. Accrual earnings and cash ows are not performing equally in predicting one-year-ahead cash ow from operations. Prior research (Barth et al., 2001; Dechow et al., 1998) suggests that the various accrual components of earnings capture different information not only about delayed cash ows related to past transactions, but also about expected future cash ows related to managements expected future operating and investing activity. Thus, disaggregating earnings into cash ow and the components of accrual enhances earnings predictive ability relative to aggregate earnings. Based on these results, the study predicts that disaggregating earnings into cash ow and major accrual components enhances the ability of earnings to predict future cash ows. This leads to the second hypothesis of the study, which is: Ha2. Disaggregating earnings into cash ow and accrual components enhances the ability of earnings to predict one-year-ahead cash ow from operations. Research design Sample and data Given the thinness of the Egyptian capital market, this study uses all listed rms on Egyptian Stock Exchange during the period of 1999-2007. As of the end of 2007, there were 462 rms listed on the Egyptian Stock Exchange. However, the majority of these rms (347 rms) are private and closely held. Therefore, the study cannot use them in the analysis because of lack of records of nancial statements remaining primary sample contains 115 rms. Misr Information Services & Trading is a database agency that keeps records of nancial statements and market data of all Egyptian rms that are listed on Egyptian Stock Exchange, and that are subject to the regulations by the CMA in Egypt. Primary sample rms were then screened against several factors: nancial services institutions (banks and insurance rms) were deleted from sample. The study excludes from the sample nancial services institutions because data relating to some accruals in the prediction models are unavailable for these rms, e.g. inventory and accounts receivable. Remaining rms were then tested for availability of nancial data during the test period (1999-2007). This screening yielded a sample contains 666 rm year observations representing 74 rms. In total, 18 observations are diagnosed and excluded from the total sample as outliers. This reduces the nal sample to 648 rm year observations. The rms included in the sample cover ten of non-nancial industries. Table I provides the distribution of the sample by industry. The nine years sample period used in this study covers a shorter time-series than those used in most prior cash ow

Industry name Pharmaceuticals Fertilizer and chemicals Flour and mills Foods Construction and housing Cement and construction materials Manufacturing Ginning and textiles Transportation Communication Total

Number of rms 6 10 8 8 9 12 10 5 3 3 74

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Table I. Industry distribution of the sample

prediction studies employing estimated cash ows data (Finger, 1994). However, it is somewhat similar to the sample period used in prior studies on actual cash ows under the requirement of statement of cash ows, such as Quirin et al. (1999), eight years; Krishnan and Largay (2000), six years; Barth et al. (2001), 11 years; and Al-Attar and Hussain (2004), nine years. Accordingly, the sample period is seemed as sufcient for this analysis. Cash ow from operations is from the statement of cash ows prepared according to Egyptian Accounting Standard No. 4, which is equivalent to IAS No. 7, adjusted for the accrual portion of extraordinary items and discontinued operations. The accrual components are from the statement of cash ows, when available, and calculated from balance sheet data otherwise. It is possible that components of cash ows could enhance the predictive ability of aggregate cash ow for future cash ows, just as components of earnings enhance the predictive ability of aggregate earnings. Unfortunately, such components are available only for few rms. Model Similar to Barth et al. (2001), the study uses the following prediction models to predict one-year-ahead cash ow from operations: CFOi;t1 b0 b1 EARNi;t ui;t CFOi;t1 b0 b1 CFOi;t ui;t CFOi;t1 b0 b1 CFOi;t b2 ACCRUALSi;t ui;t CFOi;t1 b0 b1 CFOi;t b2 DARi;t b3 DINVi;t b4 DAPi;t b5 DEPRi;t b6 OTHERi;t ui;t where: EARN CFO net income after tax adjusted for extraordinary items and discontinued operations. net cash ow from operations adjusted for the accrual portion of extraordinary items and discontinued operations. 1 2 3 4

ACCRUALS aggregate accruals EARN CFO.

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DAP DAR DINV DEPR

change in accounts payable and accrued liabilities. change in accounts receivable. change in inventory. depreciation and amortization expense. aggregate of other accruals EARN (CFO DAR DINV DAP DEPR).

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OTHER

i and t denotes rm and year, respectively. Similar to Barth et al. (2001), all of these variables are deated by the average of total assets. Equations (1) and (2) examine the ability of aggregate earnings and cash ows to predict next period cash ow from operations. Equations (3) and (4) examine whether disaggregating earnings into its major components could enhance the ability of current earnings to predict future cash ows. Equation (3) disaggregates earnings into cash ow and aggregate accruals, whereas in equation (4), aggregate accruals is further disaggregated into its major components since each major accrual reects different information about future cash ows, resulting in different weight in prediction. In contrast, aggregate earnings implicitly place the same weight on each earnings component, masking information relevant to predicting future cash ows. Analysis and results Descriptive statistics Table II presents a summary of descriptive statistics of the variables used in the study. Panel A shows distributional statistics and Panel B shows Pearson correlations. Similar to Barth et al. (2001), as shown in Panel A, the means and medians of EARN, CFO, DAR, DINV, and DEPR are positive. Also, the mean and median of ACCRUALS is negative. The negative mean and median of ACCRUALS reect the fact that aggregate accruals includes depreciation and amortization, but acquisition of depreciable and amortizable assets is an investing, not operating activity. In contrast with Barth et al. (2001), the mean and median of DAP are negative where the mean and median of OTHER are positive. The standard deviation of earnings is greater than cash ow from operations which may suggests that earning is more volatile than cash ow from operations. Consistent with Barth et al. (2001), current accruals, i.e. DAR, DINV, and DAP are smaller in magnitude and the standard deviations are greater than long-term accruals, i.e. DEPR. Panel B of Table II reveals that, consistent with Barth et al. (2001), EARN is signicantly positively correlated with CFO and ACCRUALS, and CFO and ACCRUALS are signicantly negatively correlated. Change in accounts receivable (DAR) and change in inventory (DINV) are the only accrual components that signicantly correlated with EARN and OTHER is the only accrual components that signicantly correlated with CFO, and generally are not signicantly correlate with each other. Regression results Table III presents regression summary statistics of one-year-ahead cash ow from operations on current aggregate earnings (Panel A), current cash ows (Panel B),

Variables 0.0992 0.0804 0.0818 20.0018 20.0071 0.0009 0.0007 0.0047 0.0003 CFOt 1 1.000 0.380 * 0.501 * 0.045 20.013 0.412 * 0.221 * 0.156 20.265 * CFOt 0.380 * 1.000 0.672 * 2 0.330 * 0.048 2 0.152 2 0.158 0.076 0.422 * DAPt 20.013 0.048 20.122 20.212 1.000 0.039 0.120 0.322 * 0.576 * EARNt 0.500 * 0.672 * 1.000 0.477 * 2 0.122 0.412 * 0.457 * 2 0.056 2 0.062 ACCRUALSt 0.045 2 0.330 * 0.477 * 1.000 2 0.212 0.345 * 0.395 * 0.018 0.421 * DARt 0.412 * 2 0.152 0.412 * 0.345 * 0.039 1.000 0.120 0.142 2 0.194 DINVt 0.221 * 20.158 0.457 * 0.395 * 0.120 0.120 1.000 20.010 20.026 DEPRt 0.156 0.076 20.056 0.018 0.322 * 0.142 20.010 1.000 0.275 * 0.1141 0.0681 0.0732 0.0574 0.0505 0.0309 0.0266 0.0036 0.0609 2 0.150 2 0.080 2 0.010 2 0.1500 2 0.150 2 0.090 2 0.090 0.030 2 0.160 0.0983 0.0849 0.0852 2 0.0038 2 0.0029 0.0021 0.0002 0.0034 2 0.0073 0.450 0.270 0.230 0.1500 0.150 0.110 0.050 0.012 0.190

Mean

Standard

Minimum

Median

Maximum

Panel A: distributional statistics CFOt 1 CFOt EARNt ACCRUALSt DAPt DARt DINVt DEPRt OTHERt Panel B: Pearson correlation

CFOt 1 CFOt EARNt ACCRUALSt DAPt DARt DINVt DEPRt OTHERt

OTHERt 2 0.265 * 0.422 * 2 0.062 0.421 * 0.576 * 2 0.194 2 0.026 0.275 * 1.000

Notes: Correlation is signicant at: *0.05 level; EARN net income after tax adjusted for extraordinary items and discontinued operations; CFO net cash ow from operations; ACCRUALS aggregate accruals EARN CFO; DAP change in accounts payable and accrued liabilities; DAR change in accounts receivable; DINV change in inventory; DEPR depreciation and amortization expense; OTHER aggregate of other accruals EARN (CFO DAR DINV DAP DEPR); all of these variables were deated by the average of total assets

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Table II. Descriptive statistics

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Sign.

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Table III. Summary statistics from regressions of future cash ows on current cash ows, current aggregate earnings, and components of accruals

Panel A: current aggregate earnings (Model 1): CFOi;t1 b0 b1 EARNi;t ui;t Constant 0.035 2.031 0.046 EARNi,t 0.837 4.907 0.000 Adjusted R 2 0.251 Panel B: current cash ows (Model 2) CFOi;t1 b0 b1 CFOi;t ui;t Constant 0.032 1.796 0.077 CFOi,t 0.780 3.700 0.000 Adjusted R 2 0.240 Panel C: current cash ows and current aggregate accruals (Model 3): CFOi;t1 b0 b1 CFOi;t b2 ACCRUALSi;t ui;t Constant 0.021 1.153 0.253 CFOi,t 0.767 5.491 0.000 ACCRUALS i,t 0.467 2.237 0.028 2 Adjusted R 0.280 Panel D: current cash ows and accrual components (Model 4): CFOi;t1 b0 b1 CFOi;t b2 DARi;t b3 DINVi;t b4 DAPi;t b5 DEPRi;t b6 OTHERi;t ui;t Constant 0.009 0.403 0.688 CFOt 0.771 4.075 0.000 DAPt 2 0.299 2 1.025 0.309 DARt 1.141 3.117 0.003 DINVt 0.556 1.349 0.018 DEPRt 5.939 1.836 0.071 OTHERt 0.034 0.126 0.009 Adjusted R 2 0.360 Notes: EARN net income after tax adjusted for extraordinary items and discontinued operations; CFO net cash ow from operations; ACCRUALS aggregate accruals EARN CFO; DAP change in accounts payable and accrued liabilities; DAR change in accounts receivable; DINV change in inventory; DEPR depreciation and amortization expense; OTHER aggregate of other accruals EARN (CFO DAR DINV DAP DEPR); all of these variables were deated by the average of total assets

current cash ow and current aggregate accruals (Panel C), and current cash ow and accrual components (Panel D). Panels A and B of Table III show that both current aggregate earnings and current cash ows are positive and signicant predictors of future cash ows. However, the explanatory power of current aggregate earnings (adjusted R 2 25.1 per cent) is higher than the explanatory power of current cash ows (adjusted R 2 24 per cent). The results of untabulated Vuong (1989), Z-statistic test exhibit that the difference in these two adjusted R 2 is signicant at the 0.05 level or lower with a Z-statistic of 2.43. This result suggests that current aggregate earnings has superior predictive ability for one-year-ahead cash ow from operations than current cash ows and, thus, support the Ha1 of the study which predicts that current accrual earnings and cash ows are not performing equally in predicting future cash ow from operations. Panels C and D of Table III show the impact of disaggregating earnings into cash ow and accrual components on the ability of earnings to predict future cash ows. As shown in Panel C, the disaggregating of earnings into cash ow and aggregate accruals leads to an increase in the explanatory power of earnings (adjusted R 2) from 25.1 to 28 per cent. The results of untabulated Vuong (1989), Z-statistic test exhibit that the difference in these two adjusted R 2 is signicant

at the 0.05 level or lower with a Z-statistic of 2.89. As Barth et al. (2001) state, each major accrual reects different information about future cash ows, resulting in different weight in prediction. In contrast, aggregate earnings implicitly place the same weight on each earnings component, masking information relevant to predicting future cash ows. Therefore, disaggregating total accruals into its major components leads to further increase in the explanatory power of earnings (adjusted R 2) from 28 to 36 per cent as shown in Panel D. The results of untabulated Vuong (1989) Z-statistic test exhibit that the difference in these two adjusted R 2 is signicant at the 0.05 level or lower with a Z-statistic of 3.13. In contrary with Barth et al. (2001), the only accrual components that relate signicantly with future cash ows are the changes in accounts receivable and in inventory, and other accruals, whereas change in accounts payable and depreciation and amortization have no signicant relation with future cash ows. The comparison of results shown in Panel A with those shown in Panels C and D supports the Ha2 of the study that disaggregating earnings into cash ow and accrual components enhances the ability of earnings to predict future cash ow. Overall, the ndings mentioned above suggest that current aggregate earnings have superior predictive ability than current cash ows for predicting one-year-ahead cash ow from operations in Egypt. These results are consistent with those have documented in some prior studies in developed markets (Kim and Kross, 2005; Murdoch and Krause, 1990; Greenberg et al., 1986) and could support the superiority of earnings as a summary measure of rm performance in Egypt. The ndings of the study also support those have documented in Hollister et al. (2008) study. Hollister et al. (2008) examine the predictive abilities of earnings and cash ows for future cash ows in nine countries and nd that for predicting next periods cash ows, accruals from code-law regimes provide more explanatory power than those from regimes based in common-law jurisdictions. Finally, and consistent with prior research in developed markets (Al-Attar and Hussain, 2004; Hollister et al., 2002; Barth et al., 2001; Dechow et al., 1998), the results reveal that disaggregating earnings into cash ow and the components of accrual enhances earnings predictive ability relative to aggregate earnings for predicting future cash ow from operations in Egypt. International Accounting researchers (Lange et al., 2006; Bushman and Piotroski, 2006; Ball et al., 2000, 2003) have documented that international institutional factors affect the properties of accounting earnings, especially, the timeliness with which economic income (i.e. changes in expected future cash ows peroxide by scal-year change in market value of equity) is recognized in accounting income. Specically, in market-oriented common-law countries, the shareholder model typically gives exclusive corporate governance rights to shareholders. There typically is a larger, more diverse base of individual shareholders and bondholders, and information asymmetry is more efciently resolved through public disclosure. Hence, there is a larger demand for high-quality public nancial reporting and disclosure, including more timely incorporation of economic income in reported accounting earnings. Conversely, in planning-oriented code-law countries, standard setting and enforcement primarily are public-sector functions. Politicization leads to a stakeholder model in which major parties contracting with rms suppliers of capital (typically banks), labor, major customers or suppliers, and governments are represented in both writing the accounting code for rms generally and in the governance of individual corporations. Debt tends to be private (not publicly issued or traded), and shareholding tends

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to be concentrated in institutions such as banks. Information asymmetry more likely is resolved by insider communication with stakeholder representatives, so there is a lower demand for high-quality public nancial reporting and disclosure. Consequently, there is a lower demand for timeliness in incorporating economic income in reported accounting earnings. Accordingly, it is expected that accounting earnings in code-law countries to be of less timely in incorporating economic income than accounting earnings in common-law countries. This means that economic income is impounded more quickly, or earlier, in accounting earnings in common-law countries than it is in code-law countries. Although, it is hard to tell whether the differential timeliness observation tells us something about differential accounting properties, Hollister et al. (2008) depend upon this difference in accounting earnings timeliness between common-law and code-law countries in explaining the superiority of earnings in predicting the next periods cash ow from operations in code-law countries compared to common-law countries. Theoretically, economic income (peroxide by the change in market value of equity) reects changes in expectations of the time-series distribution of future cash ows for the rm. The ability of accounting earnings to incorporate economic income in common-law countries earlier than it is in code-law countries means that it incorporates more distant expected cash ows into current earnings through accruals, implying that the time horizon underlying the accruals in common-law countries is longer than that in code-law countries. These differing accruals horizons have interesting implications concerning the ability of accruals to predict next periods cash ows. Ignoring the degenerate zero horizon or cash basis regime, accruals in both common-law and code-law countries have a horizon of at least one period, so will impound information about next periods cash ows. However, the greater the extent that accruals provide information about cash ows arriving after the next period, the more they will confound the information pertaining to the next periods cash ows. Because the accruals in code-law countries are less timely and, therefore, impound information about changes in future cash ows for less future periods beyond the rst period than the accruals in common-law countries, Hollister et al. (2008) have hypothesized that the accruals in code-law countries will be more predictive of next period cash ows than those in common-law countries. The empirical ndings of Hollister et al. (2008) have supported this hypothesis. However, Hollister et al. (2008) nd that accounting accruals in the code-law countries provide less signicant incremental explanatory power when the horizon is extended to two years. In the third year, they are not signicantly different from the incremental information provided by accounting accruals from common-law countries. Thus, accounting accruals in code-law countries provide incremental explanatory power for predicting near term cash ows, but not more distant ones. Since, this study has focused on the predictive abilities of current period cash ows and earnings (and its components) for next periods cash ow from operations, I could build on the ndings of Hollister et al. (2008) to demonstrate the superiority of current accrual earnings in predicting next periods cash ow from operations compared to current cash ows in Egypt as a code-law country. Conclusion FASB asserts that information about rms earnings and its components measured by accrual accounting generally provides a better indication of rms future cash ows than information about current cash ows. However, prior research that empirically

examines this assertion provides mixed results. The study aims to empirically examine this fundamental issue in Egypt as one of emerging markets where accounting information (especially earnings) plays an important role in Egyptian capital market due to the lack of competing information sources. Based on a sample of Egyptian-listed rms and based on cash ow prediction models developed by Barth et al. (2001), the ndings reveal that aggregate earnings have superior predictive ability than cash ows for one-year-ahead cash ow from operations. Also, the results reveal that disaggregating accruals into major components changes in accounts receivable and payable, and in inventory, depreciation, amortization, and other accruals signicantly enhances the predictive ability of earnings for future cash ows. This the rst study that examines the role of accruals in predicting one-year-ahead cash ow from operations in Egypt. Further research may examine the prediction of cash ows several years in future, also use stock prices or returns as a proxy for future cash ows. Further research may also examine the impact of operating cash cycles and industry membership on the predictive abilities of earnings and cash ows for future cash ows.
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