11as04-091-core_cfo_prediction (1).doc

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Do CoreandNon-coreCash Flows from Operations Persist

Differentially in Predicting Future Cash Flows?

by

C. S. Agnes ChengUniversity of Houston

Houston, Texas 77204-4852

Dana Hollie*University of Houston

Houston, Texas 77204-4852

i!st D!a"t# $anua!y 2004This D!a"t# A%!il 2004


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DoCoreandNon-core Cash Flows from Operations Persist

Differentially in Predicting Future Cash Flows?

I. Introduction and oti!ation

a!nings !e(ain the (ost 1iely use (et!i& "o! %!o"itability on all St!eet, but in3esto!s

a!e looing (o!e &losely at &ash "lo1s "!o( o%e!ations than e3e! be"o!e. Ho1e3e!, es%ite the

i(%o!tan&e an e(an "o! su&h in"o!(ation &o(%anies still o not !e%o!t thei! state(ent o" &ash

"lo1s in =ua!te!ly ea!nings announ&e(ents. o!eo3e!, "inan&ial analysts &ontinue to state the

i(%o!tan&e o" %!o3iing &ash "lo1 in"o!(ation an bette! yet &o!e an non-&o!e &ash "lo1

in"o!(ation. o! exa(%le, >yle ?oughlin, an analyst at Stana! @ +oo! an hea o" its &he(i&al

inust!y tea( states#

1oul al1ays "a3o! (o!e in"o!(ation Bo3e! less. T!ans%a!en&y an &lea! in"o!(ationabout the &ash "lo1 gene!ate "!o( corebusiness a&ti3ities is %a!t an %a!&el to goo &!eitanalysis. So, i" the etails a!e (ae a3ailable in a ti(ely (anne!, it is an i(%o!tant&onsie!ation, es%e&ially in this en3i!on(ent Chang, 20026.E

n aition, the S%e&ial Co((ittee on inan&ial Fe%o!ting "o!(e by the A(e!i&an nstitute

o" Ce!ti"ie +ubli& A&&ountants AC+A6 &on"i!(e the i(%o!tan&e o" "inan&ial state(ents G they


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o!e s%e&ially, the AC+A !e&o((ens that "i!(s shoul istinguish bet1een the "inan&ial

e""e&ts o" a &o(%any9s &o!e (aIo! o! &ent!al o%e!ations6 an non-&o!e %e!i%he!al o! in&iental

a&ti3ities6 &ash "lo1s, the!eby, %!esenting the best %ossible in"o!(ation in 1hi&h to analy;e t!ens in

a "i!( 1ithout the %otential isto!ti3e e""e&ts o" non-&o!e a&ti3ities. Ho1e3e!, &o!e an non-&o!e &ash

"lo1s ha3e not been &lea!ly e"ine by the %!o"ession o! a&ae(i&s. o! exa(%le, shoul &o!e an

non-&o!e &ash "lo1s be ete!(ine by its "un&tional %!o%e!ties e.g., %a!allel to the in&o(e state(ent

G &o!e ea!nings6, o! shoul they be ete!(ine base on thei! %e!sisten&e le3els e.g., &o(%onents

that %e!sist (o!e a!e &lassi"ie as &o!e &ash "lo1s an those that o not a!e &lassi"ie as non-&o!e

&ash "lo1s. n this %a%e!, 1e e"ine core cash flowsas &ash "lo1s !elate to sales, &ost o" goos sol,

an o%e!ating ex%enses an noncore cash flowsas &ash "lo1s !elate to inte!est, taxes, an othe!

ex%enses. Ju! e"inition is &onst!aine by t1o "a&to!s. i!st 1e %a!allel &ash "lo1s 1ith the e"inition

o" in&o(e Go%e!ating an non-o%e!ating. These a!e the t1o (ain &atego!ies 1ithin o%e!ating in&o(e

o"ten !e"e!!e to as &o!e9 ea!nings.The se&on "a&to! is the &onst!aint o" ata a3ailability in

Co(%ustat. e esti(ate &o!e an non-&o!e &ash "lo1 &o(%onents "!o( a3ailable Co(%ustat ata.

sing in"o!(ation "!o( in&o(e state(ent Co(%ustat ite(s in&luing sales, &ost o" goos sol,

ti i t t t t i bi ith b l h t


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The obIe&ti3e o" this stuy is t1o-"ol. i!st, 1e a!ess the issue o" 1hethe! &ash "lo1

&o(%onents &o!e an non-&o!e &ash "lo1s6 !e"le&t i""e!ent in"o!(ation !elating to "utu!e &ash "lo1s.

Se&on, 1e exa(ine 1hethe! the &o(%onents o" &ash "lo1s signi"i&antly enhan&e the in-sa(%le

%!ei&ti3e ability o" existing &ash "lo1 %!ei&tion (oels. +!io! !esea!&h has sho1n that 6 &u!!ent

%e!io &ash "lo1s a!e (o!e %e!sistent than &u!!ent %e!io a&&!uals in %!ei&ting ea!nings e.g., Sloan

LLM6 an 26 agg!egate &ash "lo1s an a&&!ual &o(%onents %e!sist i""e!ently than agg!egate &ash

"lo1s an agg!egate a&&!uals in %!ei&ting "utu!e &ash "lo1s e.g., De&ho1 LL4< De&ho1 et al.

LL8< 'a!th, C!a(, an elson he!ea"te! !e"e!!e to as 'C6 2006. Ho1e3e!, these stuies o not

ex%li&itly exa(ine the %e!sisten&e an %!ei&tability o" &ash "lo1 &o(%onents &o!e an non-&o!e

&ash "lo1s6 in %!ei&ting "utu!e &ash "lo1s. e exten %!e3ious !esea!&h by &ont!asting the

%e!sisten&e bet1een &o!e an non-&o!e &ash "lo1 &o(%onents an the in-sa(%le %!ei&ti3e ability o"

(oels using agg!egate an isagg!egate &ash "lo1s. e analy;e &ash "lo1 %!ei&tion (oels

1ithout a&&!ual &o(%onents an then exten ou! analyses to in&lue the a&&!ual &o(%onents as

exa(ine in 'C.

To ete!(ine 1hethe! &o!e an non-&o!e &ash "lo1s %e!sist i""e!entially in %!ei&ting "utu!e

h "l " t ti th ""i i t i i b th i t i ti " th h


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statisti&s i(%ly highe! stability. e belie3e both the (agnitues an the stability o" the &oe""i&ients o"

&ash "lo1 &o(%onents a!e i(%o!tant to assess the %e!sisten&e an the %!ei&tability o" &ash "lo1

&o(%onents. Ju! e(%i!i&al "inings sho1 that &o!e an non-&o!e &ash "lo1 &o(%onents %e!sist

i""e!entially in %!ei&ting "utu!e &ash "lo1s "!o( o%e!ations. S%e&i"i&ally, 1e "in that &o!e &ash

"lo1s !elate to sales, &ost o" goos sol an o%e!ating ex%enses ha3e si(ila! %e!sisten&e an %e!sist

(o!e than non-&o!e&ash "lo1s !elate to taxes an othe! ex%enses. 'ase on %ai!-1ise &o(%a!isons,

1e "in that the %e!sisten&e o" the &oe""i&ients "o! non-&o!e &ash "lo1 &o(%onents is signi"i&antly

less than those "o! &o!e &ash "lo1 &o(%onents G they a!e also less stable a&!oss yea!s.

e exten ou! analysis to in&lue a&&!ual &o(%onents in the &ash %!ei&tion (oel.)'C

sho1 that agg!egate &ash "lo1s an a&&!ual &o(%onents enhan&e &ash "lo1 %!ei&tion beyon

agg!egate o%e!ating &ash "lo1s an agg!egate a&&!uals That is, they "in a&&!uals &o(%onents

&ont!ibute to %!ei&ting next %e!io9s &ash "lo1s6. To ete!(ine 1hethe! the &ash "lo1 &o(%onents

signi"i&antly enhan&e &ash "lo1 %!ei&tion beyon agg!egate &ash "lo1s an a&&!ual &o(%onents

using existing &ash "lo1 %!ei&tion (oels, 1e "i!st !e%li&ate 'C. Ju! o3e!all "inings a!e !obust to

thei! e(%i!i&al !esults. e then exten the 'C oel by e&o(%osing &ash "lo1s "!o( o%e!ations

i t h "l t i l ib Thi i th


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(oels. Hen&e, ou! "inings a!e !ele3ant to a&ae(i& !esea!&he!s using &ash "lo1 %!ei&tion (oels

to (easu!e "inan&ial !e%o!ting =uality4

sin&e ou! (oel i(%!o3es in-sa(%le %!ei&tion. u!the!(o!e,

ou! "inings a!e also !ele3ant to "inan&ial state(ent use!s inte!este in bette! %!ei&ting a "i!(9s

"utu!e &ash "lo1s an the!eby, its "i!( 3alue.

The !e(aine! o" this %a%e! is o!gani;e as "ollo1s. Se&tion %!o3ies a lite!atu!e !e3ie1

an e3elo%s the hy%otheses. Se&tion es&!ibes the !esea!&h esign an a!esses the

(ethoologi&al issues. Se&tion O %!esents the sa(%le sele&tion &!ite!ia an is&usses ou! e(%i!i&al

"inings. Se&tion O su((a!i;es an &on&lues the %a%e!.

II. "elated #iterature and $ypotheses De!elopment

hile %!io! !esea!&h on &ash "lo1s gene!ally "ins that ea!nings a!e su%e!io! to &ash "lo1s in

ex%laining sto& !etu!ns, e3ien&e also suggests that &ash "lo1s a!e in&!e(entally use"ul in 3aluing

se&u!ities 'o1en, et al. L87< Ali LL4< De&ho1 LL4< Cheng et al. LLM6. Aitionally, Deon

an Hung 200)6 o&u(ent a !e&ent !ise in the t!en o" (a!et %a!ti&i%ants e(aningPan

"inan&ial analysts (aingP&ash "lo1 "o!e&asts. Thei! "inings "u!the! 3aliate the in&!easing

i t " "i i l t t t 9 bilit t t l i t " t h "l th


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&ont!ast, (o!e !e&ent stuies e.g., inge!, LL4< an 'u!gstahle! et al., LL86 o&u(ent that &u!!ent

&ash "lo1s ha3e (o!e %!ei&ti3e ability 1hen %!ei&ting "utu!e &ash "lo1s than &u!!ent ea!nings in

the sho!t-ho!i;on.5n these stuies, the sho!t ho!i;on is base on next-%e!io-ahea &ash "lo1

%!ei&tions, 1hi&h is &onsistent 1ith the "o!e&ast ho!i;on in ou! stuy.MSo, although the e(%i!i&al

"inings in this a!ea o" !esea!&h a!e (ixe 1ith !ega!s to 1hethe! &u!!ent %e!io ea!nings o! &u!!ent

%e!io &ash "lo1s a!e su%e!io! to %!ei&ting "utu!e &ash "lo1s, these stuies &o(bine suggest that

both a!e i(%o!tant ete!(inants in %!ei&ting "utu!e &ash "lo1s.

+!io! !esea!&h that exa(ines the asso&iation bet1een &u!!ent %e!io ea!nings &o(%onents

e.g., a&&!uals an &ash "lo1s6 on "utu!e &ash "lo1s in&lue De&ho1 et al. LL86 he!ea"te! !e"e!!e

to as D>6, 1hi&h (oels &ash "lo1s an a&&!uals to e!i3e %!ei&tions "o! the !elati3e abilities o"

ea!nings an &ash "lo1s to %!ei&t "utu!e &ash "lo1s. They sho1 that "i!(-s%e&i"i& 3a!iation in &ash

"lo1 "o!e&ast e!!o!s base on agg!egate ea!nings is signi"i&antly lo1e! than that base on agg!egate

&ash "lo1s. n Aition, D> %!o3ie e3ien&e that agg!egate ea!nings an agg!egate &ash "lo1 on

"utu!e &ash "lo1s both ha3e in&!e(ental ex%lanato!y %o1e!.

A (o!e !e&ent stuy 'a!th et al. 2006 exa(ines the asso&iation bet1een &u!!ent %e!io &ash

"l t i l t " t h "l Th i t l


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n LL, the AC+A "o!(e a S%e&ial Co((ittee on inan&ial Fe%o!ting to a!ess &on&e!ns

about the !ele3an&e an use"ulness o" business !e%o!ting AC+A6.7

Stana!-sette!s, !egulato!s, an

(any othe!s ha3e e3ote &onsie!able !esou!&es to (aintaining an i(%!o3ing the !ele3an&e an

!eliability o" "inan&ial !e%o!ting. Qi3en the &ent!al i(%o!tan&e o" &o!e earnin!sto "inan&ial state(ent

use!s e.g., 'ea3e!, L8< Fe3sine et al., LLL< $onas an 'lan&het, 2000< an il et al., 20006, an

the !e&o((enations o" the AC+A Co((ittee an "inan&ial analysts, the istinguish(ent bet1een

&o!e an non-&o!e &ash "lo1s shoul also be o" &ent!al i(%o!tan&e to "inan&ial state(ent use!s.

Hen&e, 1e exa(ine the !ole o" &o!e an non-&o!e &ash "lo1 &o(%onents in %!ei&ting "utu!e &ash

"lo1s. e "o&us on a ey i(ension o" !ele3an&e to use!s o" "inan&ial state(ents G 1hethe! &o!e an

non-&o!e &o(%onents o" &ash "lo1s signi"i&antly enhan&e %!ei&ti3e ability !elati3e to agg!egate &ash

"lo1s. n othe! 1o!s, 1e %!ei&t that &o(%onents o" &ash "lo1s &o!e an non-&o!e6 %e!sist

i""e!entially in %!ei&ting "utu!e &ash "lo1s an i(%!o3ing &ash "lo1 %!ei&tability.

n this stuy, &o!e &ash "lo1 &o(%onents a!e ienti"ie as sales, &ost o" goos sol, o%e!ating

an a(inist!ati3e ex%enses, an non-&o!e &ash "lo1 &o(%onents a!e ienti"ie as inte!est, tax, an

othe! ex%enses. e ha3e ienti"ie these six &o(%onents, si(ila! to the e"initions o" &o!e an non-

i th i t " h "l " ti i t th t l t "


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"o! t1o !easons. i!st, taxes a!e !elate to all as%e&ts o" the business in&luing both o%e!ating an

non-o%e!ating a&ti3ities. Se&on, unlie othe! &ash "lo1 &o(%onents 1hi&h a!e a""e&te by (anage!s9

o%e!ating, "inan&ing an in3est(ent a&ti3ities, taxes a!e ete!(ine (ostly by tax %oli&ies an "i!(s9

tax st!ategies 1hi&h &an be =uite i""e!ent "!o( "i!(s9 othe! ongoing business a&ti3ities. Jthe!

ex%enses J6 (ay &onsist o" one-ti(e &ha!ges su&h as !est!u&tu!ing an s%e&ial &ha!ges that &oul

ha3e i""e!ing an un%!ei&table e""e&ts on &ash "lo1 %!ei&tability.

III. "esearch Design

Consistent 1ith %!io! !esea!&h e.g., D>, 'C6, 1e exa(ine the in-sa(%le %!ei&tability o"

3a!ious &ash "lo1 %!ei&tion (oels by using gooness o" "it tests a&!oss (oels# (oels 1ith

agg!egate &ash "lo1s 3e!sus (oels 1ith &ash "lo1 &o(%onents. n testing the %e!sisten&e o" the

&o(%onents, 1e %!o3ie analyses by &onu&ting %ai!-1ise &o(%a!isons o" the !eg!ession &oe""i&ients

a&!oss yea!s in the (oels 1ith the &ash "lo1 &o(%onents. e analy;e t1o sets o" &ash "lo1

%!ei&tion (oels, one set "o&uses on &ash "lo1 in"o!(ation an the othe! "o&uses on extening

'C9s (oel by isagg!egating &ash "lo1s into &o!e an non-&o!e &o(%onents. =uation 6

t i th ""i i t th t " h "l t b l ti 26 l th


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a!e inte!est CRT6, taxes CRTA6, an othe! ex%enses CRJTHF6. e e"ine ou! &o!e an non-

&o!e &ash "lo1s in %a!allel 1ith the &lassi"i&ation in the in&o(e state(ent. e e"ine &o!e &ash "lo1s

base on thei! &lose !elation to o%e!ating a&ti3ities. nte!est is !e%o!te as a non-o%e!ating ite( in the

in&o(e state(ent. Hen&e, 1e e"ine &ash "lo1s !elate to inte!est as non-&o!e. n the in&o(e

state(ent, tax ex%enses a!e allo&ate bet1een &ontinuing an is&ontinuing a&ti3ities< also, this int!a-

%e!io tax allo&ation is a%%lie to ext!ao!ina!y ite(s. hile &o(%anies o not allo&ate taxes

bet1een o%e!ating an non-o%e!ating in&o(e, !esea!&he!s e.g. +en(an an hang, 20026 o"ten

allo&ate taxes to "in net o%e!ating in&o(e. e o not allo&ate taxes bet1een &o!e an non-&o!e &ash

"lo1s an 1e %!ei&t that 1e 1ill not "in a syste(ati& %e!sisten&e "o! taxes. Jthe! &ash "lo1s

in&lue non-o%e!ating an s%e&ial ite(s 1hi&h a!e &onsie!e a non-&o!e ite( in the in&o(e

state(ent. =uations 6 an 26 a!e ex%!esse as "ollo1s L#

CJtUV W U XCJtU Yt 6

CJtUV W U XCRSA?StU XCRCJQStU XCRJtU XCRTtU XCRTAtU XCRJTHFtU Yt26

Also 1!itten as# CJtUV W U XZCJ tU Yt1he!e#

ZCJ V XC SA?St U XC CJQSt U XC Jt U XC Tt U XC TAt U XC JTHFt


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CRJ V &ash "lo1 "!o( o%e!ating an a(inist!ati3e ex%enses a!e &al&ulate as o%e!ating ex%enses 2

(inus &hange in et J%e!ating o!ing Ca%ital ex&luing &hanges in a&&ounts !e&ei3able-

t!ae, in3ento!y, tax %ayable an inte!est %ayable)

. elson, 200. A&&!uals an the +!ei&tion o" utu!e Cash lo1s. %heAccountin! $eview7M $anua!y6# 27-58.

'a!th, . ., . H. 'ea3e!, $. F. . Han, an . F. ?ans(an. LLL. A&&!uals, &ash "lo1s, ane=uity 3alues.$eview of Accountin! &tudies4# 205-22L

'ea3e!, . H. L8.Financial $eportin!' An Accountin! $evolution. ngle1oo Cli""s, .$.#

+!enti&e-Hall, n&., L8.

'o1en, F., D. 'u!gstahle!, an ?. Daley. L87. The in&!e(ental in"o!(ation &ontent o" a&&!ual3e!sus &ash "lo1s. %he Accountin! $eviewM2# 72)-747.

'o1en, F. ., D. 'u!gstahle!, an ?. A. Daley, L8M. 3ien&e on the !elationshi%s bet1eenea!nings an 3a!ious (easu!es o" &ash "lo1. %he Accountin! $eviewM# 7)-725.

'u!gstahle!, D., $. $ia(bal3o, an K. +yo, LL8. The in"o!(ati3eness o" &ash "lo1s "o! "utu!e &ash"lo1s. o!ing %a%e!, ni3e!sity o" ashington.

Chang, $ose%h. Analysis o" &ash "lo1 i(%e!ati3e "o! in3esto!s in i""i&ult ti(e# (any &he(i&al


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Deon, a!, an Hung, 200). An (%i!i&al Analysis o" Analysts9 Cash lo1 o!e&asts. #ournal

of Accountin! and "conomics)5# 7)-00.

a(a, . ., an $. D. a&'eth. L7). Fis, !etu!n, an e=uilib!iu(# e(%i!i&al tests. %he #ournal ofPolitical "conomy. 8# M07-M)M.

AS'. State(ent o" inan&ial A&&ounting Con&e%ts o. # JbIe&ti3es o" inan&ial Fe%o!ting by'usiness nte!%!ises. Sta("o!, Conn.# AS', L78.

AS'. State(ent o" Cash lo1s,E State(ent o" inan&ial A&&ounting Stana!s o. L5, Sta("o!,CT, L87.

inge!, Cathe!ine, LL4. The Ability o" a!nings to +!ei&t utu!e a!nings an Cash lo1. #ournalof Accountin! $esearch )2 Autu(n6# 20-22).

in, F. 2002. Tuning into &ash "lo1. CF* (a!a+ine. De&e(be!6# 44-4L.

Q!eenbe!g, F. F., Q. ?. $ohnson, an >. Fa(esh, L8M. a!nings 3e!sus &ash "lo1 as a %!ei&to! o""utu!e &ash "lo1 (easu!es.#ournal of Accountin!, Auditin!, and Finance# 2MM-277.

H!iba!, +. an D. . Collins. 2002. !!o!s in esti(ating a&&!uals# (%li&ations "o! e(%i!i&al !esea!&h.#ournal of Accountin! $esearch40# 05-)4.

$onas, Q. $. an $. 'lan&het. 2000. Assessing the duality o" inan&ial Fe%o!ting.Accountin!Hori+ons)5)-)M).

?o!e, >. S. an Q. ?. illinge!. LLM. A (ulti3a!iate ti(e-se!ies %!ei&tion (oel "o! &ash "lo1ata. %he Accountin! $eview7# 8-0.


28/41

Ouong, d. H., L8L. ?ielihoo !atio tests "o! (oel sele&tion an nonneste hy%otheses."conometrica57# )07-))).

atts, F. ?., an F. . ?e"t1i&h, L77. The ti(e se!ies o" annual a&&ounting ea!nings. #ournal ofAccountin! $esearch5# 25)-27.

hite, H. L84.Asymptotic %heory for "conometricians. J!lano, ?# A&ae(i& +!ess, n&.Ha!&ou!t '!a&e $o3ano3i&h.

il, $., ?. 'e!nstein, an >. F. Sub!a(anya(. 2000.Financial &tatement Analysis. 'u!!

Fige, ?.# !1inN&Q!a1 Hill.

ilson, Q. +. L8M. The !elati3e in"o!(ation &ontent o" a&&!uals an &ash "lo1s# Co(bine e3ien&eat the ea!nings announ&e(ent an annual !e%o!t !elease ate.#ournal of Accountin! $esearch24#M5-200.

ilson, Q. +. L87. The in&!e(ental in"o!(ation &ontent o" the a&&!ual an "uns &o(%onents o"ea!nings a"te! &ont!olling "o! ea!nings. %he Accountin! $eviewM2# 2L)-)22.


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'able (

Descripti!e &tatistics on %arnings) Cash Flows) Components of Cash Flows and Accruals

Panel A: &ample A for %*uations +(, and +-,

STATS CFOC_SALE

S C_COGS C_OE C_INT C_TAX C_OTHER

Mean 0.054 1.162 -0.808 -0.280 -0.018 -0.019 0.017

Std 0.125 0.753 0.647 0.265 0.018 0.021 0.105Median 0.071 1.027 -0.659 -0.228 -0.014 -0.013 0.007

N 45,942 45,942 45,942 45,942 45,942 45,942 45,942

STATS EARN ACC A" I/0 AP DEPR AMORT OTHERMean 0.003 -0.051 0.019 0.012 0.012 0.044 0.006 -0.018

Std 0.272 0.250 0.062 0.048 0.051 0.038 0.030 0.083median 0.038 -0.039 0.011 0.002 0.008 0.037 0.000 -0.006

N 45,941 45,941 43,203 42,377 35,982 45,173 27,938 20,828

Panel 1: &ample 1 for %*uations +2, and +3,

STATS CFOC_SALE

S C_COGS C_OE C_INT C_TAX C_OTHER

Mean 0.054 1.210 -0.841 -0.297 -0.018 -0.020 0.020

Std 0.137 0.808 0.700 0.283 0.019 0.024 0.120Median 0.071 1.062 -0.682 -0.243 -0.013 -0.012 0.008

N 20,828

STATS EARN ACC A" I/0 AP DEPR AMORT OTHER

Mean 0.007 -0.047 0.019 0.012 0.013 0.042 0.004 -0.018

Std 0.167 0.120 0.060 0.047 0.051 0.031 0.009 0.083Median 0.039 -0.039 0.011 0.002 0.009 0.036 0.000 -0.006


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AJFT V a(o!ti;ation [M56

11as04-091-core_cfo_prediction (1).doc

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