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Earnings Quality Measuring Based on Net Income and Net Operating Cash Flow in
Jordanian Commercial Banks (Experimental study)
Ahmad Adel Jamil Abdallah
Accounting Department, Faculty of Business, Al-Zaytoonah University of Jordan, Amman, Jordan
P.O.Box: 144128 Amman-Jordan 11814, Tel: +962795539905, E-Mail: [email protected]
Abstract
This study aimed to identify the effect of net income and net operating cash flow as an
indicator of the earnings quality in Jordanian commercial banks, in order to analyze the
effect of net operating cash flow to earnings quality, to reach the necessary conditions for
achieving the earnings quality. In order to achieve the goals of the study, we have taken
into consideration the published financial statement for a sample of listed Jordanian
banks at Amman Stock Exchange during the period of 2014-2016, the sample has
reached (3) banks the choice of the banks was based upon each bank capital (high,
intermediate, low), the researcher has used Multiple regression analysis methods to study
this relationship, After conducting the analysis procedure, the study has revealed the
inevitable relationship between net income and net operating cash flow on earnings
quality; also we have noticed the effect of the net operating cash flow over the earnings
quality in the Jordanian Commercial banks, based on these results the necessary basic
condition for achieving profits quality have been set.
Key words: Earnings quality, Net income, Net operating cash flow
Introduction
Economic activity in all countries of the world based on the existence of companies that
carry out economic activities (agricultural, industrial, service or commercial) large or
small. These companies differ in their legal forms, whether they are an individual
proprietorship, general corporation or a public shareholding company, And the public
shareholding companies are the most important types of these companies, for various
reasons, the most important (the size of the capital invested, the breadth of the ownership
base).
Before studying and analyzing the financial and economic position of this type of
companies, it is important to determine the basic financial reports used to study the
results of these companies (the statement of financial position, income statement, retained
earnings statement, changes in equity statement and cash flow statement
(Hock&Brain,2010)
although the importance of the statement of financial position and income statement for
financial analysis purposes, the cash flow statement also considered to be reliable for the
purposes of this analysis because of its special advantages in relation to the Company's
cash position (available cash) To meet their obligations from their own sources, as well
as whether the company needs external sources to finance its activities (Kaddoumi and
Kilani, 2006), The IFRS committee sets out the main objectives of the published
financial statements, to include information assist investors, lenders, and others in
determining the size, timing, and expected net future cash flow . Therefore, financial
analysis based on the cash flow statement gives sufficient time to study available
financing alternatives instead of resorting to high-cost financing sources after hindsight.
This study deals with the subject of the relationship between the net income and net
operating cash flow as an indicator of the earnings quality (Experimental study) in the
financial sector represented in the Jordanian commercial banks, also the study concerned
with focus on two important sides are, namely to determine the relationship between the
net income and net operating cash flow, and the statement of the impact of this
relationship on the earnings quality of these banks.
Previous Studies
The researcher reviewed many of the previous studies that discussed the subject of the
current study and it was
Al-attar and Maali (2017) “The Effect of Earning s Quality on The Predictability
of Accruals and Cash flow Models in Forecasting Future Cash flows”
The main questions these paper answers are: (1) is the superiority of aggregate earnings
over aggregate cash flows affected by the level of earnings quality? (2) Is the superiority
of aggregate earnings over the main components of earnings (i.e. operating cash flows,
accounts receivable, inventory, accounts payable, and depreciation) affected by the level
of earnings quality? to provide answers on the questions of this study, the whole sample
of the study is divided into two groups according to the level of earnings quality: high
earnings quality and low earnings quality. The study covers the case of Jordan and
employs data on a sample of industrial and services firms. The time horizon of this study
includes the period of 2000-2014. The results of the analysis reveal that the qualities of
earnings affect the predictability of both cash flow and earnings in those earnings
outperform cash flows in predicting one-year a head future cash flow when earning
quality is high. On the other hand, the main component earnings reveal incremental
information content beyond that exist in earnings or cash flow regardless of the quality of
earnings.
Mehrani, sasan & others, (2017) "Institutional Ownership Type and Earnings
Quality: Evidence from Iran.”
This study attempts to provide insights into the monitoring roles of institutional investors
by examining the relationship between institutional ownership and earnings quality on
the Tehran Stock Exchange, A multidimensional method is used to measure the various
aspects of earnings quality, such as earnings response coefficient, predictive value of
earnings, discretionary accruals, conservatism, and real earnings management. The
results show that institutional ownership has a positive effect on earnings quality. Similar
to total institutional ownership, active institutional ownership has positive effects on
proxies of earnings quality; passive institutional ownership does not have any power to
affect earnings quality. Moreover, lead-lag tests of the direction of causality suggest that
institutional ownership leads to more earnings quality and not the reverse
C.S. Cheng. Agnes and others (2013)"The supplemental role of operating cash flows
in explaining share returns: Effect of various measures of earnings quality"
This paper re-examine salient questions under accrual accounting: how earnings quality
affects the role of earnings and operating cash flows in a firm's valuation. Using a large
sample ranging from 1989 to 2008, the authors contrast the effects of three representative
accrual-based earnings quality measures on the association between earnings, operating
cash flows and a firm's abnormal stock returns the results indicate that earnings' role in
explaining contemporaneous abnormal returns remains unchanged when earnings quality
is better. Conversely, operating cash flows explain more contemporaneous abnormal
returns when earnings quality is better. The findings could suggest that the market reacts
to operating cash flows conditionally on earnings quality. Intriguingly, the results also
indicate that the market perceives better earnings quality captures superior performance
of operating cash flows rather than that of earnings
Study problem
It is possible that the profits or losses of the banks are due to unusual activities (non-
operating activities), and in view of these profits or losses will not be repeated in the
future except by chance, it is possible that these figures are misleading to decision
makers, we must find a realistic way to measure the real state of profits of these banks at
a given time to see how well banks can continue to meet their obligations and also to
enable users of these financial statements to make the right decisions in their current and
future investments, and to increase the ability to predict the financial situation And the
ability of this company to continue, through achieve these elements we arrived to desired
earnings quality, so this study is used to measure earnings quality by analyzing the effect
of net income and net operating cash flow of banks which represent the study problem.
Study Objective
The study aimed to determining the effect of net income and net operating cash flow in
Jordanian commercial banks as an indicator to determining the earning quality, and
explaining the importance of net operating cash flow and its impact on the earning quality
as well as clarifying the necessary conditions to achieve the earning quality and the extent
of the company's balance ability between net income and net operating cash flow.
Study Importance
The importance of this study is to measure the ability of Jordanian commercial banks to
balance net income and net operating cash flow and determine the relationship between
them, in order to arrive at a positive indicator of the earning quality of profits in the short
and long term, this study is expected to help users of financial statements, such as
shareholders and other related parties such as creditors, financial analysts, and others, to
better assess the performance of banks, and when banks must focus on earnings or cash
flows to help them make their financing and investment decisions in these banks.
Study Hypothesis
Based on the above, the study hypothesis can be formulated as follow:
Ho1: Net accounting income does not affect the measurement of earnings quality in
Jordanian commercial banks
Ho2: Net operating cash flow does not affect the measurement of earnings quality in
Jordanian commercial banks
The importance of financial statements in public shareholding companies
Accordance to international accounting standards (ISA) 1, issued by the International
Accounting Standards Committee (IASC) in 1997, and certified by the International
Accounting Standards Board (IASB) in 2001, which state the presentation of financial
statements, there are four main financial statements that we need to disclose for the
external parties (statement of financial position, income statement, cash flow statement,
and statement of changes in equity), where the income statement is the most important
statement in these four statement, because it is provide the transactions results of these
companies through (profit/losses) for financial period But we also have to pay attention
to other details that may be evidence of the success or failure of these companies Such as
knowledge of the sources and uses of cash in these companies lead us to study others
statement elements responsible for the identification and allocation of monetary activities
in the company, namely cash flow statement which is an important tool for diagnosing
the company's financial position and provides a vision for calculating financial ratios
through which the company's strengths and weaknesses are assessed (Hock, Brain,2010).
Income statement
The income statement is a list of the Company's revenues and expenses during a specific
financial period, which important for a lot of users like shareholders, management, and
creditors, the details of the income statement items vary according to the nature of the
company's business. However, the statement begins with a presentation of company
operating income followed by the direct expenses incurred to generate these revenues.
Then represent administrative and selling expenses to achieve the net operating profit,
and deduct other revenues and expenses to reach the company net income. (Kieso & T.
Warfield, 2009)
Kieso,Donalad,E. define income statement as a report that measures the success of
enterprise operations for a given period of time. The business and investment community
uses this report to determine profitability, investment value, and credit worthiness. It
provides investors and creditors with information that helps them predict the amounts,
timing, and uncertainty of future cash flows. (Kieso,Donalad,E and others, 2016)
Limitations of the Income Statement
Because net income is an estimate and reflects a number of assumptions, income
statement users need to be aware of certain limitations associated with the information
contained in the income statement. Some of these limitations include:
- Items that cannot be measured reliably are not reported in the income statement. Current
practice prohibits recognition of certain items from the determination of income even
though the effects of these items arguably affect the performance of an entity from one
point in time to another.
- Income numbers are affected by the accounting methods employed. For example, one
company may choose to depreciate its plant assets on an accelerated basis; another
chooses straight-line depreciation. Assuming all other factors are equal, the income for the
first company will be lower, even though the companies are essentially the same. In effect,
we are comparing apples to oranges.
- Income measurement involves judgment. For example, one company in good faith may
estimate the useful life of an asset to be 20 years while another company uses a 15-year
estimate for the same type of asset. Similarly, some companies may make overly
optimistic estimates of future warranty returns and bad debt write-offs, which results in
lower expense and higher income. (Kieso,Donalad,E and others, 2016)
Cash flow statement
A financial statement showing how changes in the statement of financial position and
income accounts can affect cash. the statement provides information about the
Company's ability to provide cash flow and cash management effectiveness, the purpose
of this statement is to provide information on the cash receipts and payments of the
company, and how they relate to the operation and investment, and the financing
activities of the company. The users of the financial statements use this information to
assess the solvency of the business, assess the company's ability to generate positive cash
flows in future periods, Equity, and financing growth. (Williams & F.Meigs, 2002)
Earnings Quality in Public Shareholding Companies
This concept can be achieved by the extent to current profits to continue in future periods. when
profit be more Continuity, it is Indicator on higher future profits quality, (Penman, 2003) and
(Dechow &Schrand 2004) indicate that Profits be high quality if they reflect the
company's current operating performance and present a good indicator of future
operational performance, provide a good measure of the company value.
Kieso,Donalad,E. define cash flow statement as the planned timing of revenues,
expenses, gains, and losses to smooth out bumps in earnings. In most cases, earnings
management is used to increase income in the current year at the expense of income in
future years. (Kieso,Donalad,E and others, 2016)
The relationship between net accounting income and net operating cash flows and
their impact on earning quality
Net accounting income differs from net operating cash flows for several reasons. the
main reason for this difference is non-cash flows like depreciation expenses and
amortization for intangible assets, These flows, which are not considered cash flows,
reduce net accounting income but do not affect net cash flows another reason for the
difference is the timing of revenue and expenditure recognition, and occurrence of main
cash flows and non-operating gains or losses are also included in the determination of net
accounting income which classified in the cash flows statement as investment or
financing activities, not operational activities (Williams & F.Meigs, 2002).
Depend on the financial analysis for financial statements; the researcher relied on several
approaches to determine the relationship between net accounting income and net
operating cash flow:
1. Operating cash flow index (ratio): this ratio shows the extent to which the Company's
profits are able to generate operating cash flows (Matar,2006)
Operating cash flow index (ratio) = Cash flow from operations ÷ Net income
This relationship refers to two fundamental aspects of our study: net accounting
income on accrual basis, and the net operating cash flow prepared on a cash basis,
this ratio focuses on closing or reducing the resulting gap between cash ratio from
operating activities to net accounting income if the gap became lower, the earning
quality be higher (Almoeine, 2011)
2. Return on assets (ROA) from accounting income and return on assets from net
operating cash flow:
Return on assets from accounting income = Net Income ÷ Average Total Assets
Is an indicator of how profitable a company is relative to its total assets. ROA gives
an idea as to how efficient management is at using its assets to generate earnings,
when the higher the ratio, the results of the company will be more efficient and
efficient (Hadad, 2007)
Return on assets from net operating cash flow = Net operating cash flow
÷ Average Total Assets
This ratio measures the amount of operating company cash flow generate for every
dollar of company assets own. The higher the ratio, the more efficiently company use
your assets (Car slaw & Mills, 1999)
3. Return on equity (ROE) from accounting income and return on equity from net
operating cash flow:
Return on equity from accounting income = Net Income ÷ Average Total Equity
Return on equity (ROE) is the amount of net income returned as a percentage of
shareholders equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money shareholders have
invested. (Ross & Bely, 2012)
Return on equity from operating cash flow = Net operating cash flow ÷ Average
Total Equity
This ratio shows the ability of Company's equity to generate operating cash flows, the
higher the percentage the more efficiently company, and the incentive for further
investment in the future (Ross & Bely, 2012)
Study Methodology
The researcher will use quantitative analysis based on analytical method to analyze the
data collected through the actual financial statements of the banks, to determine the effect
of the independents variables (net accounting income and net operating cash flow) on the
dependent variable (earning quality) Through using financial analysis of variables.
Study Population and Sample
The study population represents the Jordanian commercial banks, listed on the Amman
stocks exchange; consist of 15 banks, for the period 2014-2016.
The study sample was Purposive sample, which was selected based on the capital of these
banks which were classified as (high capital, medium capital and low capital)
Table (1): Banks Capital
Bank Name Capital (Jordan dinar)
Arab Bank 534,000,000
Housing Bank for trade and finance 252,000,000
Invest Bank 100,000,000
Data Collection
Been relying on two types of information sources are secondary sources, such as
accounting books and scientific articles, and specialized periodicals that are looking at
the subject of net accounting income, net operating cash flow and earnings quality, also
relied on primary sources through primary sources, which represent the financial
statements (statement of financial position, income statement, cash flow statement, and
statement) for banks through Amman stock exchange website (www.ase.com.jo)
Data Analysis and hypothesis test
Data Analysis
After collecting banks financial data used in the study for the years 2014-2016, the
quantitative approach was used to study and analyze the data, by using financial ratios as
from financial analysis tools, where this method conceder the most appropriate way for
this study on the other hand we were found the Arithmetic means and standard deviations
to achieve the purposes of descriptive analysis as follows:
Financial analysis results
1. Operating cash flow index (ratio):
Table (2): Operating cash flow index for banks
Bank name 2014 2015 2016 The
Arithmetic
mean
Arab Bank 392% 350% 191% 311%
Housing Bank
for trade and
finance
230% (155%) 481% 185%
Invest Bank 419% (548%) 271% 47%
Table (2) indicate to operating cash flow ratio (Cash flow from operations ÷ Net income)
this ratio measure the ability of Company's profits to generate operating cash flows, In
general, there is a significant increase in this indicator, whereas the net cash flow for
most years covers net income by between 2 and 3 to 1 which is high, because the
operating activity of banks mainly depends on the internal and external cash flow, noting
the relative stability in net accounting income.
For Arab bank by comparison between the periods of the study we note increase in net
operating cash flow because of some reasons (decrease in the deposits, and Increase
credit facilities). For housing bank there is a variance in this ratio in (2015), the clients
deposits decreased for (2.2%) and credit facilities increased for (7.3%), on (2016) the
increase in deposits for (7.75%) been the major reason to lifting this ratio. About Invest
bank we noting the very low in this ratio in (2015) because of increase in net operating
cash flow for (39.2%) a result of increase in credit facilities for (16.4%) and decrease in
deposit for (4%) and in various Provisions, then in (2016) its back to increase for (13.1%)
because of clients deposits.
2. Compare Return on assets (ROA) from accounting income and return on assets from
net operating cash flow:
Table (3): Return on assets (ROA) index for banks
Return on assets (ROA) from accounting income
Bank name 2014 2015 2016 The
Arithmetic
mean
Arab Bank 1.10% 1.09% 1.41% 1.20%
Housing Bank
for trade and
finance
1.44% 1.32% 1.48% 1.41%
Invest Bank 1.39% 1.59% 1.53% 1.50%
Return on assets (ROA) from net operating cash flow
Bank name 2014 2015 2016 The
Arithmetic
mean
Arab Bank 4.31% 3.83% 2.69% 3.61%
Housing Bank
for trade and
finance
3.31% (2.28%) 7.12% 2.72%
Invest Bank 5.81% (8.79%) 4.15% 0.39%
Table (3) shows the return on assets (ROA) from accounting income in Arab bank for the
three years between (1.1%-1.4%) this simple change because of change net income
through the three years, about return on assets (ROA) from net operating cash flow we
note the decrease within the three years because of change in working capital (increase
and decrease) with increase in non-cash expenses, which mean increase in return on
assets (ROA) from net operating cash flow more than return on assets (ROA) from
accounting income. For housing bank and invest bank there is simple change in return on
assets (ROA) from accounting income because of change in net income through the
years, and we can note the big deferent in return on assets (ROA) from net operating cash
flow, in housing bank (2015) the ratio was (2.28%) because of increase in operating cash
out flow (decrease in the deposits, and Increase credit facilities) then on 2016 this ratio
increased because of decrease in operating cash inflow (increase in the deposits, and
decrease credit facilities) but for invest bank (2015) there is strong decrease in this ratio
because of minus operating cash flow (change in working capital), so for the three banks
there is fluctuation changes between these twos variables.
3. Compare Return on Equity (ROE) from accounting income and return on assets
from net operating cash flow:
Table (4): Return on Equity (ROE) index for banks
Return on Equity (ROE) from accounting income
Bank name 2014 2015 2016 The
Arithmetic
mean
Arab Bank 6.90% 6.74% 8.75% 7.47%
Housing Bank
for trade and
finance
10.65% 10.99% 11.00% 10.88%
Invest Bank 7.28% 8.32% 8.55% 8.05%
Return on Equity (ROE) from net operating cash flow
Bank name 2014 2015 2016 The
Arithmetic
mean
Arab Bank 27.02% 23.60% 16.70% 22.44%
Housing Bank
for trade and
finance
24.47% (17.00%) 52.92% 20.13%
Invest Bank 30.48% (46.06%) 23.17% 2.53%
Table (3) shows the return on equity (ROE) from accounting income, in Arab bank we
note in (2014) and (2015) the return on equity from accounting income was approximate,
about net operating income from cash flow was the highest possible for the three years
because of increase in clients deposits which led to increase in ROE from (2014) of
(2015), (2016), the main reason for deviation between the two percent is the non-cash
expenses in this year and positive change in working capital, in (2016) the first percent
increased for two degrees of year (2015), and the ROE from net operating cash flow
decreased for (7) degrees of year (2016) because of increase in investment value which
let to increase in profit and decrease in volume of operating cash. In Housing bank we
note the Stability for first percent through the three years because of stability in
accounting profit, for net operating cash flow in (2014) was positive then in (2015) the
operating cash flow decreased to became negative because of decrease in the deposits,
and increase credit facilities (net change in capital was negative) then in (2016) the
percent increase more than in (2014) because increase in deposits volume, for Invest bank
ROE from accounting income was stable and ROE from operating cash flow was
vacillating because of same reason like the previous banks.
Hypothesis test
Accordance to study hypothesis which looking to test the effect of net accounting income
and net operating cash flow on measurement of earnings quality and depend on the
previous financial analysis, the researcher find correlation relationship between net
accounting income and net operating cash flow effect on earnings quality, which mean
the independent variables effect on dependent variable, and the result will be reject the
Null hypothesizes and accept the alternative hypothesizes: Net accounting income affect
the measurement of earnings quality in Jordanian commercial banks, and Net operating
cash flow affect the measurement of earnings quality in Jordanian commercial banks.
Conclusions
The researcher found the following results:
- There is an effect of the net accounting income and net operating cash flow on the
financial statements number, which conceder worthy trust for preparer the financial
statements and users.
- The study indicate that the net operating cash flow effect the earnings quality, because the
(increase or decrease) of it effect the net accounting income.
- Not depending only on net accounting income to read earnings. However, we must know
the resources and components of this income and don’t concentrate on non-operating
activities.
Recommendations
- The necessary to relying on net operating cash flow for Jordanian commercial banks to
evaluate their operating activates.
- Do not rely on non-operating activities to achieve profits Jordanian commercial banks.
- Do now follow the earnings management method which distortion profits number, because
its indicators for current and future investors.
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