The role of accounting accruals for the prediction of future cash flows: Evidence from Spain

Arnedo, Laura; Lizarraga, Fermín; Sánchez, Santiago Article The role of accounting accruals for the prediction of future cash flows: Evidence from Spain SERIEs - Journal of the Spanish Economic Association Provided in Cooperation with: Spanish Economic Association Suggested Citation: Arnedo, Laura; Lizarraga, Fermín; Sánchez, Santiago (2012) : The role of accounting accruals for the prediction of future cash flows: Evidence from Spain, SERIEs - Journal of the Spanish Economic Association, ISSN 1869-4195, Springer, Heidelberg, Vol. 3, Iss. 4, pp. 499-520, https://doi.org/10.1007/s13209-011-0070-7 This Version is available at: https://hdl.handle.net/10419/77731 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/2.0/ SERIEs (2012) 3:499–520 DOI 10.1007/s13209-011-0070-7 ORIGINAL ARTICLE The role of accounting accruals for the prediction of future cash flows: evidence from Spain Laura Arnedo ·Fermín Lizarraga · Santiago Sánchez Received: 10 September 2009 / Accepted: 12 May 2011 / Published online: 17 June 2011 © The Author(s) 2011. This article is published with open access at SpringerLink.com Abstract The aim of this study is to determine whether accruals have information value beyond that provided by isolated current cash flows for the prediction of future cash flows. Using a sample of 4,397 Spanish companies (mostly privately held), we estimate in-sample regressions of future cash flows on isolated current cash flows and on accrual-based earnings. We then find that the out-of-sample prediction errors provided by the accrual-based earnings model are significantly lower than those obtained with the cash flows model. We also regress the decrease in prediction errors brought aboutbytheadditionofaccrualsonasetoffirm-specificcircumstanceswhereaccounting manipulation is expected. In all cases the decrease in prediction errors is significantly affected in the hypothesized direction. Keywords Cash flows ·Accruals ·Prediction JEL Classification M41 1 Introduction The two main accounting standards boards (FASB 1978; IASB 1989) agree on the superiority of accrual-basis accounting over the cash basis to provide summary indicators of a firm’s performance. According to these boards, accrual-based earnings L. Arnedo ·F. Lizarraga ·S. Sánchez Business Department, Public University of Navarra, Campus Arrosadía s/n, 31106 Pamplona, Spain F. Lizarraga (B ) Departamento de Gestión de Empresas, Universidad Pública de Navarra, Campus Arrosadía s/n, 31006 Pamplona, Spain e-mail: [email protected] 123 500 SERIEs (2012) 3:499–520 generally provide a better indication of the timing and uncertainty of prospective cash flows than the information limited to cash receipts and payments. Accruals, therefore, are essential to accomplish the primary objective of financial reporting. They enhance the relevance for future cash flows prediction, reduce costs introduced by information asymmetries and contribute to a better allocation of economic resources (see SFAC, No 1, FASB 1978). Theaim of thisstudy istodetermine whether,for Spanishcompanies,accrual-based earnings have information value beyond that provided by isolated current cash flows for the prediction of future cash flows. Given that the accrual process is the result of a trade-off between relevance and reliability (Dechow 1994), one of the most important questions in accounting research is whether accruals really provide a better summary measure of firm performance. Although US researchers have already provided empirical support for this role, it is yet to be confirmed whether this evidence holds for a code-law country like Spain. Spanish stock markets are far less developed than those of the US, ownership is highly concentrated and external finance is obtained mostly from banks. This leads to different agency problems and calls into question the interest of accounting information for external users. Furthermore, the role of accounting accruals for the prediction of future cash flows is bound to differ across public and private firms and, although the former are likely to be more similar to Anglo-Saxon firms, most Spanish companies are privately held. The main motivation for our study comes from the need to provide Spanish investors and creditors with empirical evidence on the beneficial role of accruals for future cash flows prediction. In Spain, most accounting research usually takes for granted that accruals provide relevant information to better assess a firm’s future cash flows generation. However, there is little empirical evidence that supports this, especially for private firms. Accounting regulation and enforcement make the Spanish setting an interesting case study. The Spanish legal model of accounting took advantage of the reform that resulted from the implementation of EU Directives to approach the Anglo-Saxon model. Since 1990, Spain has had accounting standards of sufficiently high quality to expect accruals to provide value-relevant information. Enforcement mechanisms, nevertheless, are still ineffective in Spain. The literature highlights that the quality of accruals is not only a matter of the quality of accounting standards but also of how these standards are enforced. Empirical evidence that earnings quality is significantly lower in countries with poor enforcement mechanisms (Leuz et al. 2003) and especially in private firms (Burgstahler et al. 2006) reduces confidence in the Spanish reporting model and calls for an empirical evaluation of the information content of accruals. This is, therefore, the primary purpose of our study. Using a sample of 4,397 companies (mostly privately held), we test the role of accruals for the prediction of future cash flows (Hypothesis 1) by estimating in-sample (1997–2001) regressions of future cash flows (up to 4 years ahead) on isolated current cash flows (cash flows model, 1) and on accrual-based earnings (accrual-based model, 2) and, subsequently, looking for differences in the out-of-sample prediction errors between the two models. Overall, our results are consistent with the argument that accruals add relevant information for the prediction of future cash flows, that is, that the prediction errors provided by an accrual-based earnings model are significantly lower than those obtained with isolated current cash flows. This predictive 123 SERIEs (2012) 3:499–520 501 ability increases if we include accruals in the disaggregated fashion (five components) suggested by Barth et al. (2001). On the other hand, we also find that the role of accruals for the prediction of future cash flows is significantly moderated in firmspecific situations where managers are expected to make a more opportunistic use of accounting discretion. For each of the variables used to proxy for these situations (small size, privately held, need for new finance and high level of subjectivity of the firms’ accruals), prediction errors decrease significantly in the hypothesized direction. Our paper adds to the accounting literature by providing evidence that accruals permit a better prediction of future cash flows, thus contributing to a better allocation of resources. We are not aware of any study that has, so far, proved the out-of-sample ability of accruals to predict future cash flows in a representative sample of Spanish firms, that is, using a corresponding proportion of both public and private firms. We also find evidence of a significant moderating effect of accounting manipulation that lowers the informational value of accruals below their otherwise attainable levels. This suggests that, if Spanish regulators do not improve the enforcement of accounting standards, the accrual-based information will not be of high quality. Finally, as in Barth et al. (2001), we find that disaggregating accruals into their major components significantly increases their predictive ability. The rest of the paper is organized as follows. Section 2reviews prior research on the role of accruals for the prediction of future cash flows. Section 3focuses on the Spanish case and includes the two hypotheses of our study. Section 4describes the research methodology and the sample and we present our empirical results in Sect. 5. Finally, the summary and conclusions appear in Sect. 6. 2 Prior research on the role of accruals: literature review Thebenefitsofaccrualsareadirectconsequenceofincreasinglysophisticatedaccounting regulations. Accruals, nevertheless, are also fraught with measurement error due to the assumptions underlying their determination and the discretion allowed under GAAP. Accrual-based accounting standards involve judgment as they require estimations about future events that are not considered in current cash flows. Although subject to unintentional error, these estimations signal private information and are, thus, expected to be value relevant, that is, to increase users’ accuracy in assessing the present value of future cash flows. Managers, however, can use accounting discretion opportunistically to serve other and less benign interests by introducing estimation noise that makes reported earnings misleading about the firm’s economic performance.1 Given that the accrual process is the result of a trade-off between relevance and reliability (Dechow 1994), one of the most important questions in accounting research is whether accruals really provide a better summary measure of firm performance. It is essential to provide users with empirical evidence that supports the assertions of the FASB/IASB about this role. However, although one might expect investors and 1Decisions such as assets write-downs, research and development capitalization, the setting up of provisions, etc. are based on managers’ estimations of the expected future cash flows. 123 502 SERIEs (2012) 3:499–520 creditors to demand this empirical evidence, they often accept or reject the role of accruals without having received it. This is the case in Spain.2 Prior Anglo-Saxon literature has generated a vast number of studies addressing the incremental information content of accruals. Much of this evidence is price-based, that is, it relies on studies that substitute stock prices for real future cash flows (more difficult to obtain). These studies are widely consistent with the hypothesis that accruals are value relevant in the marketplace. Strictly speaking, market prices are the outcome of how investors, as external users, perceive accruals. These prices, however, will not map into future cash flows if the behaviour of stock markets is not efficient. Accordingly, stock prices might not be the most suitable reference for testing the benefits of accruals. Evidence of these benefits for real future cash flows prediction would serve as a guide to investors in the subsequent pricing of accruals.3 Alternative, non-price, studies provide evidence of the ability of accruals to predict future cash flows. Several studies document that, for a given year, accruals show a strong positive association with years-ahead cash flows after regressing cash flows in period t+ion cash flows and accruals in period t(see Kim and Kross 2005). Barth et al. (2001) and Al-Attar and Hussain (2004) further demonstrate that decomposing accruals into five individual reported items (and giving them separate coefficients in the estimations) provides significant additional explanatory power over and above current cash flows and aggregated accruals. In-sample regressions, however, are not prediction tests and may even provide misleading inferences concerning prediction.4 A parallel line of studies uses out-of-sample testing as a way of solving the important problems inherent in association tests. Although the earliest out-of-sample studies do not support the role of accruals for the prediction of future cash flows, more recent papers do (Brochet et al. 2008). Yoder (2007) extends Barth et al.’s (2001) evidence by finding that prediction errors using a disaggregated accrual-based model are significantly lower than those using either an isolated current cash flows model or an aggregated accruals model. Overall, and with the exception of Lev et al. (2009), recent US evidence provides support for the value of accruals in directly predicting future cash flows. 3 The role of accruals in the Spanish reporting framework: hypotheses development Accounting, like other social disciplines and human activities, is largely a product of its environment. The extension of the Anglo-Saxon empirical support for the bene2Thereisevidence that,in Spain,some banksadjust netincome toeliminate theeffectofthe mostsubjective accruals (Ansón et al. 1997). 3Kim and Kross (2005) empirically find that while the role of earnings in pricing securities deteriorates over time there is an increase in the ability of earnings to forecast future cash flows. 4The results of the so-called association studies do not necessarily suggest an incremental ability of accruals to forecast future cash flows. The superiority in goodness of fit tests (e.g. R2)does not necessarily translate into superiority in predictive ability because the model can ‘overfit’ the data. The functional relationship may change over time and, therefore, the association found in year tmay not be useful in making out-of-sample predictions in year t+i. 123 SERIEs (2012) 3:499–520 503 fits of accruals to the Spanish case is yet to be confirmed because of the well-known institutional differences between the US and Spain in terms of both corporate governance and accounting regulation and enforcement. Unlike in the US, banks are a major source of finance in Spain (stock markets are far less developed) and there is high ownership concentration. This leads to different agency problems and calls into question the interest of managers (users) in providing (demanding) high quality accounting information. Furthermore, the role of accruals for the prediction of future cash flows is bound to differ across public and private firms and, although the former are likely to be more similar to Anglo-Saxon firms, most Spanish companies are privately held. Agency problems and the mechanisms employed to solve them among private companies are different from those available for public companies.5In a bank-based financial system like the Spanish one, close monitoring through private information channels may substitute for monitoring based on accounting information and financial reports might be formulated with other intentions than predicting future cash flows (e.g. taxation or dividend policy purposes). Accounting regulation and enforcement is a further important determinant of the quality of financial reporting and, therefore, of the value relevance of accruals. In Spain, a major reform of accounting law took place with the implementation of the Fourth, Seventh and Eighth EU Directives on company law through the Acts of 1988 and 1989 and a revision in 1990 of the General Accounting Plan. Unlike other EU members that tried to preserve their status quo in accounting, Spain used the reform that resulted from this implementation to approach the Anglo-Saxon model in terms of tax alignment and policy regulation. This more equity-oriented view of accounting rules implies that, since 1990, Spanish accounting standards are of sufficient quality to expect value relevance in the companies’ accrual-based outcomes.6 Adopting high quality standards is a necessary but not sufficient condition for high quality information. The quality of accrual-based earnings is not only a matter of the quality of accounting standards but also of how these standards are enforced and, despite the relative increase in the quality of standards, a parallel increase in the efficiency of enforcing them has not yet been achieved in Spain. Investor protection rights are much weaker than in the Anglo-Saxon countries (La Porta et al. 1998) and litigation risk is almost inexistent for firm managers and auditors.7 In Spain, most accounting research usually takes for granted that accruals provide relevant information to better assess a firm’s future cash flows generation. However, there is little empirical evidence that supports this, especially among private firms, 5Although, during our period of study, public and private firms in Spain have to comply with the same accounting standards, the two groups respond differently to institutional factors and have different enforcement mechanisms. 6Oliveras and Puig (2005) suggest that Spain occupies an intermediate position between the most traditional Continental European countries (Germany, France) and the most typically Anglo-Saxon (the US and the UK) in the degree of tax influence in accounting. Hung (2001) creates a 0–1 accrual-based ranking where Anglo-Saxon countries offer values of over 0.8 while Continental European countries like Germany and Italy are just over 0.4. Although catalogued as Continental, Spain’s value of 0.77 is closer to the Anglo-Saxon countries than to its European counterparts. 7In the 15 years since the EU reform, no auditor has been required to pay damages to any third party by a court of law (Ruiz et al. 2004). 123 504 SERIEs (2012) 3:499–520 despitetheirmacroeconomicsignificance.BothGabás and Apellániz (1994) and Giner and Sancho (1996) provide some evidence that accruals display a significant association with future cash flows, but neither of them tests out-of-sample prediction or extends the analysis beyond the scope of public firms. Working with stock market prices, Íñiguez and Poveda (2008) find that strategies based on accruals help specific investors to generate positive abnormal returns, which is evidence of their economic value.8As for private firms, only two studies provide some indirect evidence of the value relevance of accruals. Gill de Albornoz and Illueca (2007) show that Spanish bank lenders perceive accruals as valuable information to set the interest rates charged to their clients, although only for large firms.9In the failure prediction area, Lizarraga (1997) offers evidence that accrual-based ratios (e.g. profitability ratios) are a much better predictor of bankruptcy than those built upon cash flows. Given the above-mentioned arguments and the lack of clear evidence, it is yet to be seen to what extent preparers’ incentives, accounting standards and enforcement mechanisms interact to produce high quality accrual-based information in Spain. We still think that, despite their possible counter effects, accruals are value relevant for the prediction of future cash flows. Our first hypothesis is, then: Hypothesis 1 In Spain, a model that includes current cash flows and accruals will better predict future cash flows than a model that includes only current cash flows. Corporate governance and oversight systems are critical to secure compliance with accounting standards. The lack of competent enforcement of these standards encourages managerial opportunism with a potential mitigating effect on the role of accruals. Gill de Albornoz and Alcarria (2003), Gallén and Giner (2005) and Mora and Sabater (2008) provide empirical support for the opportunistic use of accruals by Spanish public firms. As for private firms, Arnedo et al. (2007) show that they also engage in accruals’ manipulation and Gill de Albornoz and Illueca (2007) find that Spanish bank lenders penalize this manipulation by demanding a higher cost of debt. International studies provide substantial evidence of the higher degree of earnings management in code-law countries (Hung 2001;Leuz et al. 2003) and especially among private firms (Burgstahler et al. 2006).10 Providing evidence of a significant mitigating effect of earnings manipulation on the role of accruals for the prediction of future cash flows would draw attention to the need to strengthen the enforcement mechanisms over the financial reporting system. Testing Hypothesis 1, however, is not sufficient for this purpose because its non-rejection does not imply that accruals are free from manipulation 8These authors, however, find that these strategies are significantly more common in the UK and Germany than in Spain. 9For these authors, small and medium-size companies use alternative sources like asset-based lending or relationship lending because of the financial institutions’ lower trust in the accounting information. 10 Hung (2001) finds that the quality of accrual accounting decreases with managerial propensity to manipulate which, in turn, is a consequence of the poor shareholder protection typical of code-law contexts. He highlights the importance of considering shareholder protection when formulating accounting policies related to accruals. Leuz et al. (2003) examine systematic differences in a set of earnings management measures across 31 countries and confirm that being an Anglo-Saxon country and one with high investor protection significantly explains a lower engagement in earnings manipulation. 123 SERIEs (2012) 3:499–520 505 or that they are being used optimally. The quality of accruals is inversely proportional to the opportunistic discretion exerted by managers and, though significantly better than the cash basis, the accrual basis could still perform well below its possibilities. An overall analysis (Hypothesis 1) does not make it possible to demonstrate whether, in certain cases, the predictive ability of accruals is lower than expected. For this reason, we test, as our second hypothesis, whether the role of accruals in Spain is substantially constrained in firm-specific situations where a high level of manipulation is expected. Formally, this second hypothesis states: Hypothesis 2 In Spain, the ability of accruals to predict future cash flows is significantly constrained in situations where a high level of accounting manipulation is expected. 4 Research design 4.1 Methodological approach To analyze the value relevance of accruals for the prediction of future cash flows, we comparetwodifferentregressionmodels:thecurrentcashflowsmodel(CFM,model1) and the accrual-based model (ABM, model 2). Future cash flows are the dependent variable in both models. Cash flows projections extend up to 4 years ahead.11 We measure current and future cash flows in their operating version. We calculate operating cash flows in year t(OCFt)from the expression: Et=OCFt+Total Accruals If we substitute the five accruals components suggested by Barth et al. (2001)for Total Accruals, we have: Et=OCFt+INVt+REt−APt−OCLt−DEPt Consequently, OCFt=Et−INVt−REt+APt+OCLt+DEPt where, Et=net(after tax) earnings before extraordinary items in year t; INVt=changes in inventory in year t; REt=changes in accounts receivable in year t; 11 The FASB/IASB do not specifically address the time period over which future cash flows should be predicted for accounting information to fulfil the objective of financial reporting. Different prediction horizons have been studied in the literature, that include just 1 year, 1–2 years and even 1–5 years. Barth et al. (2001) also limit their analysis to a 1-year-ahead cash flows effect but they complement their paper with sensitivity cash flows prediction tests up to 4 years ahead, obtaining results consistent with those for 1 year. 123 506 SERIEs (2012) 3:499–520 APt=changes in accounts payable in year t; OCLt=changes in other current liabilities in year t; DEPt=amortization and depreciation expenses in year t. As for the independent variables, the first model (CFM, model 1) includes exclusively the current operating cash flows and it is taken as our benchmark for the comparison. The second model (ABM, model 2) adds total accruals to the content of the first. We estimate this second model twice. First we allow only one coefficient for total accruals (model 2a) and second we disaggregate them into the five different components mentioned above (model 2b). If accruals fulfil their role, both these versions of model 2 should have a better predictive ability than model 1. Obtaining a greater increase in this predictive ability with model 2b than with model 2a will show the benefits of accruals’ disaggregation. Formally, models 1, 2a and 2b are: FOCFt+1 SALESt=α0+α1OCFt SALESt−1+εt(CFM,model1) FOCFt+1 SALESt=α0+α1Et SALESt−1+εt(ABMa,model2a) FOCFt+1 SALESt=α0+α1OCFt SALESt−1+α2INVt SALESt−1+α3REt SALESt−1 +α4APt SALESt−1+α5OCLt SALESt−1+α6DEPt SALESt−1+εt(ABMd,model 2b) where, CFM =Cash flows model; ABMa =Accrual-based model, aggregated; ABMd =Accrual-based model, disaggregated; FOCFt+i=Future operating cash flows for the (t+1tot+i)prediction period. We compute each period-ahead operating cash flows as the mean yearly operating cash flows for all years in the period. FOCFt+iis the mean yearly OCF generated during the period starting in t+1 and ending in t+i, where iranges from 1 to 4.12 We scale all variables by the prior period total sales. We use total sales instead of total assets because, as evidenced by Dechow (1994), the intensity of the operating cycle affects both net operating assets and the association between earnings and operating cash flows. Companies with large operating cycles inherently present low operating cash flows and high total assets, so long-cycled companies will tend to have low values of the estimation errors as a consequence of the inherent behaviour of both the numerator (OCF) and denominator (total assets) in the dependent variable.13 12 For example: FOCFt+4=(OCFt+1+OCFt+2+OCFt+3+OCFt+4)/4. 13 Untabulated results show that, if we use total assets as the scaling variable, the estimations with a higher R2present a higher value in their estimation errors. 123 SERIEs (2012) 3:499–520 513 Table 2 Results of the association of cash flows and accrual-based models with future cash flows Adjusted R2 FOCFt+1FOCFt+2FOCFt+3FOCFt+4 Panel A Model 1 (CFM) 0.081*** 0.141*** 0.172*** 0.197*** Model 2a (ABMa) 0.135*** 0.199*** 0.211*** 0.225*** Model 2b (ABMd) 0.294*** 0.412*** 0.459*** 0.468*** R2Likelihood ratio test for nested models FOCFt+1FOCFt+2FOCFt+3FOCFt+4 Panel B 1–2a (CFM–ABMa) 358.87*** 447.79*** 375.79*** 265.79*** 2a–2b (ABMa–ABMd) 670.16*** 943.43*** 889.28*** 794.56*** 1–2b (CFM–ABMd) 1,029.03*** 1,391.22*** 1,265.08*** 1,060.33*** n14,002 13,993 13,993 13,910 Panel A shows in-sample adjusted R2for the three models: CFM the cash flows model (model 1); ABMa the aggregated accrual-based model (model 2a); and ABMd the disaggregated accrual-based model (model 2b). The estimation sample comprises 4,147 firms for the period 1997–2001. FOCFt+iis the average OCF generated during the period starting in t+1 and ending in t+i,whereiranges from 1 to 4. All variables have been scaled by total sales. *** Model F is statistically significant at the 0.01 level Panel B shows the results for the likelihood ratio test for R2comparison in nested models. *** Likelihood ratio test is statistically significant at the 0.01 level code-law European countries find such limited support for the informational value of accruals. Stock prices in these markets may not be efficiently capturing the present value of future cash flows. Although significance on the role of accruals for future cash flows prediction has been found from an overall perspective (Hypothesis 1), there are certain firm-specific situations where opportunistic manipulation could be lowering the quality of accruals well below their desirable levels. Hypothesis 2states that, in Spain, earnings manipulation exerts a considerable moderating effect on this role. As we apply an errors-based methodology where all determinants are simultaneously tested in the same regression, a correlation matrix is necessary to ensure the absence of multicollinearity. Table 4 shows above/below diagonal Pearson/Spearman correlation coefficients, respectively, for all the firm-specific circumstances under study. All coefficients are well below 0.5, which means there are no serious problems of multicollinearity in our holdout sample.16 In Table 5we present the estimation results from model 3, which we use to test Hypothesis 2. The dependent variable is the difference between the absolute forecast errors of models 1 and 2b (ABSE1−ABSE2d). It shows the extent to which accruals improve on current cash flows in predicting future cash flows. The greater its value, the 16 The highest variance inflation factor (VIF) in the multivariate regression is 3.31 for the service industry variable, which indicates that the variables in the model are not highly collinear. 123 514 SERIEs (2012) 3:499–520 Table 3 Paired forecast error differences between the cash flows and accrual-based models Mean FOCFt+1FOCFt+2FOCFt+3FOCFt+4 Model error Model 1 (CFM) 0.079 0.062 0.056 0.053 Model 2a (ABMa) 0.074 0.058 0.053 0.050 Model 2b (ABMd) 0.068 0.051 0.045 0.046 Error’s difference (t test) 1–2a (CFM–ABMa) 0.005*** 0.004*** 0.003*** 0.003*** 2a–2d (ABMa–ABMd) 0.006*** 0.007*** 0.008*** 0.004*** 1–2d (CFM–ABMd) 0.011*** 0.011*** 0.011*** 0.007*** Median FOCFt+1FOCFt+2FOCFt+3FOCFt+4 Model error Model 1 (CFM) 0.050 0.040 0.037 0.035 Model 2a (ABMa) 0.046 0.037 0.034 0.033 Model 2d (ABMd) 0.042 0.032 0.028 0.030 Error’s difference (Wilcoxon signed test) 1–2a (CFM–ABMa) 0.004*** 0.003*** 0.003*** 0.002*** 2a–2d (ABMa–ABMd) 0.004*** 0.005*** 0.006*** 0.003*** 1–2d (CFM–ABMd) 0.008*** 0.008*** 0.009*** 0.005*** n7,426 7,346 7,189 6,907 The table shows out-of-sample prediction errors for the three models: CFM the cash flows model (model 1); ABMa the aggregated accrual-based model (model 2a); and ABMd the disaggregated accrual-based model (model 2b). The holdout sample comprises 3,933 firms for the period 2002–2003. FOCFt+iis the average OCF generated during the period starting in t+1 and ending in t+i,whereiranges from 1 to 4. All variables are scaled by total sales Significance in error differences have been tested using the ttest for mean differences and the Wilcoxon signed test for the medians *, **, *** The difference in the error between the two models is significant at the 0.10, 0.05 and 0.01 level, respectively greater the decrease in prediction error and, hence, the better the quality of accruals. The four experimental variables (SIZE, PRIV, NNF and SUB) proxy for firm-specific circumstances identified by the literature as especially prone to manipulation. Three additional variables have been included to control for the intrinsic behaviour of accruals (GRW, VOL and IND). The table includes four columns for each of the different future cash flows prediction horizons (periods ending in t+1tot+4) considered in the calculation of errors. In general, all the variables show significant coefficients in the expected direction and are robust to most future cash flows projections. The results confirm the positive effect of firm size on the quality of accruals (SIZE, pvalue < 0.05 in all prediction periods). Monitoring and reputation costs affect large firms in Spain giving their accruals a significantly greater forecasting ability than those of smaller firms. Also in line with our expectations, the accruals of privately123 SERIEs (2012) 3:499–520 515 Table 4 Correlation matrix SIZE PRIV NNF SUB GRW VOL SIZE −0.053*** −0.059*** 0.058*** 0.124 0.157 PRIV −0.071*** 0.036*** 0.055 0.014*** −0.019 NNF −0.035** 0.027** −0.019 −0.131*** −0.319*** SUB 0.066*** −0.008 −0.003 0.059*** 0.084*** GRW 0.119*** 0.001 0.027** 0.100*** 0.006 VOL 0.118*** −0.046*** 0.062*** −0.189*** 0.010 The table shows Pearson/Spearman correlation coefficients for the holdout sample. The holdout sample comprises 3,933 firms for the period 2002–2003 SIZE log total assets; PRIV 1 if the firm is privately held (does not quote in the Spanish stock market), 0 otherwise; NNF need for new finance, measured as the ratio short-term to long-term banking debt; SUB subjectivity of accruals, measured using the Richardson et al.’s (2005) index; it is obtained by dividing the absolute value of the variation in inventories and in receivables by the whole operating accruals’ structure of the firm (absolute value of the variation in inventories, receivables and payables); GRW growth, measured as sales in year tminus sales in year t−1 divided by sales in year t−1; VOL cash flows volatility, measured as the firm-year OCF minus the median OCF for the whole sample period *, **, *** The coefficient is significant at the 0.10, 0.05 and 0.01 level, respectively held firms exhibit a lower ability to predict the companies’ future cash flows. As in Burgstahler et al. (2006), the negative sign of the PRIV variable, which is significant in all columns (pvalue =0.000) shows that, in code law countries (e.g. Spain) private firms engage in manipulation practices to a greater extent. The negative sign of the NNF variable shows that accruals experience a significant decline in predictive value as firms approach their upper level of short-term banking debt. Company directors in need of new finance exhibit a clear tendency to make use of opportunistic accounting choices to achieve their immediate targets. Following Richardson et al. (2005), we have also incorporated a variable that measures the degree of subjectivity inherent in each firm’s set of accruals (SUB). Given their more arbitrary allocations, subjective accruals have been hypothesized as negatively related to reliability and, by extension, to their level of quality. Our results confirm these expectations. The higher the SUB index (percentage of the variations of inventory and receivables in the accruals of the firm), the lower the incremental contribution of accruals to the prediction of future cash flows. In sum, the four experimental variables taken to proxy for opportunistic manipulation present significant coefficients in the expected direction. This is evidence that accounting manipulation exerts a strong constraining effect on the information value of accruals by substantially lowering their predictive ability. It is also consistent with Hypothesis 2. Except for industry, the control variables exhibit the expected signs. For firms in the growth stage, accruals produce a significantly greater decline in the out-of-sample forecast errors as shown by the positive sign of the GRW variable. Unlike firms in financial distress, growing firms seem to make a less aggressive use of accruals. Their use comes more from the inherent needs of this business stage than from manipulation Likewise, the coefficient of the cash flows volatility variable (VOL) is also significantly positive, that is, the more volatile cash flows are, the greater the predictive ability of accruals, which is consistent with their smoothing properties. 123 516 SERIEs (2012) 3:499–520 Table 5 Decrease in prediction errors as a function of expected accounting manipulation Dependent variable: ABSE1,t+i−ABSE2b,t+i e.s. FOCFt+1FOCFt+2FOCFt+3FOCFt+4 Intercept −0.019 −0.015 −0.010 −0.007 pvalue (0.002) (0.004) (0.035) (0.090) SIZE (+) 0.002 0.002 0.001 0.001 pvalue (0.000) (0.000) (0.004) (0.040) PRIV (−)−0.052 −0.057 −0.050 −0.054 pvalue (0.000) (0.000) (0.000) (0.000) NNF (−)−0.001 −0.001 0.000 −0.001 pvalue (0.008) (0.003) (0.960) (0.056) SUB (−)−0.011 −0.010 −0.011 −0.010 pvalue (0.009) (0.008) (0.003) (0.001) GRW (+) 0.013 0.013 0.008 0.015 pvalue (0.000) (0.000) (0.000) (0.000) VOL (+) 0.018 0.011 0.021 0.009 pvalue (0.000) (0.002) (0.000) (0.005) IND1 (−) 0.018 0.021 0.010 0.006 pvalue (0.000) (0.000) (0.009) (0.087) IND2 (−) 0.004 0.003 0.002 0.001 pvalue (0.042) (0.121) (0.156) (0.319) IND3 (−) 0.005 0.004 0.004 0.000 pvalue (0.011) (0.013) (0.009) (0.733) IND4 (−) 0.015 0.009 0.007 0.006 pvalue (0.000) (0.000) (0.000) (0.000) Adj. R22.29% 2.09% 1.67% 1.88% N7,426 7,346 7,189 6,907 ABSE1−ABSE2b is the difference between the absolute prediction error using the cash flows model (model 1) and the same error using the disaggregated accrual-based model (model 2b). The multivariate model is estimated for each (t+1tot+i) prediction period. FOCFt+iis the average FOCF generated during the period starting in t+1 and ending in t+i,whereiranges from 1 to 4. SIZE,PRIV,NNF and SUB proxy for circumstances where a high level of accounting manipulation is expected. SIZE log total assets. PRIV 1 if the firm is privately held (does not quote in the Spanish stock market), 0 otherwise. NNF need for new finance, measured as the ratio short-term to long-term banking debt. SUB subjectivity of accruals, measured using the Richardson et al.’s (2005) index; it is obtained by dividing the absolute value of the variation in inventories and in receivables by the whole operating accruals’ structure of the firm (absolute value of the variation in inventories, receivables and payables). GRW growth, measured as sales in year tminus sales in year t−1 divided by sales in year t−1. VOL cash flows volatility, measured as the firm-year OCF minus the median OCF for the whole sample period. e.s. expected sign. We include four dummy variables to control for five industrial sectors: IND1 energy and water; IND2 manufacturing; IND3 wholesale trade and IND4 services. Construction, is taken as the industry of reference 123 SERIEs (2012) 3:499–520 517 Finally, with respect to industry, all four variables show a positive sign, which is contrary to our expectations. As construction firms, which are our reference industry, have a longer operating cycle than most other companies, accruals should play a more important role in solving the problems suffered by their mismatched cash inflows and outflows. A possible explanation for the unexpected positive sign found in the four IND variables (all industries show a better predictive ability than construction) is that book values in the construction sector failed to correctly anticipate the decline in market value suffered by their assets in the second half of this decade.17 5.1 Robustness checks 5.1.1 Free cash flows Operating cash flows might not be the most adequate variable to capture firm value because they ignore investment cash outflows made to maintain the economic capacity of the firm (Subramanyam and Venkatachalam 2007). Using operating cash flows, firms with a greater need for long-term investments may be overvalued, unless the risk associated with their cash flows significantly reduces the value of the firm. Free cash flows represent the residual cash after these investments, so they could be a more adequate variable to measure firm value. To analyze whether our results on the forecasting behaviour of accruals and current cash flows are robust to the use of free cash flows, we have re-estimated all our models using free cash flows instead of operating cash flows predictions for each of our t+iperiods from i=1to4. 18 Results are robust in the sense that the disaggregated accrual-based model (ABMd, model 2b) still provides significantly lower forecast errors than both the aggregate model (ABMa, model 2a) and the isolated cash flows model (CFM, model 1). 5.1.2 Private-only firms Given that our main purpose is to test the role of accruals for the prediction of future cash flows in Spain, we tested our first hypothesis using the whole sample with the corresponding proportion of public and private firms. We carry out a sensitivity analysis of Hypothesis 1after ruling out public firms and we find that accruals provide significant incremental insight into future cash flows for a sample of only private firms. As we also included the PRIV dummy variable in the multivariate model estimated to test Hypothesis 2, we are in fact providing evidence that, although significant in both groups, the quality of accruals is significantly better for public than for private firms. 17 In Spain, the construction industry has been, without a doubt, the most seriously affected by the recent worldwide downturn of the economy. 18 As the cash flows statement was not required by Spanish legislation until 2008, we calculate free cash flows as operating cash flows plus the variation of long-term assets. The SABI database provides access to the value of long-term assets at their original cost so its variation is a good proxy for investing cash flows. 123 518 SERIEs (2012) 3:499–520 5.1.3 Robust standard errors One of the requisites of the ordinary least squares technique used for multivariate regression is that the standard errors of the estimated coefficients are independent and identically distributed. The use of panel data sets (e.g., data sets that contain observations on multiple firms in multiple years) increase the likelihood that this requisite is not fulfilled (standard errors are biased) because the residuals might be correlated across firms (firm effect) and across time (time effect). As we use panel data to estimate the multivariate model that tests Hypothesis 2(model 5), we consider it convenient, as an additional check, to re-estimate it assuming both (firm and time) effects are present in our sample. Following Petersen (2009), for panel data with a short-time series, the best method to obtain unbiased standard errors is to parametrically estimate the time variable and then estimate the coefficients with the standard errors clustered by firm. Our results do not change substantially after this new estimation with the exception of the private variable (PRIV), which is not significant. A possible explanation for this is that the cluster for public companies is fairly small in our sample. 6 Summary and conclusions In this paper we analyze whether, in the Spanish context, accrual-based earnings are better able to predict future cash flows than current cash flows. To date most empirical evidence of an incremental value of accruals comes from Anglo-Saxon countries. However, the extension of the Anglo-Saxon empirical support for the benefits of accruals to the Spanish case is yet to be confirmed. In Spain, institutional differences lead to different agency problems and call into question the interest of accounting information for external users. Furthermore, the role of accruals for the prediction of future cash flows is bound to differ across public and private firms and, although the former are likely to be more similar to Anglo-Saxon firms, most Spanish companies are privately held. The Spanish reporting system is especially interesting for this research purpose. While the accounting model took advantage of its adaptation to the EU Directives to approach the Anglo-Saxon model, enforcement mechanisms are still poor in Spain. Motivated by the lack of empirical evidence, the primary purpose of our study is to provide Spanish investors with empirical evidence on the informational value of accruals. Using a sample of 4,397 companies (mostly privately held), we estimate in-sample regressions of future cash flows on isolated current cash flows (model 1) and on accruals-based earnings (model 2) and we subsequently test for differences in the outof-sample prediction errors between the two models. Overall, our results are consistent with the argument that accruals add relevant information for the prediction of future cash flows, that is, that errors provided by an accrual-based model are significantly lower than those obtained with isolated cash flows. This predictive ability increases if we include accruals in the disaggregated fashion (five components) suggested by Barth et al. (2001). As a second hypothesis, we argue that, after controlling for the effect of some business fundamentals, the role of accruals for future cash flows prediction is severely constrained by accounting manipulation. To provide evidence of this, we estimate a 123 SERIEs (2012) 3:499–520 519 multivariate model that regresses the decrease in prediction errors brought about by the addition of accruals on a set of firm-specific circumstances where a high degree of manipulation is expected. For each of the variables used to proxy for these circumstances (small firm size, privately held, the need for new finance and the subjectivity of accruals) prediction errors decrease significantly in the hypothesized direction. The main contribution of the paper is to provide empirical evidence of the incremental ability of accruals to predict future cash flows in Spain. We do this using out-ofsample tests and not mere association tests. Further, we find that the role of accruals for future cash flows prediction is seriously lowered by earnings manipulation. Our results, then, have important implications for Spanish users, auditors and regulators as they highlight the need to strengthen the enforcement of accounting standards. Acknowledgments The authors want to thank the reviewers for their detailed and helpful comments on the previous versions of the manuscript. This study has been carried out with the Financial support of the Government of Navarra (Ayudas a proyectos de investigación, convocatoria 2007) and from the Ministry of Science and Innovation (ECO2010-21627). Open Access This article is distributed under the terms of the Creative Commons Attribution License which permits any use, distribution and reproduction in any medium, provided the original author(s) and source are credited. References Al-Attar A, Hussain S (2004) Corporate data and future cash flows. J Bus Financ Account 31(7–8):861–903 Ansón JA, Arcas Pellicer MJ, Labrador Barrafón M (1997) Análisis de la información contable en la evaluación de riesgos por entidades financieras. Revista Española de Financiación y Contabilidad XXVI(92):777–803 Arnedo L, Lizarraga F, Sanchez S (2007) Does public/private status affect the level of earnings management in code-law contxt outside the United States? A study based on the Spanish case. Int J Account 42(3):305–328 Audit Law (1988) Act 19/1988 of 12th July on auditing Barth M, Cram D, Nelson K (2001) Accruals and the prediction of future cash flows. Account Rev 76:27–58 Brochet F, Nam S, Ronen J (2008) The role of accruals in predicting future cash flows and returns. Working paper. Harvard University Burgstahler D, Hail LM, Leuz C (2006) The importance of reporting incentives: earnings management in European private and public firms. Account Rev 81(5):983–1016 Charitou A (1997) The role of cash flows and accruals in explaining security returns: evidence of the UK. Eur Account Rev 6(4):629–652 Dechow PM (1994) Accounting earnings and cash-flows as measures of firm performance. The role of accounting accruals. J Account Econ 18:3–42 Finance Law (2002) Law 44/2002, of 22nd November, on measures for the reformation of the Financial System Financial Accounting Standards Board (FASB) (1978) Objectives of financial reporting by business enterprises. Statement of financial accounting concepts no.1. FASB, Stamford Francis J, LaFond R, Olsson P, Schipper K (2005) The market pricing of accruals quality. J Account Econ 39(2):295–327 Gabás F, Apellániz P (1994) Capacidad predictiva de los componentes del beneficio: flujos de tesorería y ajustes corto-largo plazo. Revista Española de Financiación y Contabilidad 78:107–142 Gallén L, Giner B (2005) La alteración del resultado para evitar pérdidas y descensos: Evidencia empírica. Revista Española de Financiación y Contabilidad 34(124):141–181 García Lara JM, García Osma B, Penalva F (2007) Board of directors’ characteristics and conditional accounting conservatism: Spanish evidence. Eur Account Rev 16(4):727–755 Gill de Albornoz B, Alcarria JJ (2003) Analysis and diagnosis of income smoothing in Spain. Eur Account Rev 12(3):443–464 123 520 SERIEs (2012) 3:499–520 Gill de Albornoz B, Illueca M (2007) La calidad de los ajustes por devengo no afecta al coste de la deuda de las pymes españolas. Investigaciones Económicas XXXI(1):79–117 Giner B, Sancho A (1996) Análisis dinámico de la capacidad de los flujos de fondos para determinar los futuros flujos de caja. Revista Española de Financiación y Contabilidad 86:9–34 Gupta M, Khurana I, Pereira R (2008) Legal inforcement, short maturity debt, and the incentive to manage earnings. J Law Econ 51:619–639 Hung M (2001) Accounting standards and value relevance of financial statements: an international analysis. J Account Econ 30:401–420 Íñiguez R, Poveda F (2008) Persistencia del resultado contable y sus componentes: implicaciones de la medida de ajustes por devengo. Revista Española de Financiación y Contabilidad XXXVII(137): 31–33 InternationalAccountingStandardBoard(1989)Frameworkforthepreparationandpresentationoffinancial statements. International Accounting Standard Board, IASB, London Kim M, Kross W (2005) The ability of earnings to predict future operating cash flows has been increasing, not decreasing. J Account Res 43:753–780 La Porta R, Lopez-de-Silanes F, Shleifer A, Vishny R (1998) Law and finance. J Political Econ 106(6):1113–1155 Leuz C, Nanda D, Wysocki PD (2003) Earnings management and investor protection. An international comparison. J Financ Econ 69:505–527 Lev B, Siyi L, Sougiannis T (2009) The usefulness of accounting estimates for predicting cash flows an earnings. Working paper, New York University, University of Illinois at Urbana-Champaign Lizarraga F (1997) Los flujos de tesorería en la predicción del fracaso empresarial. Actualidad Financiera 4(abril):73–94 Mora A, Sabater A (2008) Evidence of income-decreasing earnings management before labour negotiations within firms. Investigaciones Económicas 32(2):201–230 Oliveras E, Puig X (2005) Tax and financial reporting in Spain. Account Eur 2:195–207 Petersen ME (2009) Estimating standard errors in finance panel data sets: comparing approaches. Rev Financ Stud 22(1):435–480 Richardson S, Sloan R, Soliman M, Tuna I (2005) Accrual reliability, earnings persistence and stock prices. J Account Econ 39:437–485 Ruiz E, Gómez N, De Fuentes C, García MA (2004) Audit quality and the going-concern decision-making process: Spanish evidence. Eur Account Rev 13(4):597–620 Subramanyam KR, Venkatachalam M (2007) Earnings, cash flows, and ex post intrinsic value of equity. Account Rev 82:457–481 Yoder T (2007) The incremental predictive ability of accrual models with respect to future cash flows. Working paper, Mississippi State University 123