Partitioning Earnings into Operating Cash Flow and Accrual Components
Operating cash inflows and outflows are easy to identify and measure. However, accrual accounting requires a consideration of changes in non-cash assets and liabilities to measure earnings. Non-cash assets and liabilities are called accruals. Earnings are the sum of cash flow and accrual changes. For example, if a firm performs a service for $1,000, collecting $700 in cash and a $300 account receivable from a customer and promising to pay an employee $200 in wages, the firm’s earnings equal $800:
Operating cash inflows and outflows are easy to identify and measure. However, accrual accounting requires a consideration of changes in non-cash assets and liabilities to measure earnings. Non-cash assets and liabilities are called accruals. Earnings are the sum of cash flow and accrual changes. For example, if a firm performs a service for $1,000, collecting $700 in cash and a $300 account receivable from a customer and promising to pay an employee $200 in wages, the firm’s earnings equal $800:
Accrual accounting is superior to cash accounting on the dimensions of capturing economic content and predicting future cash flows. The $100 net increase in accruals is a prediction of future cash flows. Next period, the firm will collect the $300 accounts receivable in cash and pay the $200 wages payable in cash, yielding a net inflow of $100 in cash.
Analyzing Patterns in Accruals
If managers attempt to manage reported earnings, they will typically do so through accruals estimates. Even if managers do not introduce bias into the financial statements, the accrual component of net income will exhibit a persistence that differs from the operating cash flow component of net income. To further clarify what is meant by ‘‘accruals,’’ Exhibit 6.11 provides a schematic of a statement of cash flows and identifies accruals
Analyzing Patterns in Accruals
If managers attempt to manage reported earnings, they will typically do so through accruals estimates. Even if managers do not introduce bias into the financial statements, the accrual component of net income will exhibit a persistence that differs from the operating cash flow component of net income. To further clarify what is meant by ‘‘accruals,’’ Exhibit 6.11 provides a schematic of a statement of cash flows and identifies accruals
Accruals are the adjustments that reconcile cash flows from operations and net income. They are components of earnings because they map underlying economics into reported profitability. Investors who fixate on net income or operating cash flows without understanding the relation between the two may make erroneous inferences regarding thepersistence of cash flows or earnings.
Sloan examined the relation between net income and operating cash flows by focusing on the behavior of net income conditional on the magnitude of accruals. He defines the accrual component of current earnings as net income minus operating cash flows, and then scales the amount by dividing by the average of beginning and ending total assets so that firms can be compared regardless of their size. He then ranked firms based on this measure of accruals. He plotted net income (scaled by average total assets) for five years before and after the year in which he measured the accruals.
Exhibit 6.12 provides the plots for the decile of firms with the lowest (most negative) accruals and the decile of firms with the highest (most positive) accruals. The top line on the graph indicates that in the ranking year, firms with the highest current accruals have very high income. Moreover, this high income represents a spike relative to the previous five years. More importantly, it represents a spike that reverses almost entirely
Exhibit 6.12 provides the plots for the decile of firms with the lowest (most negative) accruals and the decile of firms with the highest (most positive) accruals. The top line on the graph indicates that in the ranking year, firms with the highest current accruals have very high income. Moreover, this high income represents a spike relative to the previous five years. More importantly, it represents a spike that reverses almost entirely
in the next year. On the other side, firms with the most negative current accruals report net income that is extremely low relative to prior years, but this decline turns around over the following years. When net income is high relative to operating cash flows, we describe the firm as having recorded ‘‘income-increasing’’ accruals; when net income is low relative to operating cash flows, we describe the firm as having recorded ‘‘incomedecreasing’’ accruals. Non-working capital accruals (e.g., depreciation) tend to be more persistent than working capital accruals (e.g., accounts receivable, accounts payable, inventory), which tend to go up and down and generally fluctuate around zero for mature firms.
The patterns of net income in Exhibit 6.12 indicate that when net income is high because of large income-increasing accruals (such as increases in accounts receivable and decreases in payables), the reversal of these accruals generates predictable decreases in the level of earnings in future years. The same is true for incomedecreasing accruals (such as decreases in receivables and increases in payables). This should be intuitive. For example, if a firm generates a spike in sales made on credit, this increases accounts receivable and recognized sales. In the following year, the firm will have to generate incremental sales to maintain the level (or growth) in sales, which is difficult to do if the prior year’s high levels were unusual or transitory. The statement of cash flows highlights the evolution of receivables by quantifying periodto- period changes in the balance. If a firm with a high increase in sales made on credit does not replenish these with more sales, the statement of cash flows in the following period will indicate a decrease in receivables. Although the collection of cash will contribute to cash flows from operations, net income will tend to fall because of the relative reduction in sales due to the non-replenishment of prior-period credit sales.
The patterns of net income in Exhibit 6.12 indicate that when net income is high because of large income-increasing accruals (such as increases in accounts receivable and decreases in payables), the reversal of these accruals generates predictable decreases in the level of earnings in future years. The same is true for incomedecreasing accruals (such as decreases in receivables and increases in payables). This should be intuitive. For example, if a firm generates a spike in sales made on credit, this increases accounts receivable and recognized sales. In the following year, the firm will have to generate incremental sales to maintain the level (or growth) in sales, which is difficult to do if the prior year’s high levels were unusual or transitory. The statement of cash flows highlights the evolution of receivables by quantifying periodto- period changes in the balance. If a firm with a high increase in sales made on credit does not replenish these with more sales, the statement of cash flows in the following period will indicate a decrease in receivables. Although the collection of cash will contribute to cash flows from operations, net income will tend to fall because of the relative reduction in sales due to the non-replenishment of prior-period credit sales.
Ultimately, declines in earnings are strongly associated with declines in security prices. If investors neglect to examine the components of net income, they may fail to appreciate the fact that large earnings driven by large income-increasing accruals are less persistent. Similarly, they might fail to appreciate that low earnings driven by large income-decreasing accruals also are less persistent and generally reverse with improved earnings in future periods. If enough investors fail to fully appreciate the relation between components of current earnings and future earnings, the result may be mispricing a firm’s common stock. Indeed, this describes the pattern of stock returns for the firms shown in Exhibit 6.12.
No comments:
Post a Comment