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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS
COPY RIGHT 2013 Institute of Interdisciplinary Business Research
173
JUNE 2013 VOL 5, NO 2
The Relationship between Earnings before Interest and Tax and Operating Cash Flow
and Stock Return in Information Asymmetry Conditions at Pharmaceutical Companies
of Abidi and DarouPakhshApplying Markov-switching Approach
Hossein Parsian
M.A in accounting, Raja university
Amir Shams Koloukhi
Department of Accounting, Torbat-e-Jam Branch, Islamic Azad University, Torbat-e-
Jam, Iran
SajadAbdipour
M.A in accounting, USB university
MojtabaAkbarpour
M.A in accounting, USB university
Abstract
One of most fundamental economic issues is optimal resource allocation towards productive
investment with rational risk-taking. In doing so, there is a need to performance evaluation
indices, some of which emphasize upon cash flow variables and some others upon
information contents of accounting earning. Therefore, it is tried to consider the relationship
between earnings before interest and tax and operating cash flow and shareholders return at
pharmaceutical companies of Abidi and Daroupakhsh. Then this relationship was tested in
conditions of information asymmetry. In order to test hypotheses, nonlinear Markov-
switching was applied. Results obtained from experimental tests using relating information
from 2002 to 2011 indicate that independent variable of earnings before interest and tax has
no significant relationship with stock returns of two companies. In other words, earnings
before interest and tax have information content toward operating cash flow. Also by
increasing information asymmetry it was observed that variable of earnings before interest
and tax have more correlation with companies stock return towards variable of operating
cash flow. In other words, in conditions of information asymmetry, accrual variables have
more information content towards variables of cash flow.
Key words: INFORMATION ASYMMETRY, ACCRUALS, CASH FLOW, TOTAL
SHAREHOLDERS RETURN, MARKOV-SWITCHING APPROACH
Introduction
In terms of presence in the path of economic development and regarding privatization, it
seems that in our country size of investment will have growing trend during future periods,
while regarding information asymmetry investors need some indices to assess companies
performance to make appropriate economic decisions through following them. To do so,
some performance evaluation indices may be required, some of which emphasize upon
variables of cash flow and some others upon information content of accounting earnings.
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Studies by Aston et al (1992)and Dichev et al (1998),Haw et al (2001), and Stephen Rapp
(2010) indicate that earnings (due to additional information content in its accrual
components) has more information content towards cash flows. Also at international level,
Bartov et al (2001) examined earnings information content and cash flows for assessing
equities in countries of US, England, Canada, Germany, and Japan. Results showed that
earnings have more importance towards cash flows. However, respecting asymmetric
distribution of information among people, it seems that variables of cash flow have more
information content for explaining performance of companys market towards accounting
earnings. Hence, it is tried in present study to examine the relationship between earnings
before interest and tax and operating cash flow and shareholders return in pharmaceutical
companies of Abidi and Daroupakhsh.
Research theoretical considerations
In opinion of most of financial statements users, accounting earning provided by using
accrual system is a tool measuring performance of a company. The mean by measuring
companies performance is to assess financial statements and operations results to making
rational decisions.in statement no.6 for financial accounting concepts; financial accounting
standards board necessitates applying accrual method in accounting. Based on this, to reflect
effects of transactions and events of company doesnt mean necessarily entry and exit of
cash. In other words, in accrual method, some principles such as realization and
matching are applied to reflect incomes and costs and computing accounting earnings
(financial accounting standards board, 1985). On the other hand, operating cash flow is one
of main indices for assessing performance based on view of internaland external users of
organization, especially investors and creditors. In theoretical framework, financial
accounting that determines objectives of financial reporting takes special consideration to
cash flows and possibility of its prediction. In statement no.1 of financial accounting concepts
of financial accounting standards board it is states:
One of financial reporting objectives is to provide information to help present and
potential investors and creditors and other users in assessing the amounts, timing, and
uncertainty of prospective cash receipts from dividends or interest and the proceeds from the
sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are
affected by an enterprise's ability to generate enough cash to meet its obligations when due
and its other cash operating needs, to reinvest in operations, and to pay cash dividends and
may also be affected by perceptions of investors and creditors generally about that ability,
which affect market prices of the enterprise's securities. (FASB, 1978: par.37)
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Also International Accounting Standards Committee (IASC) states in International
Accounting Standard no.7:
Information about the cash flows of an entity is useful in providing users of financial
statements with a basisto assess the ability of the entity to generate cash and cash equivalents
and the needs of the entity to utilize those cash flows. The economic decisions that are taken
by users require an evaluation of the ability of anentity to generate cash and cash equivalents
and the timing and certainty of their generation (IASC, 1993).
Iranian Accounting Standards Committee states in the part of theoretical concepts of financial
reporting:
Taking economic decisions by users of financial statements require an evaluation of the
ability of an entity to make cash and certainty of their generation. Evaluating the ability of
generating cash is facilitated through focusing upon financial status, financial performance,
and cash flows of an entity and utilizing them in predicting expected cash flows and
measuring financial flexibility (Technical committee of Audit Organization,2002: 49).
There are some differences between accounting earning and operating cash flows due to
effect of the following factors:
1. First factor is non-cash costs (such as depreciation costs) that reduces net profit,
however causes no reduction in cash value of company.
2. Second factor is time difference of income realization and receiving its payment and
also to bear cost and to pay its payment.
3. Third factor refers to non-operating gain and loss resulted from sale of fixed
assets,securities, and other types of investment taken into account in loss statements
and may cause transition in net profit, however have no effect upon activities of cash
flows statements.
Figure.1 shows different states that accrual and cash systems may have towards each other.
Each figure shows information available for market per moment. First state is when both gain
(earning) and operating cash flow contain important information. Second one is state in
which both gain (earning) and cash flow have important information but none of them
contains incremental information content towards the other. Ultimately, the last state is when
one of variables (for example earning (gain)) has incremental information content, but its
reverse is not true(Bowen et al, 1987). In other words, it is tried in present study to consider
the relationship between earning and operating cash flows and stock return, then this
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relationship would be tested in information asymmetry conditions to signify that which one
has stronger relation with shareholders returns.
Figure.1: Possible results of the study about incremental information content of cash flows
and accrual flows (Bowen et al., 1987)
ThirdstatestateSecond First state
Literature review
Gambula and Ketz (1983) in their study examined the relationship between figures obtained
from accrual earning and cash flows. The results of their study indicate that cash flow lack
information importance compared with accounting earning (Gambula and Ketz, 1983).
Rayburn (1986) in his study examines the relationship between unexpected accrual
components and cash flows with stock return. The results of this study show that both
components, accounting earning and cash flows, have information content (Rayburn, 1986).
Wilson (1987) in a study examined the role of information content of earning components
towards the values of earning itself through dividing cash and accrual components of earning.
The results indicate that earnings accrual components contain incremental information
content towards its cash components (Wilson, 1987). Bowen et al (1987) studied incremental
information content of cash and accrual figures. The results of their study show that
information related to earning and cash flows contain incremental content towards each other.
Also, information related to cash flows has incremental information content towards earning
(Bowen et al., 1987). Easton in his research examined relative information content of earning
and cash flows. The results of this study reveal that earning has higher information content
compared with cash flows (Easton et al., 1992).
Dechow (1924) in his study considered accounting earning and cash flows as an index of
performance evaluation. The results of this study indicates that as firm has less fluctuations in
supplying its required funds, cash flows have better conditions for measuring performance. In
his opinion, during short time periods (form example; three months or a year), firm;s earning
has more relationship with return and cash flows. (Dechow, 1994).
Hodgson and Stevenson (2000) in their research studied the relationship between earning and
cash flows with stock return affected by firms size. The results of this study indicate that
Accrual basis
Cash basis
Cash basis
Accrual
basis
Accrual basis
Cash basis
Market information
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cash flows provide more additional information for firms with big size towards firms with
small size. Also, smaller firms contain more unstable earning components towards bigger
ones. In addition, non-linear relation between earning and cash flows has higher descriptive
strength compared with when this relationship was examined as linear (Hodgson and
Stevenson, 2000). Club et al. (2000) in their research examined the relationship between
earning and operating cash flows with stock return in Japan from 1985 to 1993. The results of
this study reveal that when earning has more unstable state, cash flows have more significant
role for determining return (Club et al., 2000).
Bartov et al (2001) in their study examined information content of earning and cash flows for
evaluating equities interest in Us, England, Canada, Germany, and Japan. The results indicate
that in US, England, and Canada earning has more significance towards cash flows but in
Germany and Japan it is not as such. In other words, national method in factor reporting that
effects upon information content of earning and cash flows (Bartov, 2001). Haw et al. (2001)
in a study examined information content of operating cash flows, earning, and accruals in
Chinas stock market. The results show that earning contains more information content
towards operating cash flows and also incremental information content of discretionary
accruals against non-discretionary accruals was conformed (Haw et al., 2001). Chan et al.
(2006) in their study examined the relationship between accrual figures (accounting)
(difference between earning and cash flows) with stock return. The results of this study
indicate that stock return of firms with high accrual accounting (figures) is reduced during
next period of financial information reporting (Chan, 2006). Subramanyam and
Venkatachalam (2007) examined the relative significance of earning and cash flows in equity
evaluation. The results show that earning may have better performance in explaining intrinsic
realized value compared with cash flows (Subramanyam and Venkatachalam, 2007).
Arthur et al. (2009) in their research studied information content cash flow and accruals. The
results of their study indicate that earning cash components contain information content for
investors and dividing earning into cash flows and accruals contains incremental information
content towards disclosure of total earning figure (Arthur et al., 2009).
Steffen Rapp in his research studied the relationship between accounting earning and cash
flows with shareholders return in information asymmetric conditions. The results of this
study show that in information asymmetric conditions, accounting earning contains more
information content towards cash flows. However, through increasing information
asymmetry cash flow indices are more relevant in explaining performance of stock market
(Steffen Rapp, 2010).
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Analysis model
The current method for studying dynamic behavior of economic and financial variables is to
use various models of time series. Among these time series models, linear models such as
Auto Regression (AR) or a combination of these models(ARMA) are well known. A part of
their currency may be because of easy estimation of these models through common
econometric soft wares. Although they act in some cases successfully, they fail in describing
non-linear behaviors such as asymmetry, etc. one of most famous non-linear time series
models is Markov-switching model. This model was first introduced by Quant (1972),Quant
and Goldfield (1973). Then it was developed by Hamilton (1989) to derive commercial
cycles. Generally, it is assumed in non-linear models that behavior of a variable, upon which
modeling has been done is different and transition in different states. In terms of speed of
transition from one state to another, these non-linear models are divided into two main
groups. In some of them, transition from one state to another state is slow and smooth (like
model STAR3 and artificial network ANN4). In some others, the transition is done quickly
that Markov-switching model is among them (Enders, 2004:404). In model of Markov-
switching, probability are applied to divide time series variables, or relations between
variables into two regimes or more. Method of Markov-switching is able to explain features
of regimes information asymmetry because of being non-linear; hence it is more appropriate
towards VAR and ARMIA.
Used data in present study has been collected from audited financial statements. To do so,
main part of information has been collected form software Rahavard Novin, and Tadbir
Pardaz and other information has been gathered form center of research and Islamic studies
management of organization of securities market and also from information bank of this
organization. Software Ox Metrics Vol.6 used for statistical test.
Research hypotheses
Hypothesis.1: accounting variables have better performance towards variables of cash flows
in explaining companies stock return performance (capital market)
Hypothesis.2: by increasing information asymmetry, accounting variables play more
significant role in describing companies stock return performance (capital market) compared
with variable of cash flows.
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Research variables definition
Research variable have been summarized in table.1
Table 1. Research variables definition
variables
BETAit
Variable of size for firm at time (SIZE) is measured by logarithm of
total assets
SIZEit
The market-to-book ratio of equity of firm at time MTBit
Earning per share to market stock price (firm at time ) ETPit
Return percentage of shareholders (firm at time ) Rit
Earning before interest and tax (firm at time ) EARit
Operating cash flow(firm at time ) CFit
Total dept to total asset ratio (firm at time ) LEVit
For measuring information asymmetry, three virtual variables are applied as follows;
MACPit: If value of companys market from the average market value of annual portfolio is
greater than value of market capital, it is considered as 1, otherwise zero.
INTANGit: If proportion of tangible fixed assets to total assets of company per year is greater
than average value of the same proportion in annual portfolio, it is considered as 1, otherwise
zero.
DOMINATEDit: If floating shares of company is less than 50%, it is considered as 1,
otherwise zero.
Regression models related to research hypotheses are as follows;
Hypothesis 1: =0+1it+2CFit+
Hypothesis 2:
=0+1it+2CFit+1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy
MACPit +
=0+1it+2CFit +1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy
INTANGit+ e0
=0+1it+2CFit +1BETAit+2SIZEit+3MTBit+4ETPit+5LEVit+6 dummy
DOMINATEDit+ e0
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Data analysis
First step for estimating the model in Markov-switching method is making sure that data
model is non-linear. Therefore, LR test was applied and the results were presented in table.2.
Table 2. Results of LR test
Probability Statistics Firm
0.000 623.74 Abidi
0.000 579.04 Daroupakhsh
As shown in results of the table above (by comparing value of statistic of LR test with critical
value) considered variables follow a non-linear model. Therefore, linear method for
estimating models parameters is not suitable and applying non-linear method is better for
obtaining relation between variables. Therefore, in this study Markov-switching non-linear
model has been applied. Results obtained from estimating model of hypothesis.1 in Markov-
switching are provided in Table.3.
Table.3: Results of estimating model of hypothesis.1 in Markov-switching method
Sig. variables coefficient statistics
Abidi
0.000 EAR 0.00145 24.5
0.986 CF 0.00036 0.0184
Sig. variables coefficient statistics
Daroupakhsh
0.042 EAR -0.0487 -2.30
0.667 CF -0.0168 -0.475
Results of estimating model of hypothesis.1 for company of Abidi indicate that effect of
independent variable of earning before interest and tax upon companys stock return, 0.00145
is positive and significant. In company of Daroupakhsh, effect of variable of earning before
interest and tax upon stock return, -0.04872, was negative and significant in error level of
5%. In addition, operating cash flow has no significant effect upon stock return in both
companies.
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Results obtained from estimating model of hypothesis.2 in Markov-switching are presented in
table.4.
Table 4.Results of estimating model of hypothesis.1 in Markov-switching method
When virtual variable Macp added When virtual variable Intang added When virtual variable Dominated added
Sig. Coefficient Variable Sig. Coefficient Variable Sig. Coefficient Variable Abidi 0.000 0.002289 EAR 0.000 0.002149 EAR 0.000 0.00225 EAR 0.000 -0.000326 CF 0.000 0.0003 CF 0.000 -0.00112 CF
When virtual variable Macp added When virtual variable Intang added When virtual variable Dominated added
Sig. Coefficient Variable Sig. Coefficient Variable Sig. Coefficient Variable Darupakhsh 0.000 -0.00219 EAR 0.000 -0.00222 EAR 0.000 -0.00227 EAR 0.000 0.00073 CF 0.000 0.00074 CF 0.000 0.00075 CF
As shown in table.4, after adding virtual variables as representatives for information
asymmetry, the relationship between independent variables with stock return changed for
both companies, so that a significant relationship is observed between independent variable
of earning before interest and tax and operating cash flow and companys stock return. Also,
it is observed by comparing coefficients (factors) of earning before interest and tax and
operating cash flow that in all cases, factor of earning before interest and tax is greater than
factor of operating cash flow. In other words, in conditions of information asymmetry,
variables of cash flow have more correlation with companies stock return towards accrual
variables. In figure.2 probability of each regime per year is shown.
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2-1-1: company of Abidi- through adding virtual variable of Macp
Fig.2: probability of each regime
2-1-2: company of Abidi- through adding virtual variables of Intang and Dominated.
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2-2: company of Daroupakhsh- through adding virtual variables of Macp, Intang, and
Dominated.
Respecting figure.2, years of study are categorized and summarized intable.5.
Table 5. categorization of years of study by considering regime
Years categorized in each regime
Studied
regime
Abidi
When virtual
variable Macp added
When virtual variable
Intang added
When virtual variable
Dominated added
2002-2004, 2011 2002, 2004, 2005,
2008, 2009
2002, 2004, 2005,
2008, 2009
Regime 1
2003 2003, 2006, 2007,
2010, 2011
2003, 2006, 2007,
2010, 2011
Regime 2
Years categorized in each regime
Studied
regime
Darupakhsh
When virtual
variable Macp added
When virtual variable
Intang added
When virtual variable
Dominated added
2003, 2005, 2006,
2009, 2011
2003, 2005, 2006,
2009, 2011
2003, 2005, 2006,
2009, 2011
Regime 1
2002, 2004, 2007,
2008, 2010
2002, 2004, 2007,
2008, 2010
2002, 2004, 2007,
2008, 2010
Regime 2
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At the end, in table.6 probability of transition from a regime at time t to another regime at
time t+1 for each company is shown.
Table6. probability of transition from a regime at time t to another regime at time t+1
Regime 2 in period t Regime 1 in period t Regime probability Abidi
0.49951 0.49951 Regime 1 in period t + 1
0.50049 0.50049 Regime 2 in period t + 1
Regime 2 in period t Regime 1 in period t Regime probability Darupakhsh
0.49976 0.49976 Regime 1 in period t + 1
0.50024 0.50024 Regime 2 in period t + 1
Table.6: probability of transition from a regime at time t to another regime at time t+1
Conclusions
Research results show that in pharmaceutical company of Abidi and company of
Daroupakhsh, independent variable of earning before interest and tax has a significant
relationship with stock return of both companies. It is the case that variable of operating cash
flow has no significant relationship with stock return of both companies.in other
words,Results of adding these two variables are the same; therefore further representation of
diagram is avoided.
Results of adding these three variables are the same; therefore further representation of
diagram is avoided.Interest and tax contain information content towards operating cash flow.
By increasing information asymmetry it is observed that variable of earning before interest
and tax has stronger relationship with companies stock return towards variable of operating
cash flow. In other words, in conditions of information asymmetry, accrual variables have
more information content compared with variables of cash flow. Results of this research are
similar to those of studies by Gambula and Katz (1983), Easton(1992) and Haw et al (2001)
indicating that accounting earning has more information content towards cash flow. However
it has some contrast with research by Stephen Rapp (2010) indicating that through increasing
information asymmetry, cash variables are more relevant towards accrual variables. Results
of this research shows that earning (due to additional information content within its accrual
components) contain more information content towards cash flows and investors should take
this important point into consideration in their decisions.
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