A Trading Model Demonstrating the Usefulness of Accounting-Reported Cash Flow Information

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A Trading Model Demonstrating the Usefulness of Accounting-Reported Cash Flow Information

The accounting and financial communities have recently asserted that cash flow analysis is fundamental in assessing an economic entity. The Financial Accounting Standards Board (FASB) first emphasized the importance of cash flow data in Statement of Financial Accounting Concept Number One: Objectives of Financial Reporting by Business Enterprises[8]. In this statement the FASB contends:

People engage in investing, lending and similar activities primarily to increase

their cash resources. The ultimate test of success (or failure) of those

activities is the extent to which they return more (or less) cash than they cost.

A successful investor or creditor receives not only a return of investment

but also a return on that investment (cash, goods, or services)

commensurate with the risk involved. The FASB also states that financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the enterprise. FASB concepts statement No. 5 [9], Recognition and Measurement in Financial Statements of Business Enterprises, reiterates the importance of cash flow information and directs that a full set of financial statements should show the cash flows during the period under report (para. 13). Late in 1987 the FASB adopted SFAS No. 95, which required that cash flow information become the primary basis for the third financial statement. The FASB's statements embody the beliefs of many in the investment community that cash flow analysis is necessary when examining the risk and return of an entity and that accrual-based net income is inadequate for a complete assessment of an investment.

Prior empirical studies by Ball and Brown[3], Beaver, Kettler, and Scholes[4], Gonedes[12, 13], Beaver and Manegold[5], Patell[21], and Hill and Stone[18] all show that accrual-based net income is useful in assessing systematic risk and that a correlation does exist between accounting beta and market beta. The review of market-based accounting research by Lev and Ohlson[20] stipulates that these previous studies provide the "good news" that earnings announcements do affect stock prices and, therefore, do have information content. The "bad news," however, is that investigation into the information content of other accounting variables is incomplete.

The information content of earnings has been studied[1, 2, 7, 15, 19, 22, 23], and the results seem to provide evidence that dividend information is also informative, especially when coupled with earnings information. The information of cash flows, however, falls within the "bad news" described by Lev and Ohlson [20]. Greene[14], Heath and Rosenfield[17], and Viscione[24] all suggest that cash flow is important in assessing financial distress. Heath and Rosenfield[17] also suggest that cash flow information is necessary in reporting the results from operations and that it is therefore necessary in making investment decisions.

The importance of cash flow information to investors is also empirically examined in studies conducted by Harmon[16], Bowen, Burgstahler, and Daley [6], Wilson[25], and Franz and Thies[10], all of whom use the event study technique to ascertain the information content in cash disclosures. A primary drawback in these event studies is the difficulty of establishing the date the event occurred. Wilson[25] in particular went to extremes to isolate the earnings announcement date and the release date of the financial report. His study is predicated upon the assumption that cash flow figures can only be derived from full financial statements and that market reaction does not precede the financial report release date. However, financial data are sometimes leaked or released prior to the formal release of the statements, and, therefore, the initial public availability of information may not be isolable to one specific point in time. …