UK corporate data and future cash flows

Abstract

This study examines the ability of current accounting data to explain future cash flows for UK firms, as disclosed under FRS I (1991, revised 1996). Rather than examining price data - from which cash flow implications have to be inferred -a more direct approach used in several recent US studies is adopted, in which actual future cash flow data are examined. Specifically, the methodology is a development of the OLS regression framework employed by Barth, et al. (2001). In the first stage of this study, a replication of their main OLS analysis is provided, and then extended to deal with fixed effects and time trends in the levels of cash flow data. The results show that (i) aggregate accruals have incremental information content beyond that already existing in aggregate earnings; (ii) the main components of aggregate accruals (depreciation and changes in accounts payable, accounts receivable, inventory) have incremental information content beyond that already existing in either earnings or aggregate accruals; and (iii) cash flows alone outperform earnings alone in explaining the variation in future cash flows. Furthermore, accruals (either aggregate or the individual components of accruals) have incremental information content beyond that already existing in cash flows. This evidence supports FRS I's assertion that accruals data should be used in conjunction with cash flow data in predicting future cash flows. The research design is then developed to examine the effect of firm characteristics on the association of earnings, cash flows and accruals with future cash flows. The results show that the decomposition of earnings into cash flows and accruals is more relevant and more value useful when: (i) the length of the operating cycle is short; (ii) the performance level is not extreme; (iii) the magnitude of total accruals is high; and (iii) the probability of default risk is high. The results also reveal that earnings outperform cash flows in explaining the variation in future cash flows when: (i) the magnitude of total accruals is low, and (ii) the probability of default risk is low.