Abstract:
Valuation of business entities has traditionally been backed by careful assessment of
earning components. This study aims to test for value relevance of accruals in determining
earnings quality. Quality of accounting information is crucial for financial success of any
business entity. We aim to test for predictive powers of two basic earning components namely
cash flows and accruals. All financial market models focus primarily on predicting cash flows
with minimum error. The role of accruals in determining earnings quality has largely been
ignored. Accounting literature has widely tested for predictive abilities of these two earnings
components.
This study will provide users of financial statements-analysts, investors and creditors’
information that needs to be carefully scrutinized for predicting future earnings performance and
stock returns. Loss of precious information about earnings may arise if large numbers of
investors are fixated on cash flows and ignore information in accruals. It will provide investors
interested in investing in corporate sector of Pakistan, an idea as to what variables they need to
analyze before making their investment decisions. It has relevance for shareholders, auditors and
policy makers too, as it will provide an insight in to how and through what variables managers
can take advantage of subjectivity associated with accrual components of earnings. The research
findings of this study will have policy and academic implications.
This study confirms the previous findings of lower persistence of accruals compared to
cash flows in determining future earnings quality. The reason underlying this is that accruals are
not as reliable as cash flows. Entities might manipulate accruals to make their financial reports attractive for investors. This makes accruals a subjective accounting head as it solely depends on
management’s discretion and their assumptions.
However, stock prices do not instantaneously reflect different predictive abilities of
accruals and cash flows. Investors tend to overweight accruals and underweight cash flows when
forming future earnings expectations. They ignore the fact that accruals have lower predictive
ability as compared to cash flows due to subjectivity and lower reliability associated with them.
As a result, high accrual firms earn negative abnormal returns in future and vice versa.
