Do investors fully understand the economic implications of cash flows from operations

Do Investors Fully Understand the Economic Implications of Cash
Flows from Operations?

by
Mei Luo

B.ECON. (Tsinghua University) 1998
M.S. (University o f California, Berkeley) 2002

A dissertation submitted in partial satisfaction o f the
requirements for the degree o f
Doctor o f Philosophy
in
Business Administration
in the
GRADUATE DIVISION
o f the
UNIVERSITY OF CALIFORNIA, B E R K E L E Y

Committee in charge:
Professor Xiao-Jun Zhang, Chair
Professor Sunil Dutta
Professor Daniel L. McFadden
Professor M aria Nondorf
F a ll

2004

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UMI Number: 3165474

Copyright 2004 by
Luo, Mei

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Do Investors Fully Understand the Economic Implications of Cash
Flows from Operations?

Copyright © 2004
by
Mei Luo

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ABSTRACT

Do Investors Fully Understand the Economic Implications of Cash Flows
from Operations?

by
Mei Luo

Doctor o f Philosophy in Business Administration
University o f California, Berkeley
Professor Xiao-Jun Zhang, Chair

This dissertation investigates the forecasting ability and persistence with respect to
future cash flows o f four cash components, the inclusion o f which with Cash Flows from
Operating Activities have the potential to generate misleading signals about the
company’s financial picture. It also examines whether market participants fully reflect the
cash components’ respective implications for future cash flows. Current operating cash
flows play an important role in assessing future economic conditions and security values.
The GAAP-based rules or flexibility faced by managements for reporting operating cash

flows can potentially mislead investors in their assessments. Four components of
operating cash flows are collected from fiscal years 1988-2000 for firms in the Fortune

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500 index as o f 2001: (1) nonrecuning cash flows, (2) tax benefits realized from
nonqualified employee stock options, (3) investment-type cash outflows - R&D expenses
and cash outlays involved in restructuring activities, and (4) cash proceeds from selling or
securitizing accounts receivables. The dissertation documents that these operating cash
components possess incremental value in predicting future cash flows over total
operating cash flows and accrual components. They also differ in persistence from other
operating cash flows coming from companies’ core and continuing operations.
Furthermore, hedge portfolios using the information in tax benefits realized prior to the
year 1999, research and development expenses and transactions o f selling or securitizing
accounts receivables can separately earn positive abnormal returns over the subsequent
six months up to three years. Their return predictive abilities persist after controlling for
factors previously documented to predict returns. The empirical findings indicate that the
stock market may not fully appreciate future economic implications o f components of
current operating cash flows. Further analysis verifies that the market mispricing is
partially due to failures to fully impound the future cash flow information (not
necessarily future earnings information) contained in the operating cash flow
components.

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This dissertation is dedicated to my parents: Luo Wanxin W 7 I M and Yu Dan ^

for their eternal love and faith in me, to my husband Zheng Yi ^

for his

indispensable encouragement and support, and my sister Luo Yan ^ ffe for her
company.

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TABLE OF CONTENTS

1.

Introduction........................................................................................ 1

2.

Motivation and Hypotheses

3.

Research Methodology..........................
3.1

.....

17

3.1.1 Forecasting Im p licatio n s ............................

3.L2 Persistence of C u rre n t Cash C om ponents...........................

17
21

3.2

22

Tests of Hypothesis I I ........................

3.3

...............
............................

3.3.1
3.3.2

26
Persistence of the Cash C om ponents for F u tu re E a rn in g s ..................26
A bnorm al R eturns Associated w ith F u tu re C ash N ews....................... 26

Data and Sam ples
4.1
4.2

22
23

F u tu re E arnings Im plications V ersus F u tu re C ash Flow Implications..

......

5.

17

Test of Hypotheses H I (1) - H I (4)............................

3.2.1 Portfolio A nalysis
3.2.2 Regression A nalyses

4.

9

............

29

Sam ple Selection and D escriptive Statistics ............. ........... ................... 29
D ata Collection P rocedures................. ................................. .......... ......... . 31

Empirical Results.

35

5.1

35

F u tu re Cash Flow Im p licatio n s......................
ii

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5.2
R esults of Hypothesis H I I ...........................
53
F u tu re E arnings Implications V ersus Future C ash Flow
Im plications
.............................

37

Bisciissions and Sensitivity Analyses

43

........

41

6.1
A bnorm al R etu rn s A ssociated W ith Tax Benefits From Stock O ptions
.................
.............4 3
6.2

Sensitivity Analyses..................................
44

7.

Conclusions and Implications.......................................................... 46

References............................

48

Appendixes..........................................

51

Figures...............................

59

Tables........................................................................................................... 63

m

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ACKNOWLEDGEMENTS

I would like to than my dissertation chair Xiao-Jun Zhang, for his continual
encouragement and invaluable guidance that is indispensable for the development and

completion o f this work, the dissertation committee members Daniel L. McFadden and
Maria Nondorf, for many great comments and suggestions, and especially to committee
member Sunil Dutta for his support and mentoring to my endeavors pursuing the
academic career. I have benefited greatly from discussions with William Beaver, Qintao
Fan, Dwight Jaffee, Brett Trueman, and workshop participants at University of
California, Berkeley and Stanford University.
The generous help from my fellow doctoral students is gratefully acknowledged.
Special thanks are due to Donglin Li, Haifeng You and Katherine Gunny. I would also
like to thank Qing Yang, Jinwen Xiao, Jennie Jiang and Yan Liu, whose friendship made
m y study at Berkeley enriching and enjoyable. Finally, thanks to warm-hearted dean
Campbell, faculty and staff o f the Haas School o f Business for making my stay in
Berkeley smooth.
My greatest debt is to my parents, Yu Dan and Luo Wanxin, whose love and pride in
me made the completion o f this degree possible. I am also indebted to m y husband, Yi
Zheng, whose constant support, help and encouragement accompanied me through the
whole process. I am grateful to my sister Luo Yan who grew up with me and helped me
become the person I am today.

IV

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1. Introduction

The neo-classical equity valuation model well establishes that the equity value equals
the discounted value o f expected future free cash flows. Three versions of the valuation
approaches are commonly used: free cash flows model, dividends model, and earnings
model. Under the premise that cash flow prediction is fundamental to assessing firm
value, the investment community and academic research have studied the prediction o f

future cash flows. The Financial Accounting Standards Board (FASB) also indicates that
a primary objective o f financial reporting is to provide information to help investors,
creditors and others assess the amount and timing o f prospective cash flows.' The ability
o f current operating cash flows to predict firms’ future cash flow performance is evident
in prior studies. The general conclusion is that earnings components - aggregate cash
flows from operations and accruals, have significant predictive ability for future cash
flows from operations, a component o f free cash flows (e.g., Dechow et al. 1998, Barth et
al. 2001 and Finger 1994). Using share prices as an implicit proxy for expected future
cash flows, studies have shown that current cash flows from operations has information
content incremental to current earnings and accruals (e.g., Wilson 1986, 1987). These
studies tend to treat each dollar o f current cash flows from operations as having the same
persistence or the same predictive ability for future cash flows, ignoring the composition
of the cash flows.^

FASB 1978, 37-39.
^In the presence of other explanatory variables that may capture information in the cash composition, the
same predictive ability is still imposed on each dollar of cash after controlling for the other variables in
predicting future cash flows.

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“Cash is the King”, which has been proposed as the underlying valuation metric, and
often times the closeness to cash figure is used to diagnose earnings quality. Operating
cash flows particularly measure the firm’s ability to generate cash flows internally, and
they can help investors gain important insights into a company’s core business, especially
when the faith in earnings figures is shattered by many alleged accounting irregularities.
However, the Wall Street Journal (C l, May 8, 2002) has one article illustrating how the

sums o f cash flow reported in financial filings are less than they appear at first blush.
“Long viewed as the most reliable, least manipulated o f the financial documents
filed by a company, the ‘statement o f cash flows’ has its shortcomings, too...
If you think operating cash flow as reported actually gives you operating cash
flow, you are kidding yourself.”
When certain cash flows are not generated by firms’ continuing and core operations, or
are subject to management discretion or conditions beyond management’s control, they
would behave differently from other operating cash flows in terms o f abilities to map into
future cash flows. “The Financial Numbers Game” (Mulford and Comiskey 2002) lists
various problems with the GAAP-based rules and flexibility faced by management for
reporting operating cash flows. The inclusion o f cash effects whose recurrence is
doubtful due to various economic characteristics can potentially generate misleading
signals about the company’s cash generating power if investors fixate on the face value of
reported operating cash flow. Among the transactions causing concerns to investors and
academics are the following cash events: ( 1) nonrecurring cash flows, (2) tax benefits
realized from the exercise of nonqualified employee stock options,^ (3) investment-type

^The Emerging Issues Task Force (EITF) Issue 00-15 requires the income tax benefits due to stock options
be classified as an operating cash flow in the cash flow statement, effective for financial statements after

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cash outflows - R&D expenses and cash outlays involved in restructuring activities, and
(4) cash proceeds from selling or securitizing accounts receivable.'^
To what extent investors distinguish among various cash flow components and
unravel the additional information contained in reported current operating cash flows
about future cash flows remains an interesting question. This dissertation investigates the

future economic implications o f these four components o f operating cash flows that may
behave differently from other core and continuing operating cash flows and have the
potential to generate misleading signals. It also examines whether market participants
fully incorporate the information contained in these components. I perform the analyses
on firms in the Fortune 500 index as o f year 2001. The sample period spans 13 years
from 1988 to 2000. Heavy scrutiny focused on mature and large firms ensures cash flow
statements are an important piece o f information used to assess future prospects.
I first investigate the future cash flow implications, i.e., forecasting abilities and
persistence, o f each o f the four identified cash components. Empirically shown to possess
superior cash forecasting ability, the cash forecast model in Barth, Cram and Nelson
(2001) documents the significant predictive ability o f total operating cash flow and
accruals. Therefore, I test the incremental predictive ability o f each cash component
controlling for the free cash flow (operating cash flow minus capital expenditures) and
accrual components. The results show that the four cash flow components differ in

July 20, 2000. Prior to the effective date, companies have choice of reporting them as part of operating cash
flows or financing cash flows.
If the same cash effects are not classified in ‘cash from operating activities’ but in other sections of the
statement of cash flows, this study does not deem it as problematic operating cash reporting, and those
firms would have zero of such operating cash components.

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persistence from the other operating cash flows^ and possess significant incremental
value in the prediction o f cash flows in the next three years (both operating cash flows
and free cash flows). Speciflcally, nonrecurring cash flows lead to relatively fewer future
cash flows and they are relevant for forecasting cash flows o f the following two years, in
contrast with the nonrecurring (transitory) items called by the companies. Tax benefits
realized prior to 1999 from employee stock option exercises are a strong positive

indicator o f future cash flows, but the benefits realized thereafter are less persistent and
even capture negative news about multiple-year-ahead cash flows. Research and
development cash investment outflows (measured as negative cash flows) have a lower
coefficient in predicting long-term cash flows, possibly due to offsetting of positive cash
benefits with the persistent investment cash outflows. Contrary to investors’ concerns, the
cash effects o f selling or securitizing accounts receivable that are subject to managerial
discretion, tend to have the same likelihood o f recurrence as other operating cash flows.
However, firms engaging in these inherently financing transactions will systematically
experience lower cash flows in the following three years than firms not using the
financing vehicle, implying that firms can boost current cash flows by sacrificing future
cash flows.
I investigate whether stock prices fully incorporate the components’ respective
implications for future cash flows by performing portfolio return analyses over the three
years subsequent to financial statement releases and conducting cross-sectional
regressions o f future retums on the cash flow components. The results indicate that hedge
portfolios exploiting the information in tax benefits o f stock options prior to 1999, R&D
^The other operating cash flows generally include operating cash flows from core and continuing
operations, the difference between total operating cash flows and each of the cash components o f interest
identified in this study.

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expense, or transactions of selling or securitizing part o f accounts receivables can
separately earn positive abnormal retums over the subsequent one-year, each o f the three
years, or six months. The cash transactions’ associations with future abnormal retums are
consistent with their incremental implications for future cash flows and are robust to the
inclusion of previously documented retum predictors. The cash components also fully
capture the retum predictive ability o f the accmal anomaly first found in Sloan (1996).
The reverse relation between tax benefits realized after 1998 and future retums seems to

reflect risk changes correlated with factors documented in prior studies or the wealth
transfer effects o f the stock options. Additionally, the stock market fully reflects the
additional information in nonrecurring cash flows.
This dissertation focuses on the prediction o f future cash flows, a theoretical
valuation input, to test whether the stock market correctly reflects the cash flow
components’ implications for future cash flows. There is a body o f literature on m arket’s
naive expectations about future eamings, with the underlying premise that earnings are
used in assessing equity values. Penman and Zhang (2002) suggest investors fixate on
eamings and fail to differentiate eamings quality due to conservative accounting, and
Sloan (1996) shows that stock retums do not fully reflect information about future
eamings contained in the accrual and cash flow components.® In a supplementary test, I
examine the eamings implications o f the four cash flow components. Except that tax
benefits o f stock options have a strong negative effect on eamings persistence for the
whole sample period, the other cash flow components consistently have the same
directional impact on future eamings as on future cash flows. To verify that the market

* Some of the other studies that relate market efficiency to the understanding of certain variables’
implications for future eamings include Beaver et al. (2001), Xie (2001), and Rajgopal et al. (2003).

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mispricing is at least partially attributable to failures to fully impound future cash flow
implications, I decompose the subsequent year abnormal retums into the component
arising from one-year-ahead cash flow news and the component associated with other
factors, including eamings news. The results are consistent with price corrections in
response to the one-year-ahead cash flow news that are predictable from the various cash
components. I also find that the cash news-related abnormal retums are significantly

associated with R&D, tax benefits o f stock options realized prior to 1999 and selling or
securitizing accounts receivable, in the direction consistent with their future cash flow
implications. The significant abnormal retums over multiple future years predictable by
R&D expenses indicate that price corrections are incomplete as to the realization of
short-term cash flows. However, I do not exclude the possibility that some unknown risk
factor not reflected in factors suggested by Fama and French (1992) accounts for the
persistent significant retums.
My study makes the following contributions. Foremost, this dissertation contributes
to the literature on forecasting cash flows. Until recently, this literature has largely
focused on comparing the ability o f eamings and operating cash flows to predict future
cash flows. Dechow, Kothari and Watts (1998) and Barth et al. (2001) find the accraal
components enhance the predictive ability. M y study constitutes an attempt to investigate
the incremental predictive value o f selected components o f operating cash flows over
accraals and aggregate operating cash flows. Second, it addresses public concerns that the
reported operating cash flow from the statements o f cash flows can potentially mislead
investors when the cash flow effects o f certain transactions are included. The large tax
benefits realized from employee stock options in the period o f high-flying stock prices do

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not sustain, but those realized prior to 1999 provide a positive signal about future cash
flows. The common practice o f sale or securitization o f accounts receivables does not
generate less persistent cash flows and it apparently sacrifices future cash flows while
increasing current cash flows. Third, this dissertation adds to the market efficiency
literature that investigates whether accounting information is fully impounded in stock
prices. Different from most prior studies that assume investors fixate on eamings
prediction, this study is conducted under the premise that investors also predict cash
flows to assess firm value. Failing to fully impound the future cash flow information
contained in the current statements will result in predictable abnormal retums. The results

corroborate the notion that cash flow prediction is the ultimate fundamental valuation
attribute. Prior studies have documented a significant relation between future abnormal
retums and accmals (or total cash flows). While Desai, Rajgopal and Venkatachalam
(2004) asserts that the accmal anomaly can be a manifestation o f the glamour stock
phenomenon, my study potentially provides an altemative explanation in that the market
fails to fully reflect the information in the various cash flow components. Finally, this
study provides subtle implications for standard setting bodies about cash flow reporting
and the disclosure o f cash effects from significant transactions. Investors as a whole do
not appear to fully understand the implications o f certain cash flow components, possibly
due to high costs (e.g., lack o f detailed disclosures or skill requirements) of analyzing the
statement o f cash flows reported under the current disclosure regime. Prior studies have
documented the widespread nonarticulation in the cash flow statements and listed some
factors causing the nonarticuiated differences, e.g., Bahnson et al. (1996) and Drtina and
Largay (1985).’ The results of this dissertation should also be o f interest to financial
Under the indirect method of presenting the statement of operating cash flows, net income is adjusted by

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statement users, such as asset managers, creditors, and analysts, who wish to understand
cash flow reporting and cash forecasting.
The remainder o f the dissertation is organized as follows. The next section provides
motivation and hypotheses development. Section 3 explains the estimation models and
research methodology. Section 4 describes the samples and data. Section 5 presents the
results and section 6 provides further discussion and sensitivity analyses. Section 7
concludes the dissertation with implications for future research.

changes in current accounts that would equal the differences between the beginning and ending balances on

the balance sheet. This adjustment assumes that changes in a noncash current account relate an operating
source or use of cash to an income statement account. When current accounts change without a link to the
income statement, errors occur when mechanically applying the indirect method. For example, if stocks are
issued to settle a significant portion of accounts payable, a nonarticulated difference occurs when net
income is adjusted by changes in the balance of accounts payable that obviously are not related to income
statement.

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2, Motivation and Hypotheses

Prior studies have examined the role o f current aggregate cash flows and eamings in
predicting future cash flows and report mixed results about their relative predictive ability
(e.g., Bowen et al. 1986, Finger 1994, and Greenberg et al. 1986). Barth et al. (2001)
extend prior work and find that eamings, when disaggregated into cash flows from
operations and accmal components, perform better in predicting future cash flows than
current and past cash flows or current and past aggregate eamings. Using stock prices as
a measure o f information content, research has shown that the cash flow and accmal
components o f eamings have incremental information content beyond eamings. Some
examples are Wilson (1986, 1987), Bowen et al. (1987), and Raybum (1986). Other
studies examine the association with contemporaneous security retums. Examples include
Lipe (1986) on six eamings components, Barth et al. (1999) on accmals and cash flows,
and Livnat and Zarowin (1990) on operating, financing and investing cash flows. The
current aggregate operating cash flows have incremental value over eamings or accmals
in predicting future cash flows and its incremental information content is reflected in
stock values.
Reported cash flows are generally regarded as being less subject to distortion than
reported eamings. In recent years investors have seen outbreaks o f myriad alleged
accounting irregularities, the proliferation o f pro-forma eamings and the SEC’s

broadened investigations into accounting malpractices to boost eamings figures across a

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broad range o f industries.® However, holding the cash flow statement as a beacon o f truth
can also be imprudent. Due to different composition characteristics, the same amount of
cash from operations may imply varying future cash prospects. Cash flows sustain only
when the underlying operating activity is likely to recur. For example, if current cash
flows comprise a large amount o f nonrecurring cash items, the current cash figure will
not be a good indicator for next period’s cash flows. Some studies (e.g., Barth et al. 1999)
find the cross-industry variation in the persistence parameter o f cash from operations, but
they still impose restrictions on the components o f cash flows to have the same ability to
forecast future cash flows. Taking the reported cash flows at face value forsakes
information contained in the components that is relevant for predicting future cash flows.
Several operating cash components may inform about future cash flows differently
from the other operating cash flows. By definition, nonrecurring cash items, ex-ante, are
not expected to recur in the future in the same way as other routinely generated cash.
Operating cash flows include some investment-type expenditures such as R&D expenses
that are expected to generate cash flows over multiple future periods. The lack of
matching between the cash costs o f the investments and their benefits can result in a
different predictive ability from other periodic cash outflows. The cash flow effects from
some significant special transactions can be either subject to managerial discretion or to
conditions not directly controlled by management. The items emphasized by Mulford and
Comiskey (2002) and the previously cited WSJ article are the tax benefits from the

* Among the investigations by SEC into the false accounting practices are Enron Corp. ’s various
wrongdoings, Adelphia Communications Corp.’s participation in related party transactions (WSJ, May 17,
2002), illusory “round-trip” trades to boost revenues by energy-trading companies like Dynegy Inc.,
Reliant Resources Inc. and CMS Energy Coip. (WSJ, May 16, 2002), and Computer Associates

International Inc.’s aggressive revenue-recognition policies and practices (WSJ, May 16, 2002).

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exercise o f employee stock options (when reported as part o f operating cash flow) and
cash proceeds from sale or securitization o f accounts receivable. The following
paragraphs provide the reasoning to examine the potential incremental information
contained in these four cash categories and develop the first hypothesis regarding their
forecasting abilities and persistence.®

Nonrecurring cash flows: Under the indirect method o f preparing the statement o f
cash flows from operating activities, the starting point is the net income. Included in net
income are several nonrecurring items such as Income from Discontinued Operations and
Extraordinary Items, Cumulative Effects o f Change in Accounting Principle, special
items like asset w rite -o ffs a n d others. The associated cash effects o f these unusual or
infrequent income components may possess less predictive ability for future cash flows
than the other cash flows. One example is cash from the operating income or loss o f
discontinued operations. If these items are really nonrecurring as claimed by companies
in the financial statements, they should be irrelevant for forecasting future cash flows.”
However, firms have started to include more items in the special item or nonrecurring

®This is not to claim the rest of the cash flow components do not provide incremental information about
future cash flows. Rather, I analyze the cash components that have caught the attention of investors and
academia but have not been formally examined. These cash flow items are also available by inexpensive
and skillful search in companies’ financial statements. Extracting every interesting cash flow item would
incur high costs due to nonarticulation in the operating cash flow statement under the indirect method.
Some other components, such as interest expense, are debated on the reasonableness to be classified as

operating cash flows, which is beyond the scope of this study. This dissertation analyzes the operating cash
components based on the sample-year’s effective format and classifications of cash flows.
See “Nonrecurring items...” Financial Statement Analysis, 7* Edition, Wild, Bernstein and
Subramanyam (2001, P417).
" Ohlson (1999) uses the term “forecasting irrelevancy” to label the condition that transitory eamings items
are forecasting irrelevant for next period’s abnormal eamings. Nonrecurring (or transitory) cash flows are
interpreted here as forecasting irrelevant with respect to future cash flows.

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category. Gu and Chen (2003) find that both o f the ‘nonrecurring items’ analysts decide
to keep in and exclude from reported street eamings are significantly associated with
future performance. The cash effects involved in the nonrecurring items may well be
relevant in forecasting future cash flows. The altemative hypothesis regarding
nonrecurring cash flows follows:
H I (1):

Cash flows claimed to he nonrecurring by companies are less recurring than
other operating cash flows and are relevant in forecasting future cash flows
(i.e., not nonrecurring).

Tax benefits from employee stock options: When nonqualified employee stock
options are exercised, the issuing company will receive a tax benefit that equals the tax
rate times the difference between the exercise price and market price on the date options
are exercised.

I refer to the reduction in taxes payable from this transaction as the tax

benefits from employee stock options. In 2000, the EITF reached a consensus and
decided that such tax benefits should be included with operating cash flows. This
treatment is viewed as somewhat problematic cash flow reporting (Penman 2002)
because there is no recognition o f the matching option expenses that produced the tax
benefits. In the market boom period, option exercises have created large corporate tax

This tax treatment applies in situations when options do not have a readily ascertainable fair market value
at the date of grant. Most companies that issue nonqualified stock options do not have options with a
readily ascertainable fair market value. If the options are considered subject to substantial risk of forfeiture,
the issuing company may not receive the tax benefit at the date of exercise, rather when restrictions on the
options lapse, depending on the employee’s choice o f income recognition date (correspondingly, the
entitled compensation deduction is the difference between market price of the stock on the date the
restrictions lapse and the exercise price). See more details in “Concepts in Federal Taxation”, Murphy &
Higgins (p. 655), 2003 edition.

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deductions and boosted operating cash flows,

while in the recent recession period, not

as many benefits have accrued to those firms because o f falling stock prices. The tax
benefits are mostly influenced by employee exercise decisions and market factors, and
thus are outside o f the corporation’s direct control. The cash savings are likely to be more
transitory than other operating cash flows, and less related to the core operations o f the
firm. However, large employee option exercises induced by good market conditions may

reflect the strong underlying operations that can persist promisingly into future periods.
The likelihood o f recurrence o f tax benefits from stock options is ambiguous; however,
the high levels observed during the market boom period are less likely to represent
recurring cash flows. Stated formally;
HI (2):

Tax benefits from exercising non-qualified employee stock options differ
from other operating cash flows in their likelihood o f recurrence and the
benefits realized in the market boom period are less likely to recur than those
realized in the prior period.

Cash expenses related to investing activities: Investment costs that are expensed as
incurred in the income statement are treated as uses o f cash in the operating section o f the
statement of cash flows. Two items o f interest are research and development costs and
cash expenses involved with restructuring charges. Expensing research and development
costs is criticized in some academic research for the mismatching o f costs and related
future revenues. Lev and Sougiannis (1996) show that the R&D capitalization process
Ciprianao, Collins and Hribar (2001) report that the tax savings from employee stock option deductions
for the S&P 100 and the Nasdaq 100 averaged 32 percent of operating cash flows in 2000, up from 8
percent in 1997.

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yields value-relevant information to investors. Penman and Zhang (2002) show that R&D
expensing reflects a conservative accounting process that makes the eamings less o f an
indicator for future eamings. Furthermore, restmcturing charges (sometimes reported as
part o f special items) are typically investments to streamline a company’s operations for

improving future profitability.''^ They usually impact several future years and involve
substantial cash flow commitments that are included with operating cash flows. Including
these cash investments can skew the reported cash from operations downward. Some
high-growth firms may not generate positive operating cash flows in the current period as
a result o f heavy investments, however they may have tremendous cash inflows when
those investments tum out to be successful. The ability o f these investment-type cash
expenditures to indicate future cash flows probably differs from that o f periodic operating
cash expenses that typically do not bring future benefits.
H I (3):

Investment-type expenditures included with operating cash flows have a
different ability to predict future cash flows from other periodic operating
cash expenses.

Cash proceeds from sale or securitization o f accounts receivable: Decreases in the
balances o f operating-related assets are added when reconciling net income to cash flow
from operating activities. Management can exercise discretion to decrease accounts
receivable by securitizing or selling accounts receivable, which would temporarily boost
current operating cash flow at the expense o f future cash flows. If the amounts involved
are significant, the financial health o f the firm will be distorted. The Wall Street Journal
Carter (2000) presents some evidence of operating performance improvement in the long run following a
restmcturing.

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(May 8 , 2002, C3) illustrated that TRW Inc.’s eamings dropped to

$ 6 8

million in 2001

from $438 million one year ago, but operating cash flow rose to $1.49 billion from $1.15
billion largely due to the $327 million received from accounts receivable securitization.
W ith selling or securitizating accounts receivable, firms discount all future cash inflows
into present, mechanically resulting in lower cash inflows in the future periods than
everything-else-equal firms. The cash effects o f such significant isolated events may not
recur because they are subject to managerial discretion. Nonetheless, the accounts
receivables sold or financed are generated from the continuing and core operating
activities. Therefore, if firms engage in these transactions regularly, the cash effects could
be recurring. The hypothesis regarding the persistence o f these cash flows is stated in
altemative form:
HI (4):

The cash flow effects from the sale or securitization o f accounts receivable
are less recurring than other operating cash flows.

The second hypothesis concems the extent to which stock prices distinguish among
various cash components and reflect their respective forecasting and persistence
properties for future cash flows. If the cash components are not priced in a manner
consistent with their respective cash flow implications, as new information about future
cash flows arrives or actual cash flows are revealed, subsequent stock prices will
gradually reflect the information and predictable abnormal retums will occur.
HII:

Stock prices fail to fully reflect the information contained in the four
identified cash components at the time o f financial statement release. Firms
reporting relatively high levels o f cash components providing positive

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information and firms reporting relatively low levels o f cash components
providing negative information will experience a higher abnormal return in
the subsequent periods.

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