The Role of Accrual Accounting Basis in The Prediction of Future Cash Flows: The Nigerian Evidence
The Role of Accrual Accounting Basis in The Prediction of Future Cash Flows: The Nigerian Evidence
The Role of Accrual Accounting Basis in The Prediction of Future Cash Flows: The Nigerian Evidence
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Nigeria.
3. Theoretical Framework and Research Methods
3.1 Theoretical Framework
The theoretical framework for this study is based on two models: the accrual based earnings model (model 1)
and the cash flow model (model 2). The accrual-based earnings model was built by Dechow, Kothari, and Watts
(1998). They posit that future cash flow is dependent on past aggregate earnings. The accrual based earnings
model is expressed as follows:
CF , = +
EARN , + , 1a
CF ,
= +
Where: CF ,
EARN ,
+ , 1b
EARN ,
The cash flow model was designed by Quirin, OBryan, Wilcox, and Berry (1999) and Stammerjohan and
Nassiripour (2000/2001) in which they suggested that year lags of cash flow themselves provide a good predictor
of future operating cash flows. The cash flow model is expressed as follows:
cF , = + ,- CF , + u , 2a
CF ,
= +
CF
+ u , 2b
Where:
CFi,t+1 = Future cash flows
i = firm
t- = year lags
= intercept and coefficient of independent variable
In both models, future cash flow is the dependent variable, and future cash flow refers to future operating cash
flow.
3.2 Research Methods
3.2.1 Research Design
This study used the longitudinal survey research design. The survey research design is justified on the grounds
that it is aligned with the positivism paradigm on which the study is based. The population of interest in this
study is all 120 non-financial companies quoted in the Nigerian stock exchange. The sample size is made up of
54 quoted non-financial companies which was selected using the convenience sampling technique. The sample
size was determined using the Slovins formula (Yamene, 1967): n = N/1+Ne2; where n is the sample size, N is
the population and e is the sampling error margin (10%, 5% level of significance). Applying the 10% error
margin, the study arrived at a calculated sample size, n, of 54 quoted non-financial companies. However, due to
missing data, the sample size of 54 was reduced to 40 non-financial quoted companies in the Nigerian stock
exchange.
Secondary data sourced from the Nigeria stock exchange fact book and the annual reports and accounts
of the sampled firms were used for this study. The study focused on the profit and loss account, balance sheet
and the cash flow statements of the listed companies. For proper analysis, the dependent variable and the
independent variables were made to fall within certain time frame. Annual data for the dependent variable were
from the end of year 2002 to the end of year 2013. The annual data for the independent variables were lagged, t1, from the end of year 2001 to 2012. This annual data matching in different periods was adapted from
Chotkunakitti (2005) and Chong (2012).
3.2.2 Model Specification
The two models specified for this study, the accruals based earnings model and the cash flow model are specified
as follows.
Accrual based earnings model
CFO = b1 + b EARN + 3a (one year lag)
CFO = b1 + b EARN + b7 EARN 7 + 3b (two year lag)
CFO = b1 + b EARN + b7 EARN 7 + b9 EARN 9 + 3c (three year lag)
Where:
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CFOt = Net cash flow from operating activities for the year, t, scaled by the average total assets. This is the
dependent variable.
EARNt-1; EARNt-2; EARNt-3 = Profit after tax and before extraordinary items and discontinued operations scaled
by average total assets in year t-1, t-2, and t-3.
b0, b1, b2, b3 = the unknown regression coefficients; = the error term.
Cash Flow Model
CFO = b + b CFO + u 4a (one year lag)
CFO = b + b CFO + b7 CFO 7 + u 4b (two year lag)
CFO = b + b CFO + b7 CFO 7 + b9 CFO 9 + u 4c (three year lag)
Where:
CFOt = Net cash flow from operations for year t, scaled by the average total assets.
CFOt-1, CFOt-2, and CFOt-3 are net cash flow from operations for year t-1, t-2, and t-3 lags
respectively; b0, b1, b2, and b3 = unknown regression coefficients; u = the error term.
3.2.3 Data Analysis Method
The ordinary least squares (OLS) technique was used in running the models. Prior to interpretation of the results,
regression diagnostic was carried out to check for the normality, homoskedasticity, and the independent errors
assumption of the residuals, and to check for presence of multicollinearity. The Pearson correlation matrix was
employed to test for the presence of multicollinearity. To test the hypotheses, the study utilized the following
statistics: F-statistic with its associated p-value, the adjusted R2 and the t-statistic with its associated p-values.
3.2.4 Operationalization of Variables
Table 1 presents the measurement of the variables and prior studies supporting their validity.
Table 1. Operationalization of variables
Variable
Variable
Measurement
Prior Studies
Acronym
Type
CFOt
Depend.
Net cash flows from operating activities
Chong (2012); Ebaid (2011); and
Average Total Assets
Chokunakitti (2005).
EARNt-i
Independ.
CFOt-i
Independ.
Average
total assets
Scale
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Max
1.142
1.142
1.142
1.142
0.855
0.855
0.855
0.855
Skew
0.235
0.286
0.356
0.573
-1.924
-1.752
-1.682
-1.557
Kurt.
7.084
7.241
7.453
7.663
12.960
12.194
12.059
11.593
J.Bera
337.339
335.768
339.016
345.867
2275.635
1774.907
1556.519
1253.129
Prob
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
The Jarque-Bera (JB) statistic for all the variables have significant p-values (p = 0.000) suggesting that each
variable series is not a normal distribution. The high kurtosis for the variables suggest the presence of outliers
which again indicates non-normality of the data. However the study ignored the non-normality of the data by
invoking the central limit theorem. According to Brooks (2008), as regards large data, appealing to the central
limit theorem, the test statistic will asymptotically follow the appropriate distribution even in the absence of error
normality. The sample data of 520 observations is relatively large to benefit from the central limit theorem.
4.2 Multicollinearity
The study tested for the presence of multicollinearity which could affect the regression results. Table 3 shows the
correlation between the variables, presented as a matrix. Hair, Anderson, Tatham, and Black (1998) state that a
correlation exceeding 0.90, is an indication of the presence of multicollinearity. An inspection of table 3 shows
that the correlation between the variables ranges from 0.183 to 0.685. The highest correlation is 0.685. This
indicates that multicollinearity is not present in our data.
Table 3: Correlation Matrix
CFO
CFOt-1
CFOt-2
CFOt-3
EARN
EARNt-1
EARNt-2
EARNt-3
CFO
1.000
CFOt-1
0.349
1.000
CFOt-2
0.289
0.377
1.000
CFOt-3
0.183
0.311
0.372
1.000
EARN
0.440
0.399
0.318
0.264
1.000
0.315
0.430
0.404
0.313
0.685
1.000
EARNt-1
EARNt-2
0.216
0.259
0.372
0.373
0.547
0.639
1.000
EARNt-3
0.235
0.217
0.253
0.581
0.450
0.521
0.586
1.000
Source: Authors computation from Eviews 8 output
4.3 Heteroskedasticity
Table 4 presents the results of the Breusch-Pagan / Cook-Weisberg, and White tests for heteroskedasticity. The
Breusch-Pagan / Cook-Weisberg test of heteroskedasticity test the null hypothesis against the alternative
hypothesis as follows:
Ho: variance (u) = 0
Ha: variance (u) 0
The null hypothesis of a constant variance would be rejected where there is a significant p-value. This implies
that there is heteroskedasticity in the sample data.
The White test is a test for homoskedasticity. A significant p-value means that the null hypothesis of
homoskedasticity is rejected otherwise it is not rejected. The White test of homoskedasticity tests the hypothesis
stated as follows:
Ho: homoskedasticity
Ha: unrestricted heteroskedasticity
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White Test
2
p > 2
39.11***
42.28***
28.16***
3.42
6.91
7.53
0.000
0.000
0.000
0.181
0.223
0.582
The results in table 4 indicate that under the accrual based earnings model, the Breusch-Pagan / Cook-Weisberg
tests and White test show very high significant p-values. Therefore the null hypothesis of constant variance and
null hypothesis of homoskedasticity are strongly rejected. White (1980) suggests that to correct for
heteroskedasticity, the regression should be run using heteroskedasticity robust standard errors. The OLS
regression for the accrual based earnings model was carried out using heteroskedasticity robust standard errors.
The p-values reported under the cash flow model (using both tests) show insignificant p-values (p > 0.05) under
all the year lags. Therefore the null hypothesis of constant variance and homoskedasticity are not rejected. This
is an indication that there is no heteroskedasticity in the cash flow model. We can therefore rely on the result of
the OLS regression of the cash model.
4.4 Hypothesis Testing
Under this section the hypotheses earlier postulated would be tested. In testing the hypotheses the following
statistics would be used: t-values, p-values, and the adjusted R2. Table 5 presents the results of the regression
analysis carried out on the accruals based earnings model, while table 6 provides the result of the regression
analysis on the cash flow model.
Table 6: Accrual based earnings model regression (robust standard error)
Dependent Variable: CFOt
e.s
One-year lag
Two year lag
Three-year lag
Intercept
0.108***
0.102***
0.098***
p-value
(0.000)
(0.000)
(0.000)
+
0.279***
0.206
0.286**
EARNt-1
p-value
(0.001)
(0.147)
(0.019)
EARNt-2
+
0.104
-0.034
p-value
(-)
(0.335)
(0.677)
EARNt-3
+
0.123
p-value
(-)
(-)
(0.219)
Adj. R2
0.068
F-Statistic
32.921
Prob(F-Stat)
0.000
Durbin Watson
1.448
Obs.
439
Source: Authors computation from Eviews 8 Output.
0.069
15.768
0.000
1.488
399
176
0.097
13.791
0.000
1.555
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0.173
42.562
0.000
2.090
399
Three-year lag
0.056***
(0.000)
0.275***
(0.000)
0.182**
(0.001)
0.025
(0.642)
0.149
21.900
0.000
1.980
359
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basis of F-statistics, the two models had F-statistic that were statistically significant (p values = 0.000). However
the cash flow model in table 6 had bigger F-statistics (67.405; 42.562; and 21.90) under all the year lags,
compared to the F-statistics (32.921; 15.768; and 13.791) of the accrual based earnings model in table 5.
The adjusted R2 is the best criteria for determining which model is superior. The adjusted R2 is an
indication of the explanatory power of the models. A comparison of table 5 with table 6 shows that the cash flow
model has higher adjusted R2 than the accrual based earnings model (Cash flow model: 0.132; 0.173; 0.149:
Earnings model: 0.068; 0.069; 0.097). This is an indication that the cash flow model has a stronger explanatory
power than the accrual based earnings model. We therefore reject our hypothesis which states that past accrual
based earnings information have superior predictive ability than past operating cash flows in predicting future
operating cash flows non-financial quoted companies in Nigeria.
5. Discussion of Findings
This section discusses the findings of this study. A priori, the study posited that past earnings and cash flow
information are useful in predicting future operating cash flows of quoted non-financial companies in Nigeria.
The findings of this study confirmed these hypotheses. However, the study finds out that past accrual based
earnings information has less predictive ability than past operating cash flows in predicting future cash flows of
quoted non-financial companies in Nigeria. This finding is inconsistent with the assertion of the FASB (1978)
and IASB (1989) that earnings provide a better indicator of future cash flows. The findings of this study thus
show that in the Nigerian context cash flow information are a better predictor of future cash flows than accrual
based earnings information. This finding is consistent with findings of studies carried out in the developed
countries by Bowen et al. (1986); Finger (1994); Farshadfar et al. (2008); Penham and Yehuda (2009); Lev et al.
(2010); Waldron and Jordan (2010) and Arnedo et al. (2012). The finding that cash flows are a better predictor
than accrual based earnings information is also consistent with the findings of the studies carried out in the
developing countries by Chotkunakitti(2005) and Al-Debie (2011). However this finding is inconsistent with
the findings of a study carried out by Chong (2012) on companies in Malaysia (a developing country). Chong
found that cash flow model had the weakest predictive ability in forecasting future cash flows.
The preponderance of studies seems to be in support of the cash flow model being a better predictor of
future operating cash flows than the accrual based earnings model. This is not surprising because earnings under
accrual accounting basis suffer from flexible accounting techniques, subjective judgment and manipulative
practices which result to estimates (Bernard & Stober, 1989; Lee, 1992). Furthermore, the accrual based earnings
method is less effective in predicting future cash flows under inflationary conditions. Nigeria suffers mostly
from double digit inflation rates. Nigeria inflation rates were 13.9 %, 11.8 %, 10.3 %, 12.0 % and 8.0 % in 2009,
2010, 2011, 2012 and 2013 respectively (compared to U.S: 2.7%, 1.5%, 2.96%, 1.74%, 1.5%; Japan: -1.67%, 0.4%, -0.2%, -0.1%, 1.6%; Euro Area: 0.29%, 1.62%, 2.72%, 2.50%, 1.35) (CBN Statistical Bulletin, 2013;
Http://www.globalrates.com/economic-indicators; Http://www.rateinflation.com/inflation-rate/euro-a).
6. Conclusion
This study has shown that past accrual based information and past cash flows are useful in predicting future cash
flows of quoted non-financial companies in Nigeria. The findings of this study do not support the assertion of the
FASB (1978) and the IASB (1989) that past earnings (product of accrual-basis accounting) have more superior
predictive ability than past cash flows (product of cash-basis accounting) in the prediction of future cash flows.
The study finds that cash flow information have more predictive ability than earnings information in predicting
future cash flows. The findings of this study are consistent with the preponderance of studies carried out in the
developed countries. The findings of this study suggest that the cash flow statement has more decision usefulness
than the income and balance sheet statements prepared on an accrual basis. The reason why the accrual based
earnings information is less useful than the cash flow information is that earnings under accrual basis suffer from
flexible accounting techniques and manipulative practices intended to show increased performance.
The findings of this study have important implications for investors, financial analyst, the Nigerian
Securities and Exchange Commission, accounting standard setting bodies, auditors, suppliers, lenders,
management, and government. Suppliers can employ the superior prediction model suggested in this study to
assess their customers ability to pay for goods bought. The findings of this study suggest the importance of
qualitative accounting information. The IASB can apply the findings of this study in continually developing
accounting standards that would promote qualitative and reliable financial statements. Auditors would also be
affected by the findings of this study. This study would prompt auditors to thoroughly verify reported earnings
and the claims made by the directors in the annual accounts and report that they had complied with accounting
standard in the preparation and presentation of the financial statements. The Nigerian Securities and Exchange
Commission and other regulatory bodies should properly enforce the use of accounting standards. Any company
falsifying earnings and not complying with accounting standards, though claiming to comply, should be
sanctioned by the Nigerian Securities and Exchange Commission.
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The prediction of future cash flows depends on the stability of the variables used in the forecasting
process. The awareness that high inflation can affect the variables used in predicting future cash flows can
prompt government to embark on macroeconomic policies that would reduce the high rate of inflation in Nigeria.
The study recommends that Nigeria, should without delay, enforce the implementation of the
international financial reporting standards (IFRS). These standards have the qualitative characteristics that would
ensure the transparency of accounting information and thus improve the predictive ability of accounting
information (earnings and cash flows) for the forecasting of future cash flows.
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