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One of the most common practices in terms of controlling and monitoring financial reporting is to examine both normal and abnormal financial accruals, as well as cash flow indicators to make a forecast concerning future earnings. However, because in the situation, where earnings management has already taken place, it is harder to distinguish whether the stock prices that are reported in those documents did not undergo the process of smoothing earnings. For that reason, Sloan attempts to analyze to which extent such components as information in financial accruals and cash flow elements can indeed be used as indicators of the financial performance of a particular company and, therefore, influence the prediction of the company’s future earnings.
It is also important to point out that one of the most significant aspects, in this regard, is that in terms of earnings management, such components as stock prices defined from the accruals and stock prices based on cash flow indicators are not different in the extent to which they are managed. In other words, if earnings smoothing took place, both those components would be equally inaccurate for predicting the company’s future profits. Sloan in his article attempts to support and develop this idea based on the testable hypothesis using providing evidence.
It is paramount to have some benchmarks and tools in order to be able to estimate the organizational performance, power, and potential for future earnings. In common practice, the analysis of two types of financial reporting, such as financial accruals and cash flow, serve as such tools. Moreover, the researchers often emphasize the role of those two factors in making analysts’ forecasts and predicting the potential of a particular company in the future. There are, of course, different methods of evaluation, including various arbitrary services and amortization techniques. The main underlying factor of such type of valuation is that cash flow analysis and studying abnormal accruals are considered to be ultimately different in terms of smoothing earnings and representing information on the stock-related aspects.
However, cash flow is associated with the current earnings performance of a particular company and its profitability, whereas the component of the accruals that also relate to the high earnings performance is less likely to be persistent in affecting the analysts’ predictions in the same way.
Thus, given the fact that both cash flow analysis and accruals analysis can be attributed to the forecast on the matter of profitability, there is less distinction between them than it is commonly thought.
However, on the other hand, it is important to analyze the reasons why their linkage to components to the level of current profitability of a particular company and future predictions about its performance affect the forecasts differently. Thus, the first hypothesis developed by Sloan is that the intensity of current profits of a particular company “is decreasing in the magnitude of the accrual component of earnings and increasing in the magnitude of the cash flow component of earnings” (Sloan 291).
Another supporting hypothesis comes from the fact that expectations about future profits do not reflect the fact that analysts tend to rely more on cash flow components rather than accruals when they are defining future profits. Thus, the persistence of the former is bigger than of the latter. For that reason, it is more reasonable to monitor abnormal stock returns with a high degree of expectations in reported accruals relation to the period of the announcement of stock prices.
Formation of samples and measuring variables
The data in the research conducted by Sloan include information from such databases as CRSP and Compustat; the sampling included the companies who reported their cash flows, accruals (normal and abnormal), and stock prices and stock returns information (Sloan 292).
It is also important to define the particular items in financial reporting that were considered the variables in the research. They included change in current assets and liabilities (including debt in liabilities), the difference in cash equivalents, income taxes change, and reduction in amortization costs (Sloan 293). In such a way, abnormal stock returns could be compared in all aspects to the normal operational returns.
The first couple of tests were designed to inquire about the first hypothesis. Thus, the analysis of calendar year returns compared to the position of the firm at the market in a long run and to the changes in non-cash assets demonstrated that the ability of financial accruals to forecast the future stock market returns is bigger than it was anticipated.
Also, the tests were developed to test whether it is more reasonable to monitor abnormal stock returns with a high degree of expectations in reported accruals in relation to the period of the announcement of stock prices. Based on dividing current assets and liability-related components by the average total assets, the hypothesis was proved.
Thus, in a broader perspective, analysts and investors are mostly unable to define future profits, if earnings were managed. The reason for that is in the patterns, in which cash flow components and accruals interact and how they affect the prediction of stock prices.
Sloan, Richard. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” Accounting Review 71.3 (1996): 289-315. Print.