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The Effect Of Earnings Quality On The Predictbaility Of Accruals And Cash Flow
Models In Forcasting Future Cash Flows

Article in The Journal of Developing Areas · January 2017

DOI: 10.1353/jda.2017.0030

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The EFFECT OF EARNINGS QUALITY ON THE
PREDICTBAILITY OF ACCRUALS AND CASH
FLOW MODELS IN FORCASTING FUTURE
CASH FLOWS
Ali Mohammad Al-Attar
Department of International Accounting
German-Jordanian University, Jordan

Bassam Mohammad Maali

Department of International Accounting
German-Jordanian University, Jordan

Earnings management affects negatively the quality of earnings which affect the predictability of
earnings. The main questions this paper answer are: (1) is the superiority of aggregate earnings over
aggregate cash flows affected by the level of earnings quality? (2) Is the superiority of aggregate
earnings over the main components of earnings (i.e. operating cash flows, accounts receivable,
inventory, accounts payable, and depreciation) affected by the level of earnings quality? The
methodology used in this study is a development of the study of Barth et al (2001). We provide
replication of their main analysis, and then extend this to deal with the effect of earnings quality.
Three main measures for earnings quality used (i.e. the modified Jones model (MJ, the modified
Jones model with return on assets (MJROA) and the accruals quality (AQ). To provide answers on
the questions of this study, the whole sample of the study is divided into two groups according to the
level of earnings quality: high earnings quality and low earnings quality. The study covers the case
of Jordan and employs data on a sample of industrial and services firms. The time horizon of this
study includes the period of 2000-2014. The main conclusions of this study is derived from
comparing the adjusted R2 of the models employed using Vuong’s test. The results of the analysis reveal
that the quality of earnings affect the predictability of both cash flow and earnings in that earnings
outperform cash flows in predicting one-year a head future cash flow when earning quality is high.
On the other hand, the main component earnings reveal incremental information content beyond that
exist in earnings or cash flow regardless of the quality of earnings. These findings suggest that
operating cash flow is appreciated by the market when earnings quality is low. In addition, the finding
of this study provide more evidence on the importance of using all the accounting data provided in
the financial statement to predict future cash flow to avoid the effect of earnings management on the
predictability of the accounting data. This paper contribute to the existence literature in different
ways : (i) provide more evidence on the superiority of cash flows over earnings based on developing
countries as most the evidence were based on developed countries. (ii) the results shed light on the
role of earnings management in destroying the reliability of earnings as a tool to predict future cash
flows.

JEL Classifications: M410, M480

Keywords: Earnings, Cash Flows, Accruals, Earnings Quality, Emerging markets,

Corresponding Author: Ali Mohammad Al-attar, Email: ali.attar@gju.edu.jo
The EFFECT OF EARNINGS QUALITY ON THE
PREDICTBAILITY OF ACCRUALS AND CASH
FLOW MODELS IN FORCASTING FUTURE
CASH FLOWS
INTRODCUTION
Estimating future cash flow is important for all stakeholders, but it is more important for
shareholders and creditors. Shareholders might be concerned with long term cash
generating in order to estimate the firms’ value, whereas the creditors are concerned in
estimating the ability of a company in generating short-term cash flow. The question raised
is: which is better to predict future cash flows current earnings, current cash flows or
accruals in conjunction with cash flows?
Main accounting boards (i.e. International Financial Accounting Standards Board (IASB)
and Financial Accounting Standards Board (FASB)) indicate that current cash flow is not
sufficient alone to predict future cash flow. One of the explanation for this assertion is that
cash flow figure suffer from timing and matching problem as it contains flows from prior
periods and flows belonging to future periods. The alternative measurement of future cash
flow is earnings. Earnings contain accruals which mitigate these problems (Dechow,1994).
For this reason accruals might make current earnings better than current cash flow in
predicting future cash flows. On other hand, the discretion of managers over accruals might
lead to opportunistic manipulation, which affect the quality of earnings.
The examination of the failure of international large companies (e.g. Enron, Worldcorm,
Dell, Tyco International) reveal large-scale earnings management through accrual
manipulation. The increasing number of companies’ failure result in a loss of stakeholders’
confidence in the creditability of earnings and other accounting numbers. As a result, the
role of aggregate earnings as the only performance measurement becomes questionable by
researchers, accounting standard setters, investors and other interested parties in financial
community. Moreover, operating cash flows introduced as complementary performance
measure and in some cases as competing measure of performance when the quality of
earnings is in doubt.
In responding to the financial community concerns, researchers start empirically
investigate the effect of earnings quality on the usefulness of accounting data (e.g. Dechow,
1994; Cheng et.al., 2013), and earnings performance (e.g. al-attar and hussain,2004,
Mostafa ,W. , 2014). The results of these studies reveal that the predictability of accruals
and cash flows is conditional on level of earnings quality. This study will use an emerging
market date to examine the effect of earnings quality on the predictability of accounting
data.
Prior studies aim to examine the usefulness of cash flow and earnings in predicting future
cash flows can be classified into two main streams based on the use of the dependent
variable; the first one focused on price-based proxy variables for future cash flows ( e.g.
stock returns, CARs, price levels) . Many studies use this approach such as ( Ali and Pope,
1995; Garrod et. al., 2000; Ryan and Zarowin, 2003; Jones, 2003, Al-attar and Al-khadsh,
2005; Mostafa ,W.,2014) . The general conclusion in these studies is that both earnings and
cash flows have incremental information content regarding stock price and returns.
The second group use actual future cash flows (Direct approach) as dependent variable.
The results are inconclusive regarding the superiority of accruals and cash flows in
predicting actual future cash flows. The studies adopt this direct approach includes ( Finger
,1994; Barth et. al. 2001; al-attar and hussain,2004; Shadi,2008; Ebaid,2011;Varun,2015)
among others. Generally, the results of these studies also still inclusive regarding the
superiority of cash flows and accruals in predicting future cash flow.
In this research, the direct approach is adopted to investigate the effect of earnings quality
on the predictability of accruals and cash flows. Following cheng et.al.(2013), three
popular measures of earnings quality will be contrasted , the modified Jones model
(MJ)(Dechow,1995), the modified Jones model with return on assets (MJROA) (Koathari
et.al.,2005) and the accruals quality (AQ) ( Dechow and Dichev, 2002, McNichloas, 2002).
A significant body of previous studies examined the effect of earnings quality is based on
developed markets but there is a little of results based on emerging capital market data.
Though most of emerging capital markets adopt IFRS, the way of monitoring the
accounting practices is weak because of the lack of the enforcement legislation. In addition,
emerging capital markets have different characteristics than developed capital markets
such as: fewer numbers of listed companies, less mature investors, less efficient processing
of information, less demanding disclosure requirements, and less enforcement of
established disclosures (Ibrahim, 2011). Consequently, the results based on developed
markets might not be generalized. So, the results of emerging market will add to the
literature of the predictability of accruals and cash flows.
Based on Jordanian data from 2000 – 2014, the study examine effect of earnings quality
on the ability of earnings, accruals and operating cash flows in predicting one-year ahead
future operating cash flows. This paper contribute to the existence literature in different
ways: (i) provide more evidence on the superiority of cash flows over earnings based on
developing countries as most the evidence were based on developed countries. (ii) The
results shed more light on the role of earnings management in destroying reliability of
earnings as a tool to predict future cash flows.
LITRERATURE REVIEW AND HYPOTHESIS DEVELOPMENT
As most accounting bodies over the world adopt the statement of cash flows as major
statement to enhance the predictability of accounting data for future cash flows, there have
been an extensive research trying to examine the validity of the claim of the accounting
bodies.
Barth et.al.(2001) using US data, develop a methodology to examine directly the
explanatory power of currently available data ( earnings, cash flows, accruals) in relation
to future cash flows. They provide evidence on the superiority of the component of earnings
in explaining future cash flows. Following the same methodology Al-attar and Hussain,
(2004) provide the same result based on UK data. In addition, they provide indirect
evidence on the effect of earnings level on the explanatory power of accruals and cash flow
models. They note that for extreme earnings (i.e. negative and upper quartile for positive
earnings) disaggregating earning provide the highest explanatory power.
Kim and Kross (2005),based on US data cover the period (1973-2005), provide evince on
the superiority of earnings over cash flow in predicting one-year a head future cash flow.
They also indicate that the predictability of cash flow is improving over time. The results
of the study conducted by Waldron and Jordan (2010) during economic turbulence (1994-
2004) (Information –technology industry bubble) reveal that historical cash flows
outperform historical earnings in predicting future cash flows.
Farshadfar et. al. (2008) using Australian data over the period (1992-2004) document the
superiority of cash flows over earnings in predicting future cash flows. Their results show
that this superiority is not affected by the size of the company. Ahmad et.al. (2013)
investigate the effect of surplus free cash among other factors on the predictability of
earnings for future cash flows. They argue that the high level of surplus free cash flow
imply that reported earnings is inflated. They conclude that the predictability of earnings
is declining as the increase in the level of surplus free cash flows.
Using emerging market data , Ebaid (2011) use Egyptian data over the period (1999-2007)
report results on the superiority of the components of earnings in predicting future cash
flows. his results also show that the aggregate earnings is better than cash flows in
predicting future cash flows.
In Jordan, few studies examine the information content of accruals and cash flows using
the direct approach. Al-Debi'e (2011) using Jordanian data (2000-2009) provide evidence
on the superiority of cash flows over earnings in predicting future cash flows. His study
also reveal that this superiority is enhanced for large companies, short operating cycle, and
positive operating cash flows. Shubita (2013) adopt Barth et al. (2001) model to conclude
that earnings components beat aggregate earnings in predicting future cash flows.
Many price-based studies investigate the effect of earnings quality on the information
content of earnings and cash flows. Cheng et.al.(1996) find evidence on the incremental
information content of operating cash flows beyond earnings when there is a decrease in
earnings performance. In the same line, Garood et. al.(2000) find that decomposing
earnings into cash flow and accruals have incremental information content beyond earnings
only when either earnings is negative or too high. Mostafa (2014) find additional
information content of operating cash flows beyond earnings when earning performance is
extreme and cash flow performance is moderate. Where the previous price-based studies
use earnings performance to capture the quality of earnings, Cheng et.al.(2013) use
earnings quality measures (i.e. the modified Jones model (MJ), the modified Jones model
with return on assets (MJROA) and the accruals quality (AQ) . The results of their study
reveal that the information content of operating cash flows enhanced when the quality of
earnings is better.
This research will add to the prior literature in that Barth et. al. (2001) methodology is
extended to include the effect of earnings quality on the predictability of earnings and its
components. Prior research document that the information content of cash flows improves
when earnings quality is low. On the other hand, the results do not provide conclusive
evidence on the superiority of cash flows in predicting future cash flows when earnings
quality is low. Thus, the predictive value of cash flows is improving for firms with low
earnings quality. Therefore, the first hypothesis of the study is:
H1. If earnings quality is low, operating cash flows outperform aggregate earnings in
predicting one-year-ahead cash flow from operations.
While some studies (e.g. Barth et al., 2001; Dechow et al., 1998) suggests that
decomposing earnings into accruals and operating cash flows enhances earnings’
predictive ability relative to aggregate earnings, other studies (e.g Garrod et.al.2000; Al-
attar and Hussain, 2004) reveal that the value relevance of this decomposition is conditional
on the level of earnings performance. The literature on earnings management suggests that
manipulation of earnings is most likely when earnings levels are extreme, and a
consequence of such manipulation may be a reduction in the predictive ability of accruals
( e.g. McNichols and Wislon, 1998; yoon and Miller;2002).This leads to the second
hypothesis of the study, which is:
H2. If earnings quality is low, disaggregating earnings into operating cash flows and
accrual components enhances the ability of earnings to predict one-year-ahead cash
flow from operations.
RESEARCH METHOD
Following prior studies that examine the effect of earnings performance on the
predictability of earnings and cash flows (e.g. Al-attar and Hussain; 2004, Mostafa, 2014)
the entire sample divided into two sub-samples based on earnings quality: High earning
quality and low earnings quality.
This study use three most recent measures of earnings quality: modified Jones model (MJ),
modified Jones models with return on assets (MJROA) and the accruals quality (AQ),
below are the details.
Modified Jones Model:
Following Dechow et al. (1995), the modified Jones model as follows:
1 (∆𝑅𝐸𝑉𝑖 𝑡−∆𝑅𝐸𝐶𝑖 𝑡 ) 𝑃𝑃𝐸𝑖 𝑡
𝑇𝐴𝐶𝐶𝑖 𝑡 = + 𝐵1 , , + 𝐵2 , ……………………………..(1)
, 𝐴𝑇𝐴𝑖 𝑡 𝐴𝑇𝐴𝑖 𝑡 𝐴𝑇𝐴𝑖 𝑡
, , ,
where TACCit is total accruals for firm i in year t, ATAi,t is average total assets for firm i
in year t, ∆REVi,t is change in sales revenue for firm i in year t, ∆RECi,t is change in account
receivables for firm i in year t, and PPEi,t is gross property, plant, and equipment for firm i
in year t.
The magnitude of the residual from equation (1) represent the measures for earnings
quality. The earnings consider have high quality if the magnitude of the residual (MJ) lower
than the median for the entire sample.
Modified Jones Models With Return On Assets (MJROA)
Unusual performance might affect the estimation of abnormal accruals as documented by
Kothari et al. (2005). They suggest that adding current year return on assets to the modified
Jones model will improve the ability of the model in estimating the discretionary accruals.
Therefore, the following model is used:
1 (∆𝑅𝐸𝑉𝑖 𝑡−∆𝑅𝐸𝐶𝑖 𝑡 ) 𝑃𝑃𝐸𝑖 𝑡 𝑁𝐼
𝑇𝐴𝐶𝐶𝑖 𝑡 = + 𝐵1 + 𝐵2 + 𝐵3
𝐴𝑇𝐴𝑖 𝑡 ,………………….(2)
, , ,
, 𝐴𝑇𝐴𝑖 𝑡 𝐴𝑇𝐴𝑖 𝑡 𝐴𝑇𝐴𝑖 𝑡
, , , ,
where TACCit is total accruals for firm i in year t, ATAi,tis average total assets for firm i in
year t, ∆REVi,t is change in sales revenue for firm i in year t, ∆RECi,t is change in account
receivables for firm i in year t, , PPEi,t is gross property, plant, and equipment for firm i in
year t, and NI is net income for firm i in year t
Similar to MJ, the magnitude of the residual of equation (2) used as a measure of earnings
quality. The earnings consider have high quality if the magnitude of the residual (MJROA)
lower than the median for the entire sample.
Accruals Quality (AQ)
Dechow and Dichev’s (2002) develop model of accrual estimation errors. Their model
identify the discretionary accruals as the standard deviation of the residual from regression
of change in working capital on lead, lag, and current operating cash flows. This model has
developed by McNichols(2002) by adding to the original model change in sales revenue
and gross property, plant, and equipment as follow:
∆𝑊𝐶𝑖𝑡 1 𝑂𝐶𝐹𝑖𝑡 1 𝑂𝐶𝐹𝑖𝑡 𝑂𝐶𝐹𝑖𝑡 1 ∆𝑅𝐸𝑉𝑖 𝑡 𝑃𝑃𝐸𝑖 𝑡 ….(3)
=𝛼 + 𝐵1 − +𝐵2 + 𝐵3 + 𝐵4 , + 𝐵5 ,
, 𝐴𝑇𝐴𝑖𝑡 , 𝐴𝑇𝐴𝑖𝑡 , 𝐴𝑇𝐴𝑖𝑡 , , 𝐴𝑇𝐴𝑖𝑡 , 𝐴𝑇𝐴𝑖𝑡 + 𝐴𝑇𝐴𝑖 𝑡 𝐴𝑇𝐴𝑖 𝑡
, ,
Dechow and Dichev require at least eight years of data to estimate equation (3). As this
condition not available for all the firms included in the sample of this study, the residual
from equation (3) as a measure of earnings quality. The earnings consider have high quality
if the magnitude of the residual (MJROA) lower than the median for the entire sample.
To test the research hypotheses, as stated in Section 2, I examine the predictability of
aggregate earnings, cash flows, and accruals for the entire sample and for each of the two
groups, using the following four pooled regressions (Models 1,2,3 and 4) as follows:
𝑂𝐶𝐹𝑡1 = 𝛼0 + 𝛼1𝐸𝑡 + 𝜀𝑡
+ 1…………………………………..(M 1)
𝑂𝐶𝐹𝑡 = 𝛿0 + 𝛿1𝑂𝐶𝐹𝑡 + 𝜀𝑡
+1 + 1……………………………….(M 2)
𝑂𝐶𝐹𝑡 = 𝛶0 + 𝛶1𝑂𝐶𝐹𝑡 + 𝛶2𝐴𝐺𝐺𝐴𝐶𝐶𝑡 + 𝜀𝑡
+1 + 1………………(M 3)
𝑂𝐶𝐹𝑡 = 𝛾0 + 𝛾1𝑂𝐶𝐹𝑡 + 𝛾2𝐴𝑅𝑡 + 𝛾3𝐼𝑁𝑉𝑡 + 𝛾4𝐴𝑃𝑡 + 𝛾5𝐷𝐸𝑃𝑡 +
+1
𝛾6𝑂𝑇𝐻𝐸𝑅𝑡 𝜀𝑡 1……………………………..…(M 4)
+

Where:
OCF: Operating cash flows, E: net income after tax adjusted for discontinued Operations.
AP: change in accounts payable, AR: change in accounts receivable, INV: change in
Inventory, DEP: depreciation, AGGACC: aggregate accruals measured by the difference
between operating cash flows and net income, and OTHER: other accruals (E-
(OCF+AR+INV-AP-DEP). All variables are deflated by the number of outstanding
ordinary shares.
Models (1) and (2) test the ability of earnings and operating cash flows to predict one-year
ahead operating cash flows respectively. Model (3) examines whether decomposing
earnings into operating cash flows and total accruals could enhance the ability of current
earnings to predict future operating cash flows. Model (4) disaggregates earnings into
operating cash flows and major components of accruals, since each major accrual reflects
different information about future cash flows, resulting in different weight in prediction.
Consistent with prior research (e.g. Barth et al. 2001, al-attar and Hussain, 2004), to test
which model provide more explanatory power for one-year ahead future operating cash
flows, the adjusted R-squared used. To assess the significance of one OLS model’s
superiority over another the Vuong (1989) Z-statistic is used. Vuong’s statistic is non-
nested in the sense that rejection of one model does not imply automatic acceptance of the
other.
DATA OF THE STUDY
This study uses all listed firms on Jordanian Stock Exchange during the period of 2000-
2014. Firms in the finance sector are excluded from the sample, as the components of their
financial statements are different from other non-finance companies. The initial sample of
the study is 1,910 firm-year observations over the sample period. After removing the firms
with nonsufficient data and the outliers, the final sample reduce to 1,331 firm-year
observations.
ANALYSIS AND RESULTS
Descriptive Statistics
The descriptive statistics for the variables used in the study presented in table 1. Panel A
shows that the means of all variables are positive except for aggregate accruals is negative.
In the line with prior studies ( Dechow, 1994; barth et.al.2001; al-attar and Hussain, 2004;
Dawar, 2015) the mean and the standard deviation of operating cash flow ( 0.14 and 0.49
respectively) are greater than earnings (0.10 and 0.35 respectively). This indicate that
operating cash flows is more volatile than earnings which is smoothed out by accruals
procedure. Al-attar and Hussain (2004) indicate that the volatility of cash flow is a reason
why earnings might outperform cash flow in predicting future operating cash flow.
Panel B present the correlation matrix (i.e. Pearson correlation and Spearman rank
correlation) of the study’s variables. Though the results of the correlation coefficient will
not use to test the study hypothesis, the correlation coefficients indicate that operating cash
flow is significantly positively correlated with earnings, change in accounts receivable,
depreciation. On the other hand, it is significantly negatively with change in inventory,
change in accounts payable, aggregate accruals, and other accruals.
 Table 1

DESCRIBING THE DATA

Panel A: Descriptive Statistics

Variable Mean Median Std.Dev Min. Max.

OCF 0.141 0.059 0.492 -3.036 10.209

E 0.103 0.052 0.350 -1.227 3.735
AR 0.014 0.004 0.358 -4.680 5.861
INV 0.025 0.000 0.414 -4.728 6.910
AP 0.015 0.002 0.716 -16.363 12.709
DEP 0.101 0.052 0.253 -0.085 3.534
AGGACC -0.096 -0.053 0.946 -9.284 20.279
OTHER 0.039 0.007 0.942 -18.105 14.268

Panel B: CORRELATION MATRIX

Variables OCF E AR INV AP DEP AGGACC OTHER
OCF 0.43** 0.02 -.265** -0.22** 0.30** -0.11** -.34**
E 0.42** 0.062* 0.14** -0.11** 0.14** -0.03 0.02
AR 0.16** 0.18** 0.00 -0.15** -0.09** 0.21** -0.50**
INV -0.16** 0.22** 0.10** 0.39** 0.10** 0.18** 0.07**
AP 0.02 0.10** 0.19** 0.21** 0.17** 0.03 0.77**
DEP 0.36** 0.23** 0.03 0.05 0.05 -0.23** 0.28**
AGGACC -0.22** 0.07* 0.24** 0.29** -0.12** -0.28** -0.26**
OTHER -0.15** 0.29** -0.16** -0.10** 0.24** 0.12** -0.23**

Where :
OCF : Operating cash flows, E: net income after tax adjusted for discontinued
operations., AP: change in accounts payable, AR: change in accounts receivable, INV:
change in Inventory, DEP: depreciation, AGGACC: aggregate accruals measured by the
difference between operating cash flows and net income, and OTHER: other accruals ( E-
(OCF+AR+INV-AP-DEP). All variables are deflated by the number of outstanding
ordinary shares.
REGRESSION RESULTS
The Predictive Ability Of Earnings, Cash Flows, And Accruals

Following prior studies Barth et.al., (2001), the predictive ability of earnings,
operating cash flows, and accruals examined by using ordinary least square (OLS)
regression. Using the entire sample data, the results of OLS regression for the study
models 1-4 reported in table 2. Generally, the results reveal that all the accounting
data used in the study are useful in predicting one-year ahead future cash flows as
their coefficients are significant.
Comparing the explanatory power of aggregate earnings with cash flow alone
(Model 1 vs Model 2), reveal that the adjusted R2 of Model 2 (25.6%) is higher
than for Model 1(17.7%). The difference in the adjusted R2, measured using the
Vuong test statistic is significant at any reasonable probability level.. The results
in table 2 show that adding aggregate accruals to cash flow model ( Model 3)
result in adjusted R2 higher than that for cash flow alone. This difference is
significant as the results of Vuong test reveal. More disaggregation for accruals as
presented in model 4, add more to the predictability of cash flow. The difference
in adjusted in R2 between model 4 and model 3 is 4% which is significant as can
be seen in the table.
The results of the study, using the entire sample, provide additional evidence to
prior studies evidence (e.g. Barth et.al.,2001; al-attar and Hussain,2004;
Farshadfar 2008; Ebaid, 2011; Shubita, 2013; Dawar, 2015) in that: firstly; neither
current aggregate earnings nor current cash flow is a better predictor for future
cash flows. Secondly; disaggregating earnings into its main component will
significantly improve the explanatory power of aggregate earnings and cash flows.
To sum up, the results of this section provide a direct support for the accounting
setter’s assertions in that all accounting data should be used in conjunction with
each other to predict future cash flows.
In the next section the analysis is extended to take account of the effect of
earnings quality.
 Table 2

EXPLAINING ONE-YEAR AHEAD OPERATING CASH FLOWS

𝑂𝐶𝐹𝑡 = 𝛼0 + 𝛼1𝐸𝑡 + 𝜀𝑡
+1 + 1………………………………(M 1)
𝑂𝐶𝐹𝑡 = 𝛿0 + 𝛿1𝑂𝐶𝐹𝑡 + 𝜀𝑡
+1 + 1…………………………….(M 2)
𝑂𝐶𝐹𝑡 = 𝛶0 + 𝛶1𝑂𝐶𝐹𝑡 + 𝛶2𝐴𝐺𝐺𝐴𝐶𝐶𝑡 + 𝜀𝑡
+1 + 1………….…(M 3)
𝑂𝐶𝐹𝑡 = 𝛾0 + 𝛾1𝑂𝐶𝐹𝑡 + 𝛾2𝐴𝑅𝑡 + 𝛾3𝐼𝑁𝑉𝑡 + 𝛾4𝐴𝑃𝑡 + 𝛾5𝐷𝐸𝑃𝑡 +
+1
𝛾6𝑂𝑇𝐻𝐸𝑅𝑡 𝜀𝑡 1…………………………..…(M 4)
+
model 1 model 2 model 3 model 4
Coeff. Coeff. Coeff. Coeff.
Constant(±) 0.083869 0.077 0.069 0.053
(9.43)*** (9.07)*** (8.26)*** (6.11)***
E(+) .422
(16.957)***
OCF(+) .506 .525 .692
(21.407)*** (22.446)*** (19.793)***
AGGACC(± -.165
(-7.070)***
AR(+) .314
(9.041)***
INV(+) .283
(8.319)***
AP(-) -.586
(-10.271)***
DEP(+) -.069
(-2.243)**
OTHER(±) .665
(9.361)***

Adj R2(%) 17.7 25.6 28.2 32.2

Vuong Z-stat n.a 5.5 3.7 5.2
Observations 1331 1331 1331 1331
Notes : Significance at p-values of *10 **5 ***1 percent, respectively. The sample period is from
2001 to 2014. The Voung test statistic examines the explanatory power of a model, with respect to
the previous model, i.e model 2 versus model 1, model 3 versus model 2, and model 4 versus
model 3.

The Predictive Ability Of Earnings, Cash flows, And Accruals Conditional Earnings
Quality
To examine the impact of earnings quality, the entire sample is divided into two sub-
samples according to the magnitude of discretionary accruals measured by MJ,MJROA
and AQ models. Earnings consider as low- quality (high-quality) earnings if the magnitude
of discretionary accruals higher (lower) than the median of the sample. Then the four
models of the study run for each sub-sample.
The results of the regression analysis summarized in table 3 for low-quality earnings firm
observations and in table 4 for high-quality earnings firm observations.
The results reveal that, when the quality of earnings is low and despite the measure used,
the explanatory power of cash flow alone is significantly higher than for aggregate
earnings. On the other hand, when earnings quality is high, the reported result in table 4
reveal that the predictability of aggregate earnings improve under the three measures of
earnings quality. However, only when the earnings quality is measured using MJ and
MJROA, aggregate earnings is superior to cash flow in predicting one-year ahead future
cash flow. When earnings quality is high as measured by AQ, Cheng et.al.(2011), report
that there is an obvious evidence on the increase of the value relevance of operating cash
flow, which is consistent with the result of this study. These results are consistent with the
results of prior studies (e.g. cheng et. Al. , 1996; charitou et. Al.,2000; Mostafa, 2014;
Ahmad et. Al., 2014). The general conclusion can be drawn here is that the earnings
management will affect negatively the quality of earnings and a consequence of this is a
reduction of the predicative ability of aggregate earnings.
Regarding the value relevance of aggregate accruals, the general results, as reported in
tables 3 and 4, reveal that the value relevance of accruals is conditional on earnings quality.
When earnings quality is low (high), there is (no) evidence of the gains to the
disaggregation of earnings into cash flow and aggregate accruals. The reported results in
table 3 (table 4) show that the difference in the reported adjusted R2 between model 3 and
model 2 is significant (insignificant) as measured using Vuong test statistic. These results
are consistent with Garrod et al.,(2000) and Al-attar and Hussain (2004) in that aggregate
accruals have incremental information content beyond cash flows and earnings when
earnings quality is low. The results indicate that managing earnings will distort the
predictability of aggregate earnings so the market will switch to other accounting data to
predict future cash flows ( i.e cash flows and aggregate accruals together).
Further decomposition of aggregate accruals into its main components (AR, INV, AP,
DEP, and OTHER) (Model 4) does not improve the predictability of accruals except when
the quality of earnings measured by AQ. The tabulated results of Vuong test statistic reveal
that difference between the adjusted R2 for model 4 and model 3 is always significant only
when earnings quality is high. On the other hand, when earnings quality is low, this
difference is only significant when AQ use to capture earnings quality. These results are
inconsistent with al-attar and Hussain (2004) who document the superiority of cash flow
and the components of accruals all over other models is not conditional on the level of
earnings. This inconsistency may be due to method of capturing the quality of earnings.
Al-attar and Hussain (2004) use the level of earnings performance to capture earnings
quality while in this study different earnings quality measured used.
The interesting result here is that the component of earnings (i.e. cash flows and the main
component of accruals) outperform aggregate earnings in predicting future cash flows
when earnings quality is high. The untabulated results of Vuong test statistic show that the
difference in the adjusted R2 between model 4 and model 1 is always significant. The
Vuong Z-stat are 2.57, 4.1, and 9.7 under the three earnings quality measures, (i.e. MJ,
MJROA, and AQ) respectively. Moreover, as mentioned before, the superiority of cash
flow over earnings improves when earnings quality is high (this result valid for AQ
measurement). Cheng et.al.(2013), who conclude the same results, provide several
explanation for such results. They argued that the market would trust cash flow more when
earnings quality is high and give less weight on cash flow when earnings quality is low. In
this context, they refer to Mcvay,2006 to indicate that cash flow could also be vulnerable
to management manipulation, which might affect its predictability. They also mention that
the results of behavior research reveal that the market could overreact to the components
of earnings ( i.e. cash flow and the main components of accruals in this study) when
earnings quality is high.
These results confirm that the findings of the earlier analysis, conducted on the whole
sample of firms are conditional on the quality of earnings. However, the findings in the
two sections provide an insight into the informational gains to the disaggregation of
earnings, with respect to explaining future cash flows.
Table 3

EXPLAINING ONE-YEAR AHEAD OPERATING CASH FLOWS

LOW-EARNINGS QUALITY FIRMS OBSERVATIONS

Adjusted VUONG Adjusted VUONG Adjusted VUONG

R-squared Z-STAT R-squared Z-STAT R-squared Z-STAT
MJ MJROA AQ
Model 1 14.3% n.a 14.3% n.a 16% n.a
Model 2 29.4% 5.91 28.9% 5.51 27.3% 3.88
Model 3 34.5% 4.755 33.7% 4.39 31.5% 3.45
Model 4 34.2% 0.59 33.7% 1.46 33.9% 3.11
 Table 4

EXPLAINING ONE-YEAR AHEAD OPERATING CASH FLOWS

HIGH- EARNINGS QUALITY FIRMS OBSERVATIONS

Adjusted VUONG Adjusted VUONG Adjusted VUONG

R-squared Z-STAT R-squared Z-STAT R-squared Z-STAT
MJ MJROA AQ
Model 1 23.9% 3.38 25% 3.58 18.4% n.a
Model 2 15% n.a 17.2% n.a 29.4% 6.53
Model 3 14.9% 0.221 17.1% 0.194 29.4% 0.48
Model 4 26.4% 4.25 30.5% 5.46 37.2% 7.5

CONCLUSION
Based on Jordanian data for a period 2000-2014, this study following Barth et.al.(2001)
and other studies examine the predictability of current accounting data- earnings, cash
flows , and accruals- with respect to future cash flows after controlling for the quality of
earnings. Using three most common earnings quality measures the results of this study
reveal that the findings of the studies follow the methodology of Barth et.al.(2001) are
conditional on the quality of earnings. When earnings’ quality is low: (i) cash flows show
superiority over aggregate earnings in predicting future cash flows; (ii) decomposing
earnings into cash flow and aggregate accruals outperforms both earnings model and cash
flows model; (iii) further decomposition of aggregate accruals does not improve the
explanatory power of aggregate accruals model. On the other hand, when the quality of
earnings is high: (i) earnings outperform cash flows in predicting one-year ahead cash
flows; (ii) aggregate accruals add no gain to the explanatory power of cash flows; (iii) the
main components of accruals and cash flows show superiority over aggregate earnings.
The conclusion of this study provides additional evidence on the validity of accounting
setters’ assertion in that current cash flow alone is insufficient to predict future cash flows
in spite of the quality of earnings.
A fruitful direction for future research would include replication similar models to account
for the effect of quality of operating cash flows as some studies suggest that cash flows is
also vulnerable to management manipulations.
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