Investigating the Predictive Power of Operating Income/Earnings vs. Cash Flows on Future Cash Flows

Abstract

The Financial Accounting Standards Board (FASB, 1978), as well as the International Accounting Standards Board (IASB, 2020), claim that accrual accounting methods provide investors with more useful information when making predictions about future cash flows, than do operating cash flows themselves. This paper seeks to evaluate this claim by testing accrual-based earnings variables and operating cash flow with cross-sectional, pooled estimates, and industry-specific regression models, and comparing the resulting 𝑅 values. 2 Prior research on this topic has primarily been conducted on American firms, amongst others by Ball & Nikolaev (2022), whose article has been the inspiration of this paper. To examine if the results obtained by Ball & Nikolaev (2022) also apply to Europe and IFRS accounting, our data has been retrieved from firms listed in the Schengen Area and the United Kingdom. Our results replicate the findings of previous research, with the exception of one anomaly; the variable that adjusts operating cash flow by including working capital accruals showed inferior predictive power relative to operating earnings. In line with the prior findings of Ball & Nikolaev (2022), we find that the predictive power of accrual-based earnings measures are greatly enhanced when allowing for cross-sectional differences in firms.