The Relationship between Earnings before Interest and Tax and Operating Cash Flow and Stock Return...

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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS

COPY RIGHT © 2013 Institute of Interdisciplinary Business Research

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The Relationship between Earnings before Interest and Tax and Operating Cash Flow

and Stock Return in Information Asymmetry Conditions at Pharmaceutical Companies

of Abidi and DarouPakhshApplying Markov-switching Approach

Hossein Parsian

M.A in accounting, Raja university

Amir Shams Koloukhi

Department of Accounting, Torbat-e-Jam Branch, Islamic Azad University, Torbat-e-

Jam, Iran

SajadAbdipour

M.A in accounting, USB university

MojtabaAkbarpour

M.A in accounting, USB university

Abstract

One of most fundamental economic issues is optimal resource allocation towards productive

investment with rational risk-taking. In doing so, there is a need to performance evaluation

indices, some of which emphasize upon cash flow variables and some others upon

information contents of accounting earning. Therefore, it is tried to consider the relationship

between earnings before interest and tax and operating cash flow and shareholders return at

pharmaceutical companies of Abidi and Daroupakhsh. Then this relationship was tested in

conditions of information asymmetry. In order to test hypotheses, nonlinear Markov-

switching was applied. Results obtained from experimental tests using relating information

from 2002 to 2011 indicate that independent variable of earnings before interest and tax has

no significant relationship with stock returns of two companies. In other words, earnings

before interest and tax have information content toward operating cash flow. Also by

increasing information asymmetry it was observed that variable of earnings before interest

and tax have more correlation with companies’ stock return towards variable of operating

cash flow. In other words, in conditions of information asymmetry, accrual variables have

more information content towards variables of cash flow.

Key words: INFORMATION ASYMMETRY, ACCRUALS, CASH FLOW, TOTAL

SHAREHOLDERS RETURN, MARKOV-SWITCHING APPROACH

Introduction

In terms of presence in the path of economic development and regarding privatization, it

seems that in our country size of investment will have growing trend during future periods,

while regarding information asymmetry investors need some indices to assess companies’

performance to make appropriate economic decisions through following them. To do so,

some performance evaluation indices may be required, some of which emphasize upon

variables of cash flow and some others upon information content of accounting earnings.

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Studies by Aston et al (1992)and Dichev et al (1998),Haw et al (2001), and Stephen Rapp

(2010) indicate that earnings (due to additional information content in its accrual

components) has more information content towards cash flows. Also at international level,

Bartov et al (2001) examined earnings information content and cash flows for assessing

equities in countries of US, England, Canada, Germany, and Japan. Results showed that

earnings have more importance towards cash flows. However, respecting asymmetric

distribution of information among people, it seems that variables of cash flow have more

information content for explaining performance of company’s market towards accounting

earnings. Hence, it is tried in present study to examine the relationship between earnings

before interest and tax and operating cash flow and shareholders return in pharmaceutical

companies of Abidi and Daroupakhsh.

Research theoretical considerations

In opinion of most of financial statements users, accounting earning provided by using

accrual system is a tool measuring performance of a company. The mean by measuring

companies’ performance is to assess financial statements and operations’ results to making

rational decisions.in statement no.6 for financial accounting concepts; financial accounting

standards board necessitates applying accrual method in accounting. Based on this, to reflect

effects of transactions and events of company doesn’t mean necessarily entry and exit of

cash. In other words, in accrual method, some principles such as “realization” and

“matching” are applied to reflect incomes and costs and computing accounting earnings

(financial accounting standards board, 1985). On the other hand, operating cash flow is one

of main indices for assessing performance based on view of internaland external users of

organization, especially investors and creditors. In theoretical framework, financial

accounting that determines objectives of financial reporting takes special consideration to

cash flows and possibility of its prediction. In statement no.1 of financial accounting concepts

of financial accounting standards board it is states:

“One of financial reporting objectives is to provide information to help present and

potential investors and creditors and other users in assessing the amounts, timing, and

uncertainty of prospective cash receipts from dividends or interest and the proceeds from the

sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are

affected by an enterprise's ability to generate enough cash to meet its obligations when due

and its other cash operating needs, to reinvest in operations, and to pay cash dividends and

may also be affected by perceptions of investors and creditors generally about that ability,

which affect market prices of the enterprise's securities.” (FASB, 1978: par.37)

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Also International Accounting Standards Committee (IASC) states in International

Accounting Standard no.7:

“Information about the cash flows of an entity is useful in providing users of financial

statements with a basisto assess the ability of the entity to generate cash and cash equivalents

and the needs of the entity to utilize those cash flows. The economic decisions that are taken

by users require an evaluation of the ability of anentity to generate cash and cash equivalents

and the timing and certainty of their generation” (IASC, 1993).

Iranian Accounting Standards Committee states in the part of theoretical concepts of financial

reporting:

“Taking economic decisions by users of financial statements require an evaluation of the

ability of an entity to make cash and certainty of their generation. Evaluating the ability of

generating cash is facilitated through focusing upon financial status, financial performance,

and cash flows of an entity and utilizing them in predicting expected cash flows and

measuring financial flexibility” (Technical committee of Audit Organization,2002: 49).

There are some differences between accounting earning and operating cash flows due to

effect of the following factors:

1. First factor is non-cash costs (such as depreciation costs) that reduces net profit,

however causes no reduction in cash value of company.

2. Second factor is time difference of income realization and receiving its payment and

also to bear cost and to pay its payment.

3. Third factor refers to non-operating gain and loss resulted from sale of fixed

assets,securities, and other types of investment taken into account in loss statements

and may cause transition in net profit, however have no effect upon activities of cash

flows statements.

Figure.1 shows different states that accrual and cash systems may have towards each other.

Each figure shows information available for market per moment. First state is when both gain

(earning) and operating cash flow contain important information. Second one is state in

which both gain (earning) and cash flow have important information but none of them

contains incremental information content towards the other. Ultimately, the last state is when

one of variables (for example earning (gain)) has incremental information content, but its

reverse is not true(Bowen et al, 1987). In other words, it is tried in present study to consider

the relationship between earning and operating cash flows and stock return, then this

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relationship would be tested in information asymmetry conditions to signify that which one

has stronger relation with shareholders’ returns.

Figure.1: Possible results of the study about incremental information content of cash flows

and accrual flows (Bowen et al., 1987)

ThirdstatestateSecond First state

Literature review

Gambula and Ketz (1983) in their study examined the relationship between figures obtained

from accrual earning and cash flows. The results of their study indicate that cash flow lack

information importance compared with accounting earning (Gambula and Ketz, 1983).

Rayburn (1986) in his study examines the relationship between unexpected accrual

components and cash flows with stock return. The results of this study show that both

components, accounting earning and cash flows, have information content (Rayburn, 1986).

Wilson (1987) in a study examined the role of information content of earning components

towards the values of earning itself through dividing cash and accrual components of earning.

The results indicate that earning’s accrual components contain incremental information

content towards its cash components (Wilson, 1987). Bowen et al (1987) studied incremental

information content of cash and accrual figures. The results of their study show that

information related to earning and cash flows contain incremental content towards each other.

Also, information related to cash flows has incremental information content towards earning

(Bowen et al., 1987). Easton in his research examined relative information content of earning

and cash flows. The results of this study reveal that earning has higher information content

compared with cash flows (Easton et al., 1992).

Dechow (1924) in his study considered accounting earning and cash flows as an index of

performance evaluation. The results of this study indicates that as firm has less fluctuations in

supplying its required funds, cash flows have better conditions for measuring performance. In

his opinion, during short time periods (form example; three months or a year), firm;s earning

has more relationship with return and cash flows. (Dechow, 1994).

Hodgson and Stevenson (2000) in their research studied the relationship between earning and

cash flows with stock return affected by firm’s size. The results of this study indicate that

Accrual basis

Cash basis

Cash basis

Accrual

basis

Accrual basis

Cash

basis

Market information

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cash flows provide more additional information for firms with big size towards firms with

small size. Also, smaller firms contain more unstable earning components towards bigger

ones. In addition, non-linear relation between earning and cash flows has higher descriptive

strength compared with when this relationship was examined as linear (Hodgson and

Stevenson, 2000). Club et al. (2000) in their research examined the relationship between

earning and operating cash flows with stock return in Japan from 1985 to 1993. The results of

this study reveal that when earning has more unstable state, cash flows have more significant

role for determining return (Club et al., 2000).

Bartov et al (2001) in their study examined information content of earning and cash flows for

evaluating equities interest in Us, England, Canada, Germany, and Japan. The results indicate

that in US, England, and Canada earning has more significance towards cash flows but in

Germany and Japan it is not as such. In other words, national method in factor reporting that

effects upon information content of earning and cash flows (Bartov, 2001). Haw et al. (2001)

in a study examined information content of operating cash flows, earning, and accruals in

China’s stock market. The results show that earning contains more information content

towards operating cash flows and also incremental information content of discretionary

accruals against non-discretionary accruals was conformed (Haw et al., 2001). Chan et al.

(2006) in their study examined the relationship between accrual figures (accounting)

(difference between earning and cash flows) with stock return. The results of this study

indicate that stock return of firms with high accrual accounting (figures) is reduced during

next period of financial information reporting (Chan, 2006). Subramanyam and

Venkatachalam (2007) examined the relative significance of earning and cash flows in equity

evaluation. The results show that earning may have better performance in explaining intrinsic

realized value compared with cash flows (Subramanyam and Venkatachalam, 2007).

Arthur et al. (2009) in their research studied information content cash flow and accruals. The

results of their study indicate that earning cash components contain information content for

investors and dividing earning into cash flows and accruals contains incremental information

content towards disclosure of total earning figure (Arthur et al., 2009).

Steffen Rapp in his research studied the relationship between accounting earning and cash

flows with shareholders’ return in information asymmetric conditions. The results of this

study show that in information asymmetric conditions, accounting earning contains more

information content towards cash flows. However, through increasing information

asymmetry cash flow indices are more relevant in explaining performance of stock market

(Steffen Rapp, 2010).

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Analysis model

The current method for studying dynamic behavior of economic and financial variables is to

use various models of time series. Among these time series models, linear models such as

Auto Regression (AR) or a combination of these models(ARMA) are well known. A part of

their currency may be because of easy estimation of these models through common

econometric soft wares. Although they act in some cases successfully, they fail in describing

non-linear behaviors such as asymmetry, etc. one of most famous non-linear time series

models is Markov-switching model. This model was first introduced by Quant (1972),Quant

and Goldfield (1973). Then it was developed by Hamilton (1989) to derive commercial

cycles. Generally, it is assumed in non-linear models that behavior of a variable, upon which

modeling has been done is different and transition in different states. In terms of speed of

transition from one state to another, these non-linear models are divided into two main

groups. In some of them, transition from one state to another state is slow and smooth (like

model STAR3 and artificial network ANN4). In some others, the transition is done quickly

that Markov-switching model is among them (Enders, 2004:404). In model of Markov-

switching, probability are applied to divide time series variables, or relations between

variables into two regimes or more. Method of Markov-switching is able to explain features

of regimes’ information asymmetry because of being non-linear; hence it is more appropriate

towards VAR and ARMIA.

Used data in present study has been collected from audited financial statements. To do so,

main part of information has been collected form software “Rahavard Novin”, and “Tadbir

Pardaz” and other information has been gathered form center of research and Islamic studies

management of organization of securities market and also from information bank of this

organization. Software Ox Metrics Vol.6 used for statistical test.

Research hypotheses

Hypothesis.1: accounting variables have better performance towards variables of cash flows

in explaining companies’ stock return performance (capital market)

Hypothesis.2: by increasing information asymmetry, accounting variables play more

significant role in describing companies’ stock return performance (capital market) compared

with variable of cash flows.

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Research variables definition

Research variable have been summarized in table.1

Table 1. Research variables definition

variables

BETAit

Variable of size for firm at time (SIZE) is measured by logarithm of

total assets

SIZEit

The market-to-book ratio of equity of firm at time MTBit

Earning per share to market stock price (firm at time ) ETPit

Return percentage of shareholders (firm at time ) Rit

Earning before interest and tax (firm at time ) EARit

Operating cash flow(firm at time ) CFit

Total dept to total asset ratio (firm at time ) LEVit

For measuring information asymmetry, three virtual variables are applied as follows;

MACPit: If value of company’s market from the average market value of annual portfolio is

greater than value of market capital, it is considered as 1, otherwise zero.

INTANGit: If proportion of tangible fixed assets to total assets of company per year is greater

than average value of the same proportion in annual portfolio, it is considered as 1, otherwise

zero.

DOMINATEDit: If floating shares of company is less than 50%, it is considered as 1,

otherwise zero.

Regression models related to research hypotheses are as follows;

Hypothesis 1: 𝑅𝑖𝑡=α0+β1𝑥𝐸𝐴𝑅it+β2𝑥CFit+ε

Hypothesis 2:

𝑅𝑖𝑡=α0+β1𝑥𝐸𝐴𝑅it+β2𝑥CFit+λ1𝑥BETAit+λ2𝑥SIZEit+λ3𝑥MTBit+λ4𝑥ETPit+λ5𝑥LEVit+λ6 dummy

MACPit + ε

𝑅𝑖𝑡=α0+β1𝑥𝐸𝐴𝑅it+β2𝑥CFit +λ1𝑥BETAit+λ2𝑥SIZEit+λ3𝑥MTBit+λ4𝑥ETPit+λ5𝑥LEVit+λ6 dummy

INTANGit+ e0

𝑅𝑖𝑡=α0+β1𝑥𝐸𝐴𝑅it+β2𝑥CFit +λ1𝑥BETAit+λ2𝑥SIZEit+λ3𝑥MTBit+λ4𝑥ETPit+λ5𝑥LEVit+λ6 dummy

DOMINATEDit+ e0

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Data analysis

First step for estimating the model in Markov-switching method is making sure that data

model is non-linear. Therefore, LR test was applied and the results were presented in table.2.

Table 2. Results of LR test

Probability Statistics Firm

0.000 623.74 Abidi

0.000 579.04 Daroupakhsh

As shown in results of the table above (by comparing value of statistic of LR test with critical

value) considered variables follow a non-linear model. Therefore, linear method for

estimating model’s parameters is not suitable and applying non-linear method is better for

obtaining relation between variables. Therefore, in this study Markov-switching non-linear

model has been applied. Results obtained from estimating model of hypothesis.1 in Markov-

switching are provided in Table.3.

Table.3: Results of estimating model of hypothesis.1 in Markov-switching method

Sig. variables coefficient statistics

Abidi

0.000 EAR 0.00145 24.5

0.986 CF 0.00036 0.0184

Sig. variables coefficient statistics

Daroupakhsh

0.042 EAR -0.0487 -2.30

0.667 CF -0.0168 -0.475

Results of estimating model of hypothesis.1 for company of Abidi indicate that effect of

independent variable of earning before interest and tax upon company’s stock return, 0.00145

is positive and significant. In company of Daroupakhsh, effect of variable of earning before

interest and tax upon stock return, -0.04872, was negative and significant in error level of

5%. In addition, operating cash flow has no significant effect upon stock return in both

companies.

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Results obtained from estimating model of hypothesis.2 in Markov-switching are presented in

table.4.

Table 4.Results of estimating model of hypothesis.1 in Markov-switching method

When virtual variable Macp added When virtual variable Intang added When virtual variable Dominated

added

Sig. Coefficient Variable Sig. Coefficient Variable Sig. Coefficient Variable Abidi 0.000 0.002289 EAR 0.000 0.002149 EAR 0.000 0.00225 EAR 0.000 -0.000326 CF 0.000 0.0003 CF 0.000 -0.00112 CF

When virtual variable Macp added When virtual variable Intang added When virtual variable Dominated

added

Sig. Coefficient Variable Sig. Coefficient Variable Sig. Coefficient Variable Darupakhsh 0.000 -0.00219 EAR 0.000 -0.00222 EAR 0.000 -0.00227 EAR 0.000 0.00073 CF 0.000 0.00074 CF 0.000 0.00075 CF

As shown in table.4, after adding virtual variables as representatives for information

asymmetry, the relationship between independent variables with stock return changed for

both companies, so that a significant relationship is observed between independent variable

of earning before interest and tax and operating cash flow and company’s stock return. Also,

it is observed by comparing coefficients (factors) of earning before interest and tax and

operating cash flow that in all cases, factor of earning before interest and tax is greater than

factor of operating cash flow. In other words, in conditions of information asymmetry,

variables of cash flow have more correlation with companies’ stock return towards accrual

variables. In figure.2 probability of each regime per year is shown.

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2-1-1: company of Abidi- through adding virtual variable of Macp

Fig.2: probability of each regime

2-1-2: company of Abidi- through adding virtual variables of Intang and Dominated.

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2-2: company of Daroupakhsh- through adding virtual variables of Macp, Intang, and

Dominated.

Respecting figure.2, years of study are categorized and summarized intable.5.

Table 5. categorization of years of study by considering regime

Years categorized in each regime

Studied

regime

Abidi

When virtual

variable Macp added

When virtual variable

Intang added


Dominated added

2002-2004, 2011 2002, 2004, 2005,

2008, 2009

2002, 2004, 2005,

2008, 2009

Regime 1

2003 2003, 2006, 2007,

2010, 2011

2003, 2006, 2007,

2010, 2011

Regime 2

Years categorized in each regime

Studied

regime

Darupakhsh

When virtual

variable Macp added


Intang added


Dominated added

2003, 2005, 2006,

2009, 2011

2003, 2005, 2006,

2009, 2011

2003, 2005, 2006,

2009, 2011

Regime 1

2002, 2004, 2007,

2008, 2010

2002, 2004, 2007,

2008, 2010

2002, 2004, 2007,

2008, 2010

Regime 2

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At the end, in table.6 probability of transition from a regime at time t to another regime at

time t+1 for each company is shown.

Table6. probability of transition from a regime at time t to another regime at time t+1

Regime 2 in period t Regime 1 in period t Regime probability Abidi

0.49951 0.49951 Regime 1 in period t + 1


Regime 2 in period t Regime 1 in period t Regime probability Darupakhsh



Table.6: probability of transition from a regime at time t to another regime at time t+1

Conclusions

Research results show that in pharmaceutical company of Abidi and company of

Daroupakhsh, independent variable of earning before interest and tax has a significant

relationship with stock return of both companies. It is the case that variable of operating cash

flow has no significant relationship with stock return of both companies.in other

words,Results of adding these two variables are the same; therefore further representation of

diagram is avoided.

Results of adding these three variables are the same; therefore further representation of

diagram is avoided.Interest and tax contain information content towards operating cash flow.

By increasing information asymmetry it is observed that variable of earning before interest

and tax has stronger relationship with companies’ stock return towards variable of operating

cash flow. In other words, in conditions of information asymmetry, accrual variables have

more information content compared with variables of cash flow. Results of this research are

similar to those of studies by Gambula and Katz (1983), Easton(1992) and Haw et al (2001)

indicating that accounting earning has more information content towards cash flow. However

it has some contrast with research by Stephen Rapp (2010) indicating that through increasing

information asymmetry, cash variables are more relevant towards accrual variables. Results

of this research shows that earning (due to additional information content within its accrual

components) contain more information content towards cash flows and investors should take

this important point into consideration in their decisions.

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http://ssrn.com/abstract=1555652

The Relationship between Earnings before Interest and Tax and Operating Cash Flow and Stock Return...

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