Accrual accounting vs' cash flow accounting

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Accrual accounting vs. cash flow accounting

• Homework 1 a case study
• Some evidence on whether cash flows or earnings
  are better predictors of future performance
• Introduce the Statement of Cash Flows

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2. Accrual Income vs. Operating Cash Flow
Calculate and compare the standard deviation (or
variance) of annual changes in accrual income
(IBE) and changes in cash flow from operations
(CFO). What does this comparison indicate? What
implication does your answer have regarding the
smoothing property of accrual accounting?
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3. Net Income and Returns vs. Operating Cash Flow
and Returns

• How many times is IBE-RETURN less than
  CFO-RETURN?
• 34 out of 55 years (61.8 of the observations)
• If 50/50 is the benchmark???
• Correlations between IBE, CFO, and RETURN
• Compare s(RETURN) and s(IBE)
• Accrual accounting income 231.18
• Returns 686.31
• Implications for predictions of future returns?

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4. Predictions
a. Based on information up to the end of fiscal
1990, predict IBE, CFO and RETURN for fiscal 1991
using two time series models the random walk
model and the random walk plus drift model.
Compare your predictions to the actual
realizations and calculate the prediction errors.
Any surprises?
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Value Line analysts forecast

• Forecast of accrual earnings (beg 1991) 770
• Prediction error 89 (10) 859 (actual) -
  770
• Comparable to naive models
• Cash flow forecast (beg 1991) 1,310
• Prediction error -659 (-101)
• Comparable to naive models
• What models are analysts using?

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4c. Accrual income as predictor of operating cash
flow and returns

• Prediction error for RETURN 1,027 (58)
• 1,783 (actual) -756 (predicted)
• Lower than the 139 percent error obtained when
  current returns were used as predictors of future
  returns.
• Prediction error for OCF -105 (-16)
• 651 (actual) - 756 (predicted)
• Lower than the -123 percent error obtained when
  current operating cash flow was used as a
  predictor of future cash flow.
• Consistent with (some) more general evidence

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Free cash flow

• Cash flow from operations
• net capital expenditures
• net interest payments
• The case indicates that this is the standard
  definition in finance textbooks

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Correlations of annual series(55 observations)
a. Compute the correlations between CI, FCF and
RETURN.
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Correlations of 5-year aggregates(11 groups of
5 years)
b. (i) Aggregate (add) each variable over 11
five-year periods (1937-1941, 1942-1946 and so
on). Compute the correlations between the three
variables (CI, FCF and RETURN) using the
five-year and 11-year aggregates for each. How
do the correlations compare with those in (a)?
Did you expect this result?
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Correlations of 11-year aggregates(5 groups of
11 years)
b. (ii) Aggregate (add) each variable over five
11-year periods (1937-1947, 1948-1958 and so on).
Compute the correlations between the three
variables (CI, FCF and RETURN) using the
five-year and 11-year aggregates for each. How
do the correlations compare with those in (a)?
Did you expect this result?