The EFFECT OF EARNINGS QUALITY ON THE PREDICTBAILITY OF ACCRUALS AND CASH FLOW MODELS IN FORCASTING FUTURE CASH FLOWS

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.