SUMMARY OF THE RESEARCH STUDY

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Chapter 1 provides an overview of the research project and outlines the aims and objectives of the study. Specifically the objectives of the study were:

( 1) to examine the literature on the relationship between cash flows and accruals- based accounting numbers;

(2) to conduct an empirical study, based on New Zealand annual reports, to determine the contemporaneous movement of earnings and cash flow numbers;

(3) to carry out an investigation into the contextual nature of the relationship between earnings and cash flows and to consider the effect of macroeconomic changes on the relationship.

In effect, the fundamental question of the study is " what is the relationship which prevails over time between the two types of accounting information i.e., earnings numbers and cash flow numbers"? The other questions, such as whether or not there are contextual influences on this relationship and what effect changes in economic indicators have on the relationship between the variables, follow from this primary question. Chapter 1 continues by describing the research methodology and acknowledging the project' s constraints. The last section of the chapter provides an

Chapter 2 reviews the literature on the usefulness of cash flows and earnings numbers.

There can be little doubt from an examination of this literature that most commentators consider earnings to have primacy over cash flows in terms of usefulness to users of financial information. There are very few commentators who would suggest that cash flow information has overall superiority, or who would argue in favour of some form of cash flow accounting replacing the existing accruals-based system. Notable and distinguished exceptions to this are the British academics Lawson and Lee. In the early work of Lee (1972 and 1978) and Lawson (1981) they appeared to advocate a cash flow system based on both cash flow accounting (CFA) and value added accounting (V A) as a replacement for the accrual-based system. Eggington ( 1984) was firmly of the opinion that the CFA and VA models proposed by Lawson and Lee as performance measures "would make them contenders to usurp rather than supplement the role of profit" [italics added] (p.99).

Regulatory bodies such as the Financial Accounting Standards Board in the USA are unwavering in their view that earnings are the superior performance measure. The view of such regulatory bodies is sustained by much of the research output in the area of usefulness of accounting numbers and undoubtedly up until the 1980s, there was little convincing evidence that cash flow numbers contained much additional information over and above that contained in the earnings number. However since the mid 1980s, work by Bowen, Burgstahler and Daley (1986 and 1987), Rayburn (1986) and Wilson ( 1987) among others has provided evidence that cash flow numbers do, in fact, convey information beyond that conveyed by the earnings number alone.

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149 Several interesting occurrences have arisen almost simultaneously with these research

findings. First, the provision of cash flow information has become mandatory within many accounting domains. Second, studies have shown the potential of cash flow information as an input into models of corporate failure. With respect to the former, the mandating of a cash flow statement can be viewed as a response to the loss of confidence in 'traditional' accounting numbers. Over the years criticism of the reliability of reported earnings has become more pronounced. The occurrences in 1987 of stock market collapse around the world intensified the loss in confidence which some users of published accounting information experienced. Commentators such as Largay and Stickney (1990) are clear in their opinion that such a loss in confidence has, in fact, occurred. The root cause has been the ability of preparers of financial accounting information to subject the accruals process to "significant manipulation [which] has contributed to a lack of meaningfulness in financial statements" (Neill, Schaefer, Bahnson and Bradbury, 199 1 , p. 1 18). Some of the impetus for this manipUlation was seen by Healy (1985) and DeAngelo (1986) as stemming from the relationship between management compensation (which is often based on the profit figure) and changes in current accruals. Even without the existence of the implied 'creative' accounting procedures and the negative connotation which is imbued in Healy and DeAngelo's arguments, the subjective nature of the accruals process creates the environment for a loss of faith in the veracity of published accruals-based accounting information.

Much attention in the literature has been focused on the usefulness of the cash flow number as a variable used to predict the future cash flows of an entity. Among the

issues which have arisen is the question of whether or not the usefulness of cash flow numbers is dependent upon factors such as the economic conditions which prevail during the period of the study. Associated with this is the question of whether or not the relationship between the earnings numbers and cash flow numbers is itself contextual. Several studies have addressed the issue of the association between earnings and cash flows (e.g., Bowen et al. 1986; Percy and Stokes, 1 992) but none has examined the contextual nature of the relationship over a sustained time period. One of the main issues addressed in this thesis is the question of the association between changes in the macroeconomic variables and changes in earnings and cash flows. Furthermore, the study examines the association between changes in the macroeconomic variables and changes in the relationship between earnings and cash flows over time.

The foundation for the study is laid in Chapter 3 which specifically examines the relationship between earnings and various measures of cash flows. Using tests of correlation between the accounting and cash flow variables this section provides validation of the results of overseas studies such as Bowen et al. _{(1986) and Percy and} Stokes (1992).

Examination of the relationship between earnings and cash flows was also undertaken to provide insight into the variation between reported earnings and the underlying cash flows. Many of the criticisms which have been made of accruals-based accounting numbers have been based on the subjectivity which is inherent in the accruals process. The measures of correlation between earnings and cash flows provided in Chapter 3

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illustrate the difference which the accruals process makes to the cash flow numbers.

The issue of the difference between earnings and cash flows is important for reasons other than subjectivity. Tweedie (1977) was of the opinion that non-specialist users interpreted accruals-based accounting statements as if they were prepared on a cash

flow basis. The danger of this is apparent when the collapse of companies which

were reporting substantial profits but which had been failing to generate positive

operating cash flows is considered. The need to examine the relationship between cash flows and other variables has been emphasised by Lee (1992) who saw such study as being an important activity for accounting academics. The main findings of the tests of association conducted in this study are summarised in section 6.4.

A description of the changes which occurred in the New Zealand economy during the study period is provided in Chapter 4. This provides the background for the study of the contextual nature of the cross-temporal movement in earnings and cash flows.

Chapter 5 examines the issue of whether or not the cross-temporal movement in

earnings and cash flows or the relationship between them is contextual. The main