The Information Content of Accounting Earnings and Cash Flows Measures of Performance: The Role of the Cash Recovery Rate
Review of Accounting and Finance, 2008, Vol. 7, Iss: 4, pp. 372-395
Posted: 3 Sep 2001 Last revised: 2 Jan 2013
Date Written: July 22, 2001
Purpose – The purpose of this paper is to examine the relative and incremental information content of a cash recovery-based measure of performance, the estimated internal rate of return, vs an earnings-based measure of performance, return on assets, in explaining firms’ economic performance.
Design/methodology/approach – The paper uses the cash recovery rate that is based on continuous time analysis and U-shaped cash flows to derive the estimated internal rate of return and compare it to return on assets. A cross-sectional sample was used over a short interval (year 1993 and year 2005) and a time-series sample (1993-2005) to empirically examine the relative and incremental information content of the competing measures. Tobin’s q and stock returns are used as performance benchmarks.
Findings – The results of the empirical tests indicate that the estimated internal rate of return provides better relative and incremental information content over earnings-based measures of performance. Specifically, the empirical evidence shows that the estimated internal rate of return is consistently positively related to Tobin’s q and stock returns over all measurement intervals.
Research limitations/implications – These results imply that earnings-based performance measures are less value relevant compared to cash recovery-based measures. There are some limitations that may apply to this study. First, the systematic measurement error in estimating the cash recovery rate may not be independent of the measurement error in the estimated internal rate of return. Second, the performance benchmarks used in the study are not free from problems. Particularly, the return on assets is influenced by firms’ rate of growth and the Tobin’s q is not a perfect measure of business performance. Therefore, one avenue of future research is to assess the usefulness of financial accounting data for analysts forecast. Moreover, future research may also examine the role of institutional changes in financial reporting and its effect on the quality of earnings and economic performance.
Originality/value – This paper presents extended research on cash recovery-based vs earningsbased metrics as proxies for economic return using improved research designs, larger samples and new sensitivity analyses.
Keywords: Company performance, Accounting, Rate of return, Organizational earnings
JEL Classification: M41, G14
Suggested Citation: Suggested Citation