Accruals, disclosure and the pricing of future earnings in the European market
The present study examines the role of disclosure in assisting market participants to form expectations of future earnings from the accrual (i.e., the non cash) content of reported earnings. Prior research has shown that, in general, disclosure is able to enhance future earnings information in current stock returns.
In this paper, it is shown that the role of disclosure in revealing relevant information on the prospects of the firm depends on the nature of the accruals appearing in the financial statements. In this respect, therefore, the present study addresses a significant gap in the understanding of accruals by providing an insight into the strength of the interaction between reported accounting numbers and further information disclosed by the firm, and this is done in an international context relevant to the contemporary setting of integrating capital markets.
In examining whether the information about future earnings in current returns is conditional upon disclosure, it is acknowledged that accrual-based financial statements and other disclosed material may interact in conveying useful information about the future cash flows that outside investors require for valuation. Prior evidence demonstrates how investors condition their investment decisions upon disclosure together with consideration of the accounting policies that govern the calculation of accounting results. Instead of accounting policies per se, the present study focuses on the underlying nature of accrual accounting and the complementary role of disclosure in revealing the relevance of accruals for the prediction of future earnings and cash flows. The present study contributes by providing empirical evidence on the interplay between disclosure levels and accruals, in so far as it may assist market participants to become informed about future earnings, emphasising:
- the sign of accruals, i.e. whether operating asset changes and operating liability changes together result in an increase in net operating assets (a net positive accrual) or a decrease in net operating assets (a net negative accrual), and
- the duration of accruals, considering that current accruals address matching and timing issues more promptly than non-current accruals.
Much accounting research has already investigated the role of accruals as a means of improving the relevance, usefulness and quality of financial statement information. Yet the extensive use of accrual accounting as a means of improving the relevance of financial information is jeopardised by the increasing difficulty of making reliable forecasts in fast-changing economies, and also by the frequent managerial misuse of estimates to manipulate financial data.
Thus, in this study, the importance of the role of disclosure for the interpretation of accruals is emphasised, even when these accruals may be misguided, or open to manipulation. It is argued that adequate disclosure is necessary for market participants not only to be able to deal with the information contained in accruals in a timely manner, but also to assess the reliability of the future earnings and cash flow expectations arising from these accruals. In other words, the present study also investigates the ability of disclosure to have a further corrective influence by preventing the formation of over-optimistic or over-pessimistic earnings expectations associated with the accrual signal.
A further innovation in this research study is to make use of a 'global measure' as a proxy for disclosure across a sample of firms drawn from a number of different jurisdictions. Most of the prior related research which discusses the impact of disclosure on share price anticipation employs samples drawn from just one specific jurisdiction (principally, either the US or the UK), providing evidence that is relevant only in the light of the characteristic features of the particular accounting environment. Such research tends to employ disclosure metrics whose design and measurement are inevitably constrained by their own 'jurisdiction-specific' context. On the other hand, with internationally integrating markets, it has become increasingly important to understand economic consequences not only insofar as these may be determined by legal provisions and best practices within a specific jurisdiction, but additionally from the perspective of investors who diversify not only across domestic equities but also internationally.
Thus, whilst there is strong evidence from the two well-researched jurisdictions mentioned above on the ability of disclosure to enhance the share price anticipation of earnings and cash flows, it is difficult to extrapolate from such country-specific evidence in order to evaluate the efforts of accounting standard setters and regulators towards harmonising accounting and disclosure on an international scale. In other words, it has yet to be made clear whether, when and how more disclosure, defined from the perspective of an international user of financial reports, may contribute to the share price anticipation of future earnings in a multi-jurisdictional setting, consistent with the aspirations of the international accounting standard setters and regulators. The use of Standard and Poor's 'global measure' of transparency and disclosure in this paper, together with a cross-national sample of firms, offers a suitable means of addressing such concerns, at least in a European context.