8/9/2019 Earnings and Operating Cash Flow

1/5

The Difference between Earnings and Operating Cash Flow 765

COMPUST AT for earnings before extraordinary items (data

  18),

 depreciation and

amortization expense (data 14), total assets (data 6). data for computing operating

cash tlow (data 1. 4, 5, 34, 106, 126, and 217), and data for computing control

variables (receivables, 2: inventory, 3; long-term

 debt

9;

 sales,

 12; common shares,

25;

  adjustment factor, 27; retained earnings. 36; sale of equity securities, 108;

capital expenditures, 128; auditor and audit opinion, 149; share price, 199; and

exchange listing, ZLIST) for the year the fraud was discovered and the preceding

year.' The sample consisted of 56 firms.

Data were examined for these firms for up to five years, from three years up

to the fraud discovery year to the year following the discovery year. The number

of firm-years varied during this period because of missing data, usually because a

firm did not exist in certain years prior or subsequent to the fraud discovery.

Sample sizes vary for fraud firms across tests reported in this study because of

missing data for one or more variables included in some of the tests. The

availability of earnings and cash fiow data does not guarantee that data for all

control variables are available.

The firms were distributed across 21 two-digit SIC industries, though those

with SIC codes from 3000 to 3999 w ere prominent (27 firms). Most of these were

technology firms. Event years were distributed across the sample period, with no

more than eight observations falling in the same calendar year. Fraud was

discovered for many of the firms shortly after they became publicly traded. Fraud

was discovered within the first three years of the listing period for 28 of the firms.

Twenty-three of the firms were deleted from the COMPUST AT nonresearch files

within three years of the discovery year. Sixteen firms were deleted from the non-

research files because of bankruptcy or liquidation. Another

 23

 of the firms merged

or went private. Only  17 of the firms continued to exist in 1993 as publicly traded

firms.

Variables and descriptive statistics

Earnings were measured as earnings before extraordinary items plus depreciation

and amortization expense. Depreciation and amortization were added to make the

earnings number comparable with operating cash flow . Expenditures for plant

assets are deducted in computing investing cash flow and do not enter the

computation of operating cash flow. Consequently, if all other operating

transactions were for cash, operating cash fiow would exceed earnings by the

amount of depreciation and amortization expense.

Operating cash fiow was computed as

O E

=  NI,  DAE,  E,^G,+

  T

{CL, - CL, ^)-

  CA,

 - CA, _ ,), (1)

where  OCE, is operating cash fiow in year /, N I  is earnings before extraordinary

items,

 DAE is depreciation and amortization expense, E is equity in earnings, G is

gain (or loss) from sale of long-term assets,  T  is deferred taxes,  CL  is current

liabilities (less short-term debt), and   CA  is current assets (less cash and equiva-

lents).

 Earnings (adjustment for depreciation and amortization is assumed in future

8/9/2019 Earnings and Operating Cash Flow

2/5

766 Contemporary Accounting Research

references) minus operating cash flow was the primary measure used in this study

(eamings-cash flow hereafter). Both eamings and cash flow were scaled hy

beginning-of-period assets to control for size. Om itting

  E G

and

  T

  from the

equation had minimal effect on empirical results.

Other variahles examined in the analysis included financial variables and re-

lated items considered in prior studies (see Tahle 1). A list of these variables and

their computations is provided in Table 2. We selected these variables as being

representative of

 the

 variables considered in prior studies that were available from

COMPUST AT. The large numher of firms in our analysis precluded the inclusion

of other variahles.

Table  provides descriptive statistics for continuous explanatory and control

variables for the sample of fraud firms and for a sample of 60,453 nonfraud firm-

years for 1974-93. The statistics for fraud firms are for 150 firm-years for the 3

years immediately prior to the year of fraud detec tion. Data were not availahle for

all fimi.s for all firm-years. The existence of a firm on COMPUSTAT in a

particular year did not guarantee that all variahles were available for that year. The

nonfraud sample included all firm-years for nonfraud firm s for which all variables

were availahle from COMPUSTAT annual industrial, full, and research files. These

files include essentially all publicly traded New York Stock Exchange (NYSE),

American Stock Exchange (AMEX), and over the counter (OTC) firms in the

United States, including those deleted from the nonresearch files because of

bankmptcy, liquidation, and merger.

Data also are provided in Table 3 for those firm-years in the fraud sample in

which the excess of eamings over cash fiows were the largest. Determining the

specific periods in which the frauds affected eamings or cash fiows and the

magnitudes of the effects is problematic. The discovery of fraud does not

necessarily result in specific identification of the period in which the fraud

occurred. Because many of the firms in our sample existed for a limited period as

publicly traded companies prior to the discovery, we assume the frauds affected

financial statements in the years immediately prior to discovery. We limit the

analysis to no more than three years prior to the discovery to ensure a reasonable

number of observations in which the effects of the fraud were likely to have

occurred. Using several years in the prediscovery period in the analysis will

understate the relation between fraud and accmals to the extent the fraud did not

affect the accmals throughout this period. Using the year in which the magnitude

ofthe accrual variahle was largest in the analysis assum es that the existence of high

accmals in any year is a signal of potential fraud. This assumption leads to an

overstatement of the relation only if a high accmal resulted for a fraud firm for

some reason other than the fraud. We examine both the three-year sample and the

maximum-year sample because of potential understatement or overstatement of

results. The maximum-value years were distributed across

 the

 prediscovery period.

Twenty-seven percent of the maximum years were three years prior to discovery,

41 percent w ere two years prior

 to

 discovery, and 32 percent were in the year prior

to discovery. ̂

8/9/2019 Earnings and Operating Cash Flow

3/5

The Difference between Eamings and Operating Cash Flow 767

TABLE 2

Variables included in current study

Variable

Computation

Eamings

Operating cash flow

Earnings  -  cash

Free cash flow

Amount of securities issued

Leverage

Auditor change

Audit opinion

Inventory

Change in inventory

Receivables

Change in receivables

Sales growth

Market retum

Retained eamings

Market value

Sales to assets

Assets

Sales

Years listed

Industry

Stock exchange listing

  Eam ings before extraord inary items,  +  Depreciation,)  /

Assets,, I

NI, + D, +

 E, G,

T + CL,

  -  CL,

 

, -

  CA, - CA,  ^ )*

As defined above

[Operating cash flow^  -  Cap exp,^,g , -

 2 to < -

  i)J 

Current assets, _  ,

Equity securities issued,/ M arket value, _,

CurTent assets,

 

Long-term debt,/ Assets,

1

 if

 auditor, not equal to auditor, _

  ,

1  if opinion not unqualified

Inventory,/Sales,

  Inventory,/Sales,)/ Inventory,_ |/Sales,_ 1) . ,

Receivables,/Sales,

  Receivables, /Sales,) /  Receivables, _ / Sales, _  ,)

Sales , /Sa les , . ,

  Price, -  Price, _ ,)/Pdce, _ ,  [adjusted  for  splits and divi-

dends]

Retained eamings,/Assets,

Market value^/Assets,

Sales,/Assets,

 _ ^

Assets, [log  of assets used in analysis]

Sales, [log  of sales used in analysis]

Current year -  first year on COMPUSTAT

1  if SIC > 2999 and 

8/9/2019 Earnings and Operating Cash Flow

4/5

768

Contemporary Accounting Research

TABLE 3

Desctiplive statistics and comparisons for fraud and non-fraud firms

Variable

Eamings

Operating cash flow

Eamings-cash f low

Free cash flow

Equity securities

Leverage

Inventory

Change in inventory

Receivables

Change in receivables

Sales growth

Market retums

Retained earnings

Market value

Sales to assets

Assets

Sales

Fraud firms

(prediscovery)

N

 

Mean

  84

-0 .069

0.154

-0 .262

  94

  538

  238

1.143

  228

1.349

1.426

  394

  77

1.742

1.730

229.256

222.563

15 0

Std dev

  234

0.315

  324

  557

  248

0.216

0.163

  555

0.145

L748

  594

  9 9

0.418

3.142

  95

456.809

379.742

Non-fraud

1

N

 

Mean

  79

  68

0.011

-0 .017

0.041

  477

0.169

1.034

0.166

1.050

1.143

0.197

0.103

  897

1.617

878.376

937.830

 irms

: 60,453

Std dev

0.143

0.160

0.139

  384

  258

  234

0.137

  442

0.115

0.441

  435

  867

  875

1.115

1.115

3,994.640

4.220.710

Fraud firms

(maximum)

N

Mean

0.112

-0 . 2 1 9

0.331

-0 .482

  59

  534

  245

1.252

  226

1.306

1.451

  374

  8

1.825

1.973

173.958

162.247

 

56

Std dev

0.174

  347

  353

  575

0.182

0.213

0.181

  675

0.152

  645

  524

1.031

  396

3 533

1.125

403.085

295.107

/-value

0.231

- 4 . 3 1 3

4.363

- 4 . 3 4 0

2.114

2.808

4.132

1.937

4.256

1.694

4.708

2.140

-0 .604

2.662

1.730

-3 . 3 8 0

-3 .658

Notes:

Eamings and operating cash flows are scaled by beginning-of-year assets. Other variables are

defined in Table 2 . The prediscovery fraud sample inc ludes t lrm-yeans for the 3 years up

to Ihe year of frand discovery. The m aximum fraud sample includes only the prediscov-

ery firm-year in which the excess of eamings over cash flows was largest, (-values are for

comparisons of nonfraud firm-years with maximum-value firm-years for fraud firms,  t

values assume unequal variances.

Significant differences between the fraud and nonfraud samples exist for most

of the variables in Table 3. The table reports  i values that compare the maximum -

value fraud firm-yea rs with the nonfraud firm-years. The t values take into account

unequal variances between the samples and arc more conservative than tests that

assume equal variances. Similar results (not reported) occur for the three-year

sample, though the

  i

 values are slightly lower.

The excess of earnings over cash flows is significantly larger on average for

the fraud than the nonfraud firms. This difference results from the significantly

lower operating cash fiows of the fraud firm s. Earnings for the tw o samples are not

significantly different. The free cash flow measure also is significantly lower for

the fraud firms. Compared with nonfraud firms, the fraud firms, on average, issue

more equity securities, are more highly levered, have larger amounts of receivables

and inventories, have larger sales growth, have larger market retums and larger

market values relative to assets, and are sm aller in terms of assets and sales.

8/9/2019 Earnings and Operating Cash Flow

5/5

The Difference between Eam ings and Operating Cash Flow 769

Table 4 provides descriptive statistics for noncontinuous variables. Percentages

are based on firm-years in tbe fraud up to the discovery year) and nonfraud

sam ples. A larger percentage of firms in tbe fraud sample are OTC firms tban for

those in tbe non-fraud sample. A smaller percentage of fraud firms are AMEX

firms tban for those in tbe nonfraud sample. A larger percentage of fraud firms

experienced auditor changes than for tbe nonfraud sample. A larger percentage of

qualified opinions were issued for the fraud sample. Finally, though distributed

across many industries, fraud firms were grouped in the 3000-39 99 SIC codes to

an extent that was larger than tbe proportions for nonfraud firms. Indicator

variables are used for tbese variables in the empirical ana lysis. Using an indicator

variable for tbe 30 K) SIC code group resulted in stronger results tban using sepa-

rate indicator variables for two-digit SIC code groups within the 3000 group.

Table 5 p rovides a correlation matrix for continuous variables examined in the

study. Data are from tbe com bined sam ple of fraud and nonfraud firm-years

  60,688 observations). Most of the correlations in the table are significant at the

0.01 level. Because of the large sample size, only correlations less than 0.02 are

insignificant at tbe 0.05 level. The correlations indicate that several variables are

correlated witb tbe excess of eaming s over casb flows; free cash fiows, inventory,

change in inventory, receivables, change in receivables, sales growth, and sales to

assets. These variables are likely to be proxying, at least partially, for the same

accrual construct as tbe excess of eam ings over cash flows. Consequently, they are

not likely to provide much additional information with respect to signaling fraud.

Most of the correlations in the table are low tbougb significant), other than tbose

among tbe accrual-related variables.

Table

 6

 reports statistics for

 the

 earnings and operating cash flow variables for

fraud firms across the five years, beginning tbree years prior to the fraud discovery.

Means and medians reveal tbe same pattem s. Eam ings are higher prior to the year

the frauds were discovered than after, wbile operating cash flows are lower in tbe

prior years. As a result, the earnings -cash flow variable is positive in tbe years up

to the fraud discovery eam ings are higher tban cash fiow). Tbe

 

test for mean

greater tban zero is significant in prediscovery years and insignificant in

postdiscovery years.

Table 7 com pares the distribution of tbe eam ings-cash flow variable for fraud

firms relative to the distribution for nonfraud firm-years. The table lists selected

percentiles of the distribution of the eamings-cash fiow variable for 60,453 firm-

years using all available CO MPU STA T observations for nonfraud firms from 1974

to 1993. These distributions indicate tbat a large percentage of observations for

fraud firms falls within the extreme upper percentiles of tbe distribution of all

COM PUST AT firm-years. Almost 93 percent of the fraud firms exbibit values of

eamings-cash flow above the median value for nonfraud fimis in at least one of tbe

prediscovery years. Over 64 percent of tbe fraud firms exbibit a value greater than

tbe ninetieth percentile, and over 5 percent exbibit a value greater than the ninety-

fifth percentile. These results are consistent with the hypothesis that the difference

between net income and operating cash flow is higb for fraud firms in prediscovery

years relative to tbe difference for a broad sample of firm-years.