The supplemental role of operating cash flows in explaining share returns : Effect of various measures of earnings quality

Purpose – In response to recent concerns on earnings quality and a firm's fundamental performance, the purpose of this paper is to re‐examine salient questions under accrual accounting: how earnings quality affects the role of earnings and operating cash flows in a firm's valuation. Design/methodology/approach – Using a large sample ranging from 1989 to 2008, the authors contrast the effects of three representative accrual‐based earnings quality measures on the association between earnings, operating cash flows and a firm's abnormal stock returns. Findings – In the univariate analysis it was found that earnings explain returns similarly to operating cash flows. With control of earnings quality, the results indicate that earnings' role in explaining contemporaneous abnormal returns remains unchanged when earnings quality is better. Conversely, operating cash flows explain more contemporaneous abnormal returns when earnings quality is better. The findings could suggest that the market reacts to operating cash flows conditionally on earnings quality. Intriguingly, the results also indicate that the market perceives better earnings quality captures superior performance of operating cash flows rather than that of earnings. These findings are further fortified by additional analyses revealing that the earnings quality measure with control of operating cash flows affects the supplemental role of operating cash flows most. Originality/value – The paper's findings provide insights on how the market processes firm value signals embedded in earnings quality, which have direct implications for regulators, standard setters, academics and practitioners.