We investigate the relative and incremental usefulness of earning, cash flows, accruals and book values of financially distressed firms to extend our understanding of the price–earnings relationships of distressed firms. As expected, we find that earnings usefulness deteriorates with the onset of distress. We document that the decline in usefulness of earnings is initially gradual and then steep. We also document a surprisingly comparable decline in the usefulness of operating cash flows. Further, we find that accruals continue to provide incrementally useful information beyond cash flows up to 1 year prior to the bankruptcy or liquidation election. Our results hold even when the effects of book values and solvency measures are controlled.
Repeatedly, accounting earnings have been found to be the premier measure of performance for shareholder value (Barth et al., 2001, Biddle et al., 1995, Chambers et al., 1999, Dechow, 1994 and Penman and Sougiannis, 1998). However, studies of troubled firms report that the usefulness of earnings deteriorates with the onset of financial distress. For example, Burgstahler and Dichev (1997), Collins et al. (1999) and Hayn (1995) report that the earnings of firms with losses cannot explain positive share values. These studies report that the missing information is the implicit value proxied by book value. Hence, book value provides useful information about the liquidation value of the assets. Thus, positive earnings are sufficient to explain value, but negative earnings are not. Book value takes over as the determinant of share price.
Since earnings and book values are steeped in accounting rules and management choices, some theorists and practitioners argue that operating cash flows are conceptually preferable. Arbitrary rules and management manipulations of accruals do not contaminate cash flows. Hanna (1995) reports that cash flows of distressed firms are more value relevant than are earnings. Black's (1998) study of the incremental usefulness of earnings and cash flows over the life cycle provides similar results for firms in decline.
These studies and the increased U.S. business failure rates, starting in the early eighties and persisting to the present (Council of Economic Advisers, 2001), motivate the following questions. When do earnings lose their premier place in explaining value for distressed firms? Do cash flows also suffer a similar degradation in usefulness? Can book values offset the degradations? What is the intertemporal behavior of the incremental usefulness of accruals?
The motivation for these questions derives from the assumption of going concern. Accruals are expected to lose their value relevance with the onset of severe distress. In contrast, cash flows capture the ability of firms to meet short-term obligations and determine their ability to survive the early signs of distress. Hence, theorists often assert that cash flows are more useful than earnings in cases of distress (Black, 1998). In addition, Burgstahler and Dichev (1997) find that book values of loss firms are more value relevant. Specifically, for distressed firms, book values are more useful than earnings (or losses), as firms adapt their resources to alternative uses, including liquidation. Thus, book value provides ‘downside protection’ to distressed firms.
We study distressed firms from an ex post perspective: we sample delisted firms whose stocks are delisted as a result of either bankruptcy or liquidation elections. We measure the value relevance of earnings, operating cash flows, book value, and accruals on an intertemporal basis, beginning 8 years prior to delisting. The choice of 8 years follows Altman et al. (1977), who reported that distress is discernible as early as 5 years before bankruptcy. Our findings indicate that the explanatory usefulness of all three measures (earnings, cash flows, and cash flows with accruals) degrades earlier than the eighth year. The usefulness of book values also declines prior to the eighth year, but its decline is more gradual than the decline in usefulness of the three operating performance measures. The severity of the decline in usefulness of cash flows and cash flow plus accruals is unexpected, given the preferences for cash flow over earnings. These results hold when book values are used jointly with the operating measures. But unexpectedly, the deterioration in cash flows is at least as severe as is the decline in earnings. Finally, our results suggest that accruals are value relevant up to the point of delisting.
The remaining Sections of this study are: hypotheses and models (Section 2), statistical tests (Section 3), sample selection and descriptive statistics (Section 4), results (Section 5) and conclusion (Section 6).
We evaluate the performance of earnings and cash flows on relative usefulness and incremental usefulness in a model that associates stock prices with these two measures of performance. Our purpose is to provide evidence about the behavior of the usefulness of accounting information (earning, cash flows and accruals) from the onset of distress to its culmination in either bankruptcy or liquidation. We find that earnings suffer significant and substantial declines in relative usefulness. But cash flows are not immune. They also suffer the same deterioration. Our evaluation of incremental usefulness of cash flows and accruals are similar. Both deteriorate. Thus, while cash flow information may be more useful than earnings of distressed firms, its ability to explain share prices is not impressive and diminishes with the onset of operating problems. Unexpectedly, usefulness of accruals remains significant throughout the firm's decline, which contradicts assertions that accruals are arbitrary.
