Incremental information content of cash flow variables: A spanning approach

This study investigates whether alternative cash flow measures have an incremental information content over accounting measure. This study employes the arbitrage argument to establish an economic model which makes it possible to incorporate raw accounting variables into a return generating process. Based on the economic model, a new methodology, the spanning portfolio approach is used to extract the information contained in the accounting measures of cash flow. This issue is first examined by testing for an association between actual security returns and spanning returns of alternative cash flow measures. Secondly, the issue is analyzed in the context of explaining market risk. The results indicate that both cash flow and accrual accounting earnings have incremental information content relative to each other in explaining the actual security returns. Also, the results reveal that, in explaining market risk, only cash flow has information consistent with that contained in market risk measure (market beta) and provides significant incremental information over that provided by earnings. These findings imply that the accrual adjustment process in accounting may not be valuable at least for assessing the company's systematic risk.