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Rev Account Stud (2009) 14:453479
DOI 10.1007/s11142-009-9109-4
Stephen H. Penman Nir Yehuda
Published online: 13 August 2009 Springer Science+Business Media, LLC 2009
Abstract Under accrual accounting, earnings add to shareholders equity. Cash ow generated by a business has no effect on the book value of shareholders equity but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value, but cash ow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash ow from a businesscash ow from operations minus cash investmentis, on average, associated with approximately a dollar less in the market value of the business and has no association with changes in the market value of the equity claim on the business. Furthermore, controlling for the cash investment component of free cash ow, cash ow from operations also reduces the market value of the business dollar-for-dollar and is unrelated to the changes in market value of the equity.
Keywords Accruals Cash ow Accrual accounting
JEL Classication G14 M40 M41
S. H. Penman (&)
Graduate School of Business, Columbia University, 612 Uris Hall, 3022 Broadway, New York, NY 10027, USAe-mail: [email protected]
N. Yehuda
Johnson Graduate School of Management, Cornell University, 355 Sage Hall, Ithaca, NY 14853, USAe-mail: [email protected]
The pricing of earnings and cash ows and an afrmation of accrual accounting
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454 S. H. Penman, N. Yehuda
This paper examines a core idea in accounting, drummed into every beginning accounting student: accrual accounting, rather than cash accounting, is appropriate for business reporting. Accounting goes beyond a mere cash book, to report (accrual) earnings rather than cash ow as the measure of valued added. The paper investigates whether common shares are priced in the stock market according to accounting prescriptions on how earnings and cash ows affect shareholders equity.
To develop an empirical specication that incorporates the prescriptions, the paper rst formally lays out how earnings and cash ows relate to shareholders equity in the accounting system. With a focus on the shareholder, it makes the standard distinction in both valuation theory and accounting between the business...