Research Journal of Recent Sciences _________________________________________________ ISSN 2277-2502 Vol. 2(2), 76-80, February (2013) Res.J.Recent Sci. International Science Congress Association 76 Review Paper Can Current Earnings Predict Future Cash Flows? A Literature Survey Nawazish Mirza 1 , Ayesha Afzal 1 , Syed Kumail Abbas Rizvi 1 and Bushra Naqvi 2 1 Lahore School of Economics, PAKISTAN 2 Lahore University of Management Sciences, PAKISTAN Available online at: www.isca.in Received 10 th November 2012, revised 21 st November 2012, accepted 20 th December 2012 Abstract Investors consider cash flows to be more value relevant than profitability disclosures. This value relevance emerges from low discretionary control of managers on cash flows compared to net income. The accrual accounting is based on recognizing revenues and expenses as they occur and not when the cash transaction takes place. This will result in a variance of net income from cash flows. However, given the nature of accounting system, in general it is assumed that earnings and cash flows are co integrated. As a result, an exhaustive literature exists that attempts to explore the capacity of current earnings in predicting future cash flows of a firm. The findings on the subject are mixed with some studies validating the hypothesis that earnings can be a good predictor of future cash flows, while others refute it questioning the value relevance of earnings. In this literature survey, we present and discuss some notable findings on this important financial issue. Keywords: Earnings, cash flows, value relevance. Introduction The profitability of a firm is a function of its revenues and expenses, the composition and contribution of which varies on industry wide basis. The revenue side comprises of operating and non operating revenues, while expenses include variable and overheads along with administrative and financial costs. The accounting statements are prepared using accrual practices; therefore, there is a strong tendency that the net profit differs from the actual cash proceeds to the firm. The simplest reason for the difference in net income and cash flows could be the possible future bad debts on account of credit sales that have been recorded as revenues but were never collected. Since investors incorporate accounting data in their investment decisions, quality of accruals questions the value relevance of earnings. An alternative measure to gauge the firm’s performance is the operating cash flows. These cash flows represent internally generated cash from core operations. The financing and investing cash flows are a function of cash flows from operations since its level will determine the need for external financing and future investment. While operating cash flows represents real cash as opposed to net income, there exists an exhaustive debate in financial literature on cash flows being more value relevant vis-à-vis earnings. The earnings and cash flows are based on the recognition of asset liability values on balance sheet and revenues and expenses in income statement. Financial accounting uses two approaches for valuation purposes namely balance sheet and income statement approach. In a balance sheet approach the values for the assets and liabilities are determined using accounting principles and expenses and revenues emanate from the variation in the values of assets and liabilities while in an income statement approach the revenues and expenses are documented first and these warrants for an update in the asset liability value. In balance sheet approach, the assets recognized are real assets and Generally Accepted Accounting Principles (GAAP), while following balance sheet approach, does not recognize deferred expenses or losses as assets since these do not represent any rights as attached with real assets. This makes more sense for investors as they are more comfortable with physical assets as compared to numbers appearing due to accounting practices. However, there might be some problems with this approach. Investors base their investment decisions on the discounted future cash flows. These future cash flows are derived from the expected earnings and thus investors must have some income statement numbers to estimate future earnings. The operating cash flows are net of cash inflows and outflows related to the core operating activities. Cash inflows might differ from the revenues because of unearned and credit portion while cash outflow will differ from the expenses because of accrued and prepaid expenses. The cash inflow or outflow against these accruals normally takes place in the next accounting period thus the future cash flows are a function of current earnings. As mentioned earlier, the firm’s ability to generate cash flow affects its stock value; therefore, Financial Account Standard Board (FASB) indicates that the primary objective of financial reporting is to provide information to investors enabling them to assess the amount and timing of future cash flows (FASB 1978, 37 – 39).