The Difference between Earnings and Operating Cash Flow

765

COMPUSTAT for earnings before extraordinary items (data 18), depreciation and
amortization expense (data 14), total assets (data 6). data for computing operating
cash tlow (data 1. 4, 5, 34, 106, 126, and 217), and data for computing control
variables (receivables, 2: inventory, 3; long-term debt, 9; sales, 12; common shares,
25; adjustment factor, 27; retained earnings. 36; sale of equity securities, 108;
capital expenditures, 128; auditor and audit opinion, 149; share price, 199; and
exchange listing, ZLIST) for the year the fraud was discovered and the preceding
year.'" The sample consisted of 56 firms.
Data were examined for these firms for up to five years, from three years up
to the fraud discovery year to the year following the discovery year. The number
of firm-years varied during this period because of missing data, usually because a
firm did not exist in certain years prior or subsequent to the fraud discovery.
Sample sizes vary for fraud firms across tests reported in this study because of
missing data for one or more variables included in some of the tests. The
availability of earnings and cash fiow data does not guarantee that data for all
control variables are available.
The firms were distributed across 21 two-digit SIC industries, though those
with SIC codes from 3000 to 3999 were prominent (27 firms). Most of these were
technology firms. Event years were distributed across the sample period, with no
more than eight observations falling in the same calendar year. Fraud was
discovered for many of the firms shortly after they became publicly traded. Fraud
was discovered within the first three years of the listing period for 28 of the firms.
Twenty-three of the firms were deleted from the COMPUSTAT nonresearch files
within three years of the discovery year. Sixteen firms were deleted from the nonresearch files because of bankruptcy or liquidation. Another 23 of the firms merged
or went private. Only 17 of the firms continued to exist in 1993 as publicly traded
firms.
Variables and descriptive statistics
Earnings were measured as earnings before extraordinary items plus depreciation
and amortization expense. Depreciation and amortization were added to make the
earnings number comparable with operating cash flow." Expenditures for plant
assets are deducted in computing investing cash flow and do not enter the
computation of operating cash flow. Consequently, if all other operating
transactions were for cash, operating cash fiow would exceed earnings by the
amount of depreciation and amortization expense.
Operating cash fiow was computed as
OCE, = NI, + DAE, + E,^G,+ T, + {CL, - CL, ^)-

(CA, - CA, _ ,),

where OCE, is operating cash fiow in year /, NI is earnings before extraordinary

items, DAE is depreciation and amortization expense, E is equity in earnings, G is
gain (or loss) from sale of long-term assets, T is deferred taxes, CL is current
liabilities (less short-term debt), and CA is current assets (less cash and equivalents). Earnings (adjustment for depreciation and amortization is assumed in future

(1)

766

Contemporary Accounting Research

references) minus operating cash flow was the primary measure used in this study
(eamings-cash flow hereafter). Both eamings and cash flow were scaled hy
beginning-of-period assets to control for size.'' Omitting E, G, and T from the
equation had minimal effect on empirical results.
Other variahles examined in the analysis included financial variables and related items considered in prior studies (see Tahle 1). A list of these variables and
their computations is provided in Table 2. We selected these variables as being
representative of the variables considered in prior studies that were available from
COMPUSTAT. The large numher of firms in our analysis precluded the inclusion
of other variahles.
Table 3 provides descriptive statistics for continuous explanatory and control
variables for the sample of fraud firms and for a sample of 60,453 nonfraud firmyears for 1974-93. The statistics for fraud firms are for 150 firm-years for the 3
years immediately prior to the year of fraud detection. Data were not availahle for
all fimi.s for all firm-years. The existence of a firm on COMPUSTAT in a
particular year did not guarantee that all variahles were available for that year. The
nonfraud sample included all firm-years for nonfraud firms for which all variables
were availahle from COMPUSTAT annual industrial, full, and research files. These
files include essentially all publicly traded New York Stock Exchange (NYSE),
American Stock Exchange (AMEX), and over the counter (OTC) firms in the
United States, including those deleted from the nonresearch files because of
bankmptcy, liquidation, and merger.
Data also are provided in Table 3 for those firm-years in the fraud sample in
which the excess of eamings over cash fiows were the largest. Determining the
specific periods in which the frauds affected eamings or cash fiows and the
magnitudes of the effects is problematic. The discovery of fraud does not
necessarily result in specific identification of the period in which the fraud
occurred. Because many of the firms in our sample existed for a limited period as
publicly traded companies prior to the discovery, we assume the frauds affected
financial statements in the years immediately prior to discovery. We limit the
analysis to no more than three years prior to the discovery to ensure a reasonable
number of observations in which the effects of the fraud were likely to have
occurred. Using several years in the prediscovery period in the analysis will
understate the relation between fraud and accmals to the extent the fraud did not
affect the accmals throughout this period. Using the year in which the magnitude
ofthe accrual variahle was largest in the analysis assumes that the existence of high
accmals in any year is a signal of potential fraud. This assumption leads to an
overstatement of the relation only if a high accmal resulted for a fraud firm for
some reason other than the fraud. We examine both the three-year sample and the
maximum-year sample because of potential understatement or overstatement of
results. The maximum-value years were distributed across the prediscovery period.
Twenty-seven percent of the maximum years were three years prior to discovery,
41 percent were two years prior to discovery, and 32 percent were in the year prior
to discovery.'^

The Difference between Eamings and Operating Cash Flow

767

TABLE 2
Variables included in current study
Variable

Computation

Eamings

(Eamings before extraordinary items, + Depreciation,) /

Assets,, I

Operating cash flow

Earnings - cash
Free cash flow

NI, + D, + E,+ G,+ T, + (CL, - CL, _ ,) - (CA, - CA, _ ^)*

Amount of securities issued

Leverage
Auditor change
Audit opinion
Inventory
Change in inventory
Receivables
Change in receivables
Sales growth
Market retum
Retained eamings
Market value
Sales to assets
Assets
Sales
Years listed
Industry
Stock exchange listing

As defined above
[Operating cash flow^ - Cap exp,^,g , - 2 to < - i)J '
Current assets, _ ,
Equity securities issued,/ Market value, _,
CurTent assets, + Long-term debt,/ Assets,
1 if auditor, not equal to auditor, _ ,
1 if opinion not unqualified
Inventory,/Sales,
(Inventory,/Sales,)/(Inventory,_ |/Sales,_ 1) . ,
Receivables,/Sales,
(Receivables, /Sales,) / (Receivables, _ , / Sales, _ ,)
Sales,/Sales,. ,
(Price, - Price, _ ,)/Pdce, _ , [adjusted for splits and dividends]
Retained eamings,/Assets,
Market value^/Assets,
Sales,/Assets, _ ^
Assets, [log of assets used in analysis]
Sales, [log of sales used in analysis]
Current year - first year on COMPUSTAT
1 if SIC > 2999 and < 4(X)0
Indicator variables for NYSE and AMEX

Notes:
Nl
D
E
G
T
CL
CA

= eamings before extraordinary items.

= depreciation and amortization expense.
= equity in eamings.
= gain (or loss) from sale of long-term assets.
= deferred taxes
= current liabilities (less short-term debt),
= cunent assets (less cash and equivalents).

Firms and enforcement releases typically do not identify the amounts of fraud.
We assume the amounts typically are material to eamings, because they often result
in failure of the firm as a publicly traded company. Though reputation effects may
be important to the failures, we assume these effects also are increasing in the
magnitude of the fraud.

768

Contemporary Accounting Research

TABLE 3
Desctiplive statistics and comparisons for fraud and non-fraud firms
Fraud firms
(prediscovery)
N = 150
Variable

Mean

0.084
Eamings
Operating cash flow -0.069
0.154
Eamings-cash flow
-0.262
Free cash flow
0.094
Equity securities
0.538
Leverage
0.238
Inventory
Change in inventory
1.143
0.228
Receivables
Change in receivables 1.349
1.426
Sales growth
0.394
Market retums
0.077
Retained earnings
1.742
Market value
1.730
Sales to assets
229.256
Assets
222.563
Sales

Non-fraud
1'irms
N =: 60,453

Std dev

Mean

0.234
0.315
0.324
0.557
0.248
0.216
0.163
0.555
0.145
L748
0.594
0.909
0.418
3.142
0.950
456.809
379.742

0.079
0.068
0.011
-0.017
0.041
0.477
0.169
1.034
0.166
1.050
1.143
0.197
0.103
0.897
1.617
878.376
937.830

Fraud firms
(maximum)
N--= 56

Std dev

Mean

0.143
0.160
0.139
0.384
0.258
0.234
0.137
0.442
0.115
0.441
0.435
0.867
0.875
1.115
1.115
3,994.640
4.220.710

0.112
-0.219
0.331
-0.482
0.059
0.534
0.245
1.252
0.226
1.306
1.451
0.374
0.080
1.825
1.973
173.958
162.247

Std dev /-value

0.174
0.347
0.353
0.575
0.182
0.213
0.181
0.675
0.152
0.645
0.524
1.031
0.396
3.533
1.125
403.085
295.107

0.231
-4.313
4.363
-4.340
2.114
2.808
4.132
1.937
4.256
1.694
4.708
2.140
-0.604
2.662
1.730
-3.380
-3.658

Notes:
Eamings and operating cash flows are scaled by beginning-of-year assets. Other variables are
defined in Table 2. The prediscovery fraud sample includes t'lrm-yeans for the 3 years up
to Ihe year of frand discovery. The maximum fraud sample includes only the prediscovery firm-year in which the excess of eamings over cash flows was largest, (-values are for
comparisons of nonfraud firm-years with maximum-value firm-years for fraud firms, tvalues assume unequal variances.

Significant differences between the fraud and nonfraud samples exist for most
of the variables in Table 3. The table reports i values that compare the maximumvalue fraud firm-years with the nonfraud firm-years. The t values take into account
unequal variances between the samples and arc more conservative than tests that
assume equal variances. Similar results (not reported) occur for the three-year
sample, though the i values are slightly lower.
The excess of earnings over cash flows is significantly larger on average for
the fraud than the nonfraud firms. This difference results from the significantly
lower operating cash fiows of the fraud firms. Earnings for the two samples are not
significantly different. The free cash flow measure also is significantly lower for
the fraud firms. Compared with nonfraud firms, the fraud firms, on average, issue
more equity securities, are more highly levered, have larger amounts of receivables
and inventories, have larger sales growth, have larger market retums and larger
market values relative to assets, and are smaller in terms of assets and sales.

The Difference between Eamings and Operating Cash Flow

769

Table 4 provides descriptive statistics for noncontinuous variables. Percentages

are based on firm-years in tbe fraud (up to the discovery year) and nonfraud
samples. A larger percentage of firms in tbe fraud sample are OTC firms tban for
those in tbe non-fraud sample. A smaller percentage of fraud firms are AMEX
firms tban for those in tbe nonfraud sample. A larger percentage of fraud firms
experienced auditor changes than for tbe nonfraud sample. A larger percentage of
qualified opinions were issued for the fraud sample. Finally, though distributed
across many industries, fraud firms were grouped in the 3000-3999 SIC codes to
an extent that was larger than tbe proportions for nonfraud firms. Indicator
variables are used for tbese variables in the empirical analysis. Using an indicator
variable for tbe 30(K) SIC code group resulted in stronger results tban using separate indicator variables for two-digit SIC code groups within the 3000 group.
Table 5 provides a correlation matrix for continuous variables examined in the
study. Data are from tbe combined sample of fraud and nonfraud firm-years
(60,688 observations). Most of the correlations in the table are significant at the
0.01 level. Because of the large sample size, only correlations less than 0.02 are
insignificant at tbe 0.05 level. The correlations indicate that several variables are
correlated witb tbe excess of eamings over casb flows; free cash fiows, inventory,
change in inventory, receivables, change in receivables, sales growth, and sales to
assets. These variables are likely to be proxying, at least partially, for the same
accrual construct as tbe excess of eamings over cash flows. Consequently, they are
not likely to provide much additional information with respect to signaling fraud.
Most of the correlations in the table are low (tbougb significant), other than tbose
among tbe accrual-related variables.
Table 6 reports statistics for the earnings and operating cash flow variables for
fraud firms across the five years, beginning tbree years prior to the fraud discovery.
Means and medians reveal tbe same pattems. Eamings are higher prior to the year
the frauds were discovered than after, wbile operating cash flows are lower in tbe
prior years. As a result, the earnings-cash flow variable is positive in tbe years up
to the fraud discovery (eamings are higher tban cash fiow). Tbe t test for mean
greater tban zero is significant in prediscovery years and insignificant in
postdiscovery years.
Table 7 compares the distribution of tbe eamings-cash flow variable for fraud
firms relative to the distribution for nonfraud firm-years. The table lists selected
percentiles of the distribution of the eamings-cash fiow variable for 60,453 firmyears using all available COMPUSTAT observations for nonfraud firms from 1974
to 1993. These distributions indicate tbat a large percentage of observations for
fraud firms falls within the extreme upper percentiles of tbe distribution of all
COMPUSTAT firm-years. Almost 93 percent of the fraud firms exbibit values of
eamings-cash flow above the median value for nonfraud fimis in at least one of tbe
prediscovery years. Over 64 percent of tbe fraud firms exbibit a value greater than
tbe ninetieth percentile, and over 53 percent exbibit a value greater than the ninetyfifth percentile. These results are consistent with the hypothesis that the difference
between net income and operating cash flow is higb for fraud firms in prediscovery
years relative to tbe difference for a broad sample of firm-years.