Earnings Quality Measuring Based on Net Income and Net Operating Cash Flow in Jordanian Commercial Banks (Experimental study)

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1 Earnings Quality Measuring Based on Net Income and Net Operating Cash Flow in Jordanian Commercial Banks (Experimental study) Ahmad Adel Jamil Abdallah Accounting Department, Faculty of Business, Al-Zaytoonah University of Jordan, Amman, Jordan P.O.Box: Amman-Jordan 11814, Tel: , Abstract This study aimed to identify the effect of net income and net operating cash flow as an indicator of the earnings quality in Jordanian commercial banks, in order to analyze the effect of net operating cash flow to earnings quality, to reach the necessary conditions for achieving the earnings quality. In order to achieve the goals of the study, we have taken into consideration the published financial statement for a sample of listed Jordanian banks at Amman Stock Exchange during the period of , the sample has reached (3) banks the choice of the banks was based upon each bank capital (high, intermediate, low), the researcher has used Multiple regression analysis methods to study this relationship, After conducting the analysis procedure, the study has revealed the inevitable relationship between net income and net operating cash flow on earnings quality; also we have noticed the effect of the net operating cash flow over the earnings quality in the Jordanian Commercial banks, based on these results the necessary basic condition for achieving profits quality have been set. Key words: Earnings quality, Net income, Net operating cash flow Introduction Economic activity in all countries of the world based on the existence of companies that carry out economic activities (agricultural, industrial, service or commercial) large or small. These companies differ in their legal forms, whether they are an individual proprietorship, general corporation or a public shareholding company, And the public shareholding companies are the most important types of these companies, for various reasons, the most important (the size of the capital invested, the breadth of the ownership base). Before studying and analyzing the financial and economic position of this type of companies, it is important to determine the basic financial reports used to study the results of these companies (the statement of financial position, income statement, retained earnings statement, changes in equity statement and cash flow statement (Hock&Brain,2010) although the importance of the statement of financial position and income statement for financial analysis purposes, the cash flow statement also considered to be reliable for the purposes of this analysis because of its special advantages in relation to the Company's cash position (available cash) To meet their obligations from their own sources, as well as whether the company needs external sources to finance its activities (Kaddoumi and Kilani, 2006), The IFRS committee sets out the main objectives of the published financial statements, to include information assist investors, lenders, and others in

2 determining the size, timing, and expected net future cash flow. Therefore, financial analysis based on the cash flow statement gives sufficient time to study available financing alternatives instead of resorting to high-cost financing sources after hindsight. This study deals with the subject of the relationship between the net income and net operating cash flow as an indicator of the earnings quality (Experimental study) in the financial sector represented in the Jordanian commercial banks, also the study concerned with focus on two important sides are, namely to determine the relationship between the net income and net operating cash flow, and the statement of the impact of this relationship on the earnings quality of these banks. Previous Studies The researcher reviewed many of the previous studies that discussed the subject of the current study and it was Al-attar and Maali (2017) The Effect of Earning s Quality on The Predictability of Accruals and Cash flow Models in Forecasting Future Cash flows The main questions these paper answers are: (1) is the superiority of aggregate earnings over aggregate cash flows affected by the level of earnings quality? (2) Is the superiority of aggregate earnings over the main components of earnings (i.e. operating cash flows, accounts receivable, inventory, accounts payable, and depreciation) affected by the level of earnings quality? to provide answers on the questions of this study, the whole sample of the study is divided into two groups according to the level of earnings quality: high earnings quality and low earnings quality. The study covers the case of Jordan and employs data on a sample of industrial and services firms. The time horizon of this study includes the period of The results of the analysis reveal that the qualities of earnings affect the predictability of both cash flow and earnings in those earnings outperform cash flows in predicting one-year a head future cash flow when earning quality is high. On the other hand, the main component earnings reveal incremental information content beyond that exist in earnings or cash flow regardless of the quality of earnings. Mehrani, sasan & others, (2017) "Institutional Ownership Type and Earnings Quality: Evidence from Iran. This study attempts to provide insights into the monitoring roles of institutional investors by examining the relationship between institutional ownership and earnings quality on the Tehran Stock Exchange, A multidimensional method is used to measure the various aspects of earnings quality, such as earnings response coefficient, predictive value of earnings, discretionary accruals, conservatism, and real earnings management. The results show that institutional ownership has a positive effect on earnings quality. Similar to total institutional ownership, active institutional ownership has positive effects on proxies of earnings quality; passive institutional ownership does not have any power to affect earnings quality. Moreover, lead-lag tests of the direction of causality suggest that institutional ownership leads to more earnings quality and not the reverse C.S. Cheng. Agnes and others (2013)"The supplemental role of operating cash flows in explaining share returns: Effect of various measures of earnings quality"

3 This paper re-examine salient questions under accrual accounting: how earnings quality affects the role of earnings and operating cash flows in a firm's valuation. Using a large sample ranging from 1989 to 2008, the authors contrast the effects of three representative accrual-based earnings quality measures on the association between earnings, operating cash flows and a firm's abnormal stock returns the results indicate that earnings' role in explaining contemporaneous abnormal returns remains unchanged when earnings quality is better. Conversely, operating cash flows explain more contemporaneous abnormal returns when earnings quality is better. The findings could suggest that the market reacts to operating cash flows conditionally on earnings quality. Intriguingly, the results also indicate that the market perceives better earnings quality captures superior performance of operating cash flows rather than that of earnings Study problem It is possible that the profits or losses of the banks are due to unusual activities (nonoperating activities), and in view of these profits or losses will not be repeated in the future except by chance, it is possible that these figures are misleading to decision makers, we must find a realistic way to measure the real state of profits of these banks at a given time to see how well banks can continue to meet their obligations and also to enable users of these financial statements to make the right decisions in their current and future investments, and to increase the ability to predict the financial situation And the ability of this company to continue, through achieve these elements we arrived to desired earnings quality, so this study is used to measure earnings quality by analyzing the effect of net income and net operating cash flow of banks which represent the study problem. Study Objective The study aimed to determining the effect of net income and net operating cash flow in Jordanian commercial banks as an indicator to determining the earning quality, and explaining the importance of net operating cash flow and its impact on the earning quality as well as clarifying the necessary conditions to achieve the earning quality and the extent of the company's balance ability between net income and net operating cash flow. Study Importance The importance of this study is to measure the ability of Jordanian commercial banks to balance net income and net operating cash flow and determine the relationship between them, in order to arrive at a positive indicator of the earning quality of profits in the short and long term, this study is expected to help users of financial statements, such as shareholders and other related parties such as creditors, financial analysts, and others, to better assess the performance of banks, and when banks must focus on earnings or cash flows to help them make their financing and investment decisions in these banks. Study Hypothesis

4 Based on the above, the study hypothesis can be formulated as follow: Ho1: Net accounting income does not affect the measurement of earnings quality in Jordanian commercial banks Ho2: Net operating cash flow does not affect the measurement of earnings quality in Jordanian commercial banks The importance of financial statements in public shareholding companies Accordance to international accounting standards (ISA) 1, issued by the International Accounting Standards Committee (IASC) in 1997, and certified by the International Accounting Standards Board (IASB) in 2001, which state the presentation of financial statements, there are four main financial statements that we need to disclose for the external parties (statement of financial position, income statement, cash flow statement, and statement of changes in equity), where the income statement is the most important statement in these four statement, because it is provide the transactions results of these companies through (profit/losses) for financial period But we also have to pay attention to other details that may be evidence of the success or failure of these companies Such as knowledge of the sources and uses of cash in these companies lead us to study others statement elements responsible for the identification and allocation of monetary activities in the company, namely cash flow statement which is an important tool for diagnosing the company's financial position and provides a vision for calculating financial ratios through which the company's strengths and weaknesses are assessed (Hock, Brain,2010). Income statement The income statement is a list of the Company's revenues and expenses during a specific financial period, which important for a lot of users like shareholders, management, and creditors, the details of the income statement items vary according to the nature of the company's business. However, the statement begins with a presentation of company operating income followed by the direct expenses incurred to generate these revenues. Then represent administrative and selling expenses to achieve the net operating profit, and deduct other revenues and expenses to reach the company net income. (Kieso & T. Warfield, 2009) Kieso,Donalad,E. define income statement as a report that measures the success of enterprise operations for a given period of time. The business and investment community uses this report to determine profitability, investment value, and credit worthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. (Kieso,Donalad,E and others, 2016) Limitations of the Income Statement

5 Because net income is an estimate and reflects a number of assumptions, income statement users need to be aware of certain limitations associated with the information contained in the income statement. Some of these limitations include: - Items that cannot be measured reliably are not reported in the income statement. Current practice prohibits recognition of certain items from the determination of income even though the effects of these items arguably affect the performance of an entity from one point in time to another. - Income numbers are affected by the accounting methods employed. For example, one company may choose to depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the income for the first company will be lower, even though the companies are essentially the same. In effect, we are comparing apples to oranges. - Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years while another company uses a 15-year estimate for the same type of asset. Similarly, some companies may make overly optimistic estimates of future warranty returns and bad debt write-offs, which results in lower expense and higher income. (Kieso,Donalad,E and others, 2016) Cash flow statement A financial statement showing how changes in the statement of financial position and income accounts can affect cash. the statement provides information about the Company's ability to provide cash flow and cash management effectiveness, the purpose of this statement is to provide information on the cash receipts and payments of the company, and how they relate to the operation and investment, and the financing activities of the company. The users of the financial statements use this information to assess the solvency of the business, assess the company's ability to generate positive cash flows in future periods, Equity, and financing growth. (Williams & F.Meigs, 2002) Earnings Quality in Public Shareholding Companies This concept can be achieved by the extent to current profits to continue in future periods. when profit be more Continuity, it is Indicator on higher future profits quality, (Penman, 2003) and (Dechow &Schrand 2004) indicate that Profits be high quality if they reflect the company's current operating performance and present a good indicator of future operational performance, provide a good measure of the company value. Kieso,Donalad,E. define cash flow statement as the planned timing of revenues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. (Kieso,Donalad,E and others, 2016)

6 The relationship between net accounting income and net operating cash flows and their impact on earning quality Net accounting income differs from net operating cash flows for several reasons. the main reason for this difference is non-cash flows like depreciation expenses and amortization for intangible assets, These flows, which are not considered cash flows, reduce net accounting income but do not affect net cash flows another reason for the difference is the timing of revenue and expenditure recognition, and occurrence of main cash flows and non-operating gains or losses are also included in the determination of net accounting income which classified in the cash flows statement as investment or financing activities, not operational activities (Williams & F.Meigs, 2002). Depend on the financial analysis for financial statements; the researcher relied on several approaches to determine the relationship between net accounting income and net operating cash flow: 1. Operating cash flow index (ratio): this ratio shows the extent to which the Company's profits are able to generate operating cash flows (Matar,2006) Operating cash flow index (ratio) = Cash flow from operations Net income This relationship refers to two fundamental aspects of our study: net accounting income on accrual basis, and the net operating cash flow prepared on a cash basis, this ratio focuses on closing or reducing the resulting gap between cash ratio from operating activities to net accounting income if the gap became lower, the earning quality be higher (Almoeine, 2011) 2. Return on assets (ROA) from accounting income and return on assets from net operating cash flow: Return on assets from accounting income = Net Income Average Total Assets Is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings, when the higher the ratio, the results of the company will be more efficient and efficient (Hadad, 2007) Return on assets from net operating cash flow = Net operating cash flow Average Total Assets This ratio measures the amount of operating company cash flow generate for every dollar of company assets own. The higher the ratio, the more efficiently company use your assets (Car slaw & Mills, 1999)

7 3. Return on equity (ROE) from accounting income and return on equity from net operating cash flow: Return on equity from accounting income = Net Income Average Total Equity Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. (Ross & Bely, 2012) Return on equity from operating cash flow = Net operating cash flow Average Total Equity This ratio shows the ability of Company's equity to generate operating cash flows, the higher the percentage the more efficiently company, and the incentive for further investment in the future (Ross & Bely, 2012) Study Methodology The researcher will use quantitative analysis based on analytical method to analyze the data collected through the actual financial statements of the banks, to determine the effect of the independents variables (net accounting income and net operating cash flow) on the dependent variable (earning quality) Through using financial analysis of variables. Study Population and Sample The study population represents the Jordanian commercial banks, listed on the Amman stocks exchange; consist of 15 banks, for the period The study sample was Purposive sample, which was selected based on the capital of these banks which were classified as (high capital, medium capital and low capital) Table (1): Banks Capital Bank Name Capital (Jordan dinar) Arab Bank 534,000,000 Housing Bank for trade and finance 252,000,000 Invest Bank 100,000,000 Data Collection Been relying on two types of information sources are secondary sources, such as accounting books and scientific articles, and specialized periodicals that are looking at the subject of net accounting income, net operating cash flow and earnings quality, also relied on primary sources through primary sources, which represent the financial

8 statements (statement of financial position, income statement, cash flow statement, and statement) for banks through Amman stock exchange website ( Data Analysis and hypothesis test Data Analysis After collecting banks financial data used in the study for the years , the quantitative approach was used to study and analyze the data, by using financial ratios as from financial analysis tools, where this method conceder the most appropriate way for this study on the other hand we were found the Arithmetic means and standard deviations to achieve the purposes of descriptive analysis as follows: Financial analysis results 1. Operating cash flow index (ratio): Table (2): Operating cash flow index for banks Bank name The Arithmetic mean Arab Bank 392% 350% 191% 311% Housing Bank 230% (155%) 481% 185% for trade and finance Invest Bank 419% (548%) 271% 47% Table (2) indicate to operating cash flow ratio (Cash flow from operations Net income) this ratio measure the ability of Company's profits to generate operating cash flows, In general, there is a significant increase in this indicator, whereas the net cash flow for most years covers net income by between 2 and 3 to 1 which is high, because the operating activity of banks mainly depends on the internal and external cash flow, noting the relative stability in net accounting income. For Arab bank by comparison between the periods of the study we note increase in net operating cash flow because of some reasons (decrease in the deposits, and Increase credit facilities). For housing bank there is a variance in this ratio in (2015), the clients deposits decreased for (2.2%) and credit facilities increased for (7.3%), on (2016) the increase in deposits for (7.75%) been the major reason to lifting this ratio. About Invest bank we noting the very low in this ratio in (2015) because of increase in net operating cash flow for (39.2%) a result of increase in credit facilities for (16.4%) and decrease in deposit for (4%) and in various Provisions, then in (2016) its back to increase for (13.1%) because of clients deposits.

9 2. Compare Return on assets (ROA) from accounting income and return on assets from net operating cash flow: Table (3): Return on assets (ROA) index for banks Return on assets (ROA) from accounting income Bank name The Arithmetic mean Arab Bank 1.10% 1.09% 1.41% 1.20% Housing Bank for trade and 1.44% 1.32% 1.48% 1.41% finance Invest Bank 1.39% 1.59% 1.53% 1.50% Return on assets (ROA) from net operating cash flow Bank name The Arithmetic mean Arab Bank 4.31% 3.83% 2.69% 3.61% Housing Bank for trade and finance 3.31% (2.28%) 7.12% 2.72% Invest Bank 5.81% (8.79%) 4.15% 0.39% Table (3) shows the return on assets (ROA) from accounting income in Arab bank for the three years between (1.1%-1.4%) this simple change because of change net income through the three years, about return on assets (ROA) from net operating cash flow we note the decrease within the three years because of change in working capital (increase and decrease) with increase in non-cash expenses, which mean increase in return on assets (ROA) from net operating cash flow more than return on assets (ROA) from accounting income. For housing bank and invest bank there is simple change in return on assets (ROA) from accounting income because of change in net income through the years, and we can note the big deferent in return on assets (ROA) from net operating cash flow, in housing bank (2015) the ratio was (2.28%) because of increase in operating cash out flow (decrease in the deposits, and Increase credit facilities) then on 2016 this ratio increased because of decrease in operating cash inflow (increase in the deposits, and decrease credit facilities) but for invest bank (2015) there is strong decrease in this ratio because of minus operating cash flow (change in working capital), so for the three banks there is fluctuation changes between these twos variables. 3. Compare Return on Equity (ROE) from accounting income and return on assets from net operating cash flow: Table (4): Return on Equity (ROE) index for banks

10 Return on Equity (ROE) from accounting income Bank name The Arithmetic mean Arab Bank 6.90% 6.74% 8.75% 7.47% Housing Bank for trade and 10.65% 10.99% 11.00% 10.88% finance Invest Bank 7.28% 8.32% 8.55% 8.05% Return on Equity (ROE) from net operating cash flow Bank name The Arithmetic mean Arab Bank 27.02% 23.60% 16.70% 22.44% Housing Bank for trade and 24.47% (17.00%) 52.92% 20.13% finance Invest Bank 30.48% (46.06%) 23.17% 2.53% Table (3) shows the return on equity (ROE) from accounting income, in Arab bank we note in (2014) and (2015) the return on equity from accounting income was approximate, about net operating income from cash flow was the highest possible for the three years because of increase in clients deposits which led to increase in ROE from (2014) of (2015), (2016), the main reason for deviation between the two percent is the non-cash expenses in this year and positive change in working capital, in (2016) the first percent increased for two degrees of year (2015), and the ROE from net operating cash flow decreased for (7) degrees of year (2016) because of increase in investment value which let to increase in profit and decrease in volume of operating cash. In Housing bank we note the Stability for first percent through the three years because of stability in accounting profit, for net operating cash flow in (2014) was positive then in (2015) the operating cash flow decreased to became negative because of decrease in the deposits, and increase credit facilities (net change in capital was negative) then in (2016) the percent increase more than in (2014) because increase in deposits volume, for Invest bank ROE from accounting income was stable and ROE from operating cash flow was vacillating because of same reason like the previous banks. Hypothesis test Accordance to study hypothesis which looking to test the effect of net accounting income and net operating cash flow on measurement of earnings quality and depend on the previous financial analysis, the researcher find correlation relationship between net

11 accounting income and net operating cash flow effect on earnings quality, which mean the independent variables effect on dependent variable, and the result will be reject the Null hypothesizes and accept the alternative hypothesizes: Net accounting income affect the measurement of earnings quality in Jordanian commercial banks, and Net operating cash flow affect the measurement of earnings quality in Jordanian commercial banks. Conclusions The researcher found the following results: - There is an effect of the net accounting income and net operating cash flow on the financial statements number, which conceder worthy trust for preparer the financial statements and users. - The study indicate that the net operating cash flow effect the earnings quality, because the (increase or decrease) of it effect the net accounting income. - Not depending only on net accounting income to read earnings. However, we must know the resources and components of this income and don t concentrate on non-operating activities. Recommendations - The necessary to relying on net operating cash flow for Jordanian commercial banks to evaluate their operating activates. - Do not rely on non-operating activities to achieve profits Jordanian commercial banks. - Do now follow the earnings management method which distortion profits number, because its indicators for current and future investors. References Al-Attar, Ali & Maali, Bassam, (2017), The Effect of Earning s Quality on The Predictability of Accruals and Cash flow Models in Forecasting Future Cash flows Journal of Developing Areas, Spring2017, Vol. 51 Issue 2, p p. Almoeine, Saed, (2011), Measuring Earnings quality in commercial banks "An analytical study of a sample of accounts in Iraqi commercial banks", Journal of Economic and Administrative Sciences, issue 64, Vol 17, (pp ) Amman Stock exchange ( C.S. Cheng. Agnes and others (2013)"The supplemental role of operating cash flows in explaining share returns: Effect of various measures of earnings quality", International Journal of Accounting and Information Management, Vol. 21 Issue: 1, pp.53-71, Carslaw, C.A., & Mills, J.R, (1999). "Developing Ratios for Effective Cash Flow Statement Analysis", Journal of - Accountancy, November, pp

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