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: 144128 Amman-Jordan 11814, Tel: +962795539905, E-Mail: Ahmad.adel@zuj.edu.jo.com

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 2014-2016, 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

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 2000-2014. 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"

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 (non-

operating 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

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

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)

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)

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 2014-2016.

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

statements (statement of financial position, income statement, cash flow statement, and

statement) for banks through Amman stock exchange website (www.ase.com.jo)

Data Analysis and hypothesis test

Data Analysis

After collecting banks financial data used in the study for the years 2014-2016, 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 2014 2015 2016 The

Arithmetic

mean

Arab Bank 392% 350% 191% 311%

Housing Bank

for trade and

finance

230% (155%) 481% 185%

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.

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 2014 2015 2016 The

Arithmetic

mean

Arab Bank 1.10% 1.09% 1.41% 1.20%

Housing Bank

for trade and

finance

1.44% 1.32% 1.48% 1.41%

Invest Bank 1.39% 1.59% 1.53% 1.50%

Return on assets (ROA) from net operating cash flow

Bank name 2014 2015 2016 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

Return on Equity (ROE) from accounting income

Bank name 2014 2015 2016 The

Arithmetic

mean

Arab Bank 6.90% 6.74% 8.75% 7.47%

Housing Bank

for trade and

finance

10.65% 10.99% 11.00% 10.88%

Invest Bank 7.28% 8.32% 8.55% 8.05%

Return on Equity (ROE) from net operating cash flow

Bank name 2014 2015 2016 The

Arithmetic

mean

Arab Bank 27.02% 23.60% 16.70% 22.44%

Housing Bank

for trade and

finance

24.47% (17.00%) 52.92% 20.13%

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

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.

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