Int. j. econ. manag. soc. sci., Vol(3), No (11), November, 2014. pp.

681-685

TI Journals

International Journal of Economy, Management and Social Sciences

www.tijournals.com

ISSN:
2306-7276

Copyright 2014. All rights reserved for TI Journals.

Cash Flows, Earnings Opacity and Stock Price Crash Risk in Tehran
Stock Exchange
Mohammad Reza Jafari *
Master of Accounting, Central Tehran branch, Islamic Azad University, Tehran, Iran

Eskandar Vaziri
Master of Accounting, North Tehran Branch, Islamic Azad University, Tehran, Iran
*Corresponding author: MohammadRezaJafari@gmail.com

Keywords

Abstract

Cash Flows
Earnings Opacity
Stock Price
Crash Risk

One of the main presumptions of agency theory is that company managers (employees) and stockholders
(employers) have contradictions in benefits and managers do not necessarily make decisions for the benefits
of stockholders. Thus the present research has studied the relation Cash Flows, Earnings Opacity and Stock
Price Crash Risk. This research has been carried out in the statistical population of the firms accepted in
Tehran Stock Exchange during the years between 2008 and 2012 among 148 active companies there as our
statistical sample. To test the hypotheses we have used a logistic regression model. The research findings
showed that earnings opacity and operating cash flow sensitivity have a positive and meaningful effect on
the risk of stock price crash.

1.

Introduction

One of the opportunistic behaviors of managers is to carry out earnings management in the presence of earnings opacity in companies and they
have an incentive to maintain their positions and hide a part of losses to preserve their jobs. This process of not disclosing the real losses
continues up to the end of the presence of the manager in a certain company. After leaving the company by the manager a great deal of
unrevealed information enters into the market and this result in stock price crash. Also operating cash flows which is considered as an important
criterion in profitability and it is deemed to be manipulated less and higher cash flow sensitivity are related with bankruptcy risk. Specifically
when earnings are considered as the criterion for the primary profitability, operating cash flow sensitivity plays an important role in earnings.
Thus, by increasing the fluctuations in cash flows it is probable that stock price crash risk will increase.

2.

Theoretical framework and research hypotheses

According to Hsiu & et al (2006) earnings opacity occurs when managers use optional accruals for several years and this will result in great
changes in costs of a business unit and in investments. Hutton & et al (2006) believed that in a lack of complete transparency in earnings
companies try earnings management and managers have an incentive to hide a part of losses to preserve their jobs.
Additionally, in an opacity reporting environment, the investors are not able to recognize and discover the projects which will end with incurring
losses. The inability of investors in differentiating between profitable and unprofitable projects causes the continuance of projects resulting in
losses and the pass of time increases the amount of their losses. The negative return of these projects during the pass of time is accumulated
internally within the company and when the information related to them is disclosed the stock price will reduce extensively [12]. The amount of
negative information which can be accumulated and hid by the managers is different for different companies. Additionally, the abilities and
opportunities to accumulate and not to reveal negative news depend on the costs and benefits of these tasks. For example, when there is not any
information asymmetry between managers and investors, managers do not have any incentive to disclose asymmetrical information because in
such a situation the cost of preserving and not revealing negative news will be more than its benefits. But when there exists a high amount of
information asymmetry between managers and investors, the costs of not revealing negative news and their accumulation within the company
will be less than the benefits and therefore the managers will have an incentive to accumulate negative news within the company and not to
disclose them [20]. When managers manipulate earnings to avoid showing bad news, the entities are valuated more than their real values but
when managers can not hide bad news anymore a considerable price crash occurs [13].
On the other hand cash is one of the important and critical resources for each economic unit. Creating balance between present cash and cash
needs is one of the most important factors in economic health of a business unit and the continuity of its activities. Cash flows have a
fundamental role in most financial decisions, bonds' valuating patterns; capital plans assessment methods and ... [12]. Almeida & et al (2004)
and Bates &et al (2009) believed that firms tend to change cashes into investment by increasing cash flows because positive shocks in cash flows
is a criterion for more yields of assets. Faulkender & Wang (2006) claimed that when a company encounters cash flow sensitivity, cash flows
lose their normal status. It was documented that operating cash flow is an important input data in assessing an entity.
One of the important factors in operating cash flow sensitivity is to preserve bad news and in such a case managers try to alternate better news
for the bad news and this increases cash flows sensitivity [15]. Additionally, Bartech & et al (2010) showed that operating cash flows entail
extensive information about earnings and when bad news is hidden by management the operating cash flows can reveal a part of this bad news
due to the fact that there is a low probability of manipulation in this part and this will result in a more risk resulting from stock price.
Since operating cash flows is an important criterion for profitability and it is probably manipulated less, by increasing the fluctuations in cash
flows it becomes probable for stock price crash risk to increase [4]. Kothari (2009) first dealt with whether higher operating cash flow sensitivity
is related with bankruptcy risk especially since earnings are typically considered as a criterion for primary profitability. Operating cash flow
sensitivity plays an important role in earnings. Cheng & et al (2012) believe that operating cash flow sensitivity is a surplus information resource
and since operating cash flow has more information for the users, operating cash flow sensitivity is more related in revealing the hidden bad

Mohammad Reza Jafari *, Eskandar Vaziri

682

International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

news than opacity earnings. Therefore, when earnings transparency increases the limitations of bad news accumulated stays unchanged. But a
less reduction in operating cash flow sensitivity results in a reduction of bad news and stock price crash. Thus, regarding the importance of stock
price crash risk for the investors and the effect of earnings opacity and operating cash flow sensitivity on stock price crash risk, the following
hypotheses were presented in the present research:
1- Earnings opacity affects stock price crash risk.
2- Operating cash flow sensitivity affects stock price crash risk.

3.

Research literature review

Hutton & et al (2009) studied the relationship between financial reporting opacity and stock price crash risk. They utilized earnings management
as a criterion for financial information opacity and concluded that financial information opacity is related with less information disclosure.
Additionally, those companies which have had financial statements with opacity were exposed to stock price crash risk more. Hejazi & et al
(2010) investigated about the effect of economic growth variables and economic freedom on earnings opacity. They utilized the criteria of
impetuous financial reporting, loss avoidance, and earnings' smoothening as the criteria for measuring earnings opacity and found out that there
is a direct and meaningful relationship between earnings opacity and economic growth but there were not any evidences observed showing any
relationship between earnings opacity and economic freedom.Dichu & et al (2012) studied asymmetrical cash flows sensitivity in firms having
financial limitations and in companies without financial limitations. They found out companies having negative cash flows have different cash
flows sensitivity than those companies which have positive cash flows. This difference is the same as asymmetrical cash flows sensitivity. Also
they concluded that firms having financial limitations have more asymmetrical cash flow sensitivity than companies without financial
limitations. Cheng & et al (2012) studied the relationship between earnings opacity, cash flows and stock price crash risk. They showed that
earnings opacity and operating cash flows sensitivity result in lack of revealing bad news and this increases the risk of stock price crash. Moshki
& Fattahi (2012) studied the relationship between accounting conservatism and stock price crash risk. They found out that during the study
period those companies which have had more conservative approaches applied in their financial reporting encountered stock price crash risk
less.

The models related with testing hypotheses

The dependent variable in the present research was stock price crash risk derived from the model posed by Cheng & et al (2012) and also
Moshki & Fattahi (2011) as follows:
Rit = 0+ 1r m,t-2 + 2r m,t-1 + 1r m,t+ 1r m,t+1 + 1r m,t+2 +it
In the model above, Rit is the return of the company and r m is market return and t is time. Thus, to calculate stock price risk first the model
should be tested for each year-company and then the residual LN (1+) should be calculated. After that we calculate the average of the equation
above for each year. If the amount of residuals calculated in the year-company intended is less than the average we have the number (1) which
means that there exists stock price risk and if it is more we would have (0) and it means that we do not have stock price risk.

Independent variables
The independent variables in the present research are earnings opacity and operating cash flow sensitivity which can be calculated in the
following way.

How to calculate earnings opacity

The independent variable in this research is earnings opacity and to calculate it we have used the model posed by Cheng & et al (2012).
First we extract optional accruals from the adjusted model of Jones' (1991). The reason to use the adjusted model by Jones is that Nikoomaram
& et al (2009) have shown that the next editions of Jones' model have acceptable capabilities to discover optional accruals [17].

it

In the equation above:

TAit : total accruals of firm i in the year t which can be calculated by subtracting operating cashes from the net profit before unprecedented items
Ait-1 : total assets of firm i in the year t-1
REV : change in revenue of firm i between the years t and t-1
REC : change in accounts receivable of firm i between the years t and t-1
PPE : the amount of properties, machinery, and equipments (gross) of firm i in the year t
In this model first the parameters of 1 , 1, 1 estimated solely for the company through the estimation of the least squares were calculated and
then they were tested for the research time period. In this model the criterion (optional accruals) is the same as error sentence (). If this criterion
is negative the manager has used the minimization of earnings and if it is positive the manager has used maximization of earnings [14].
Now after calculating optional accruals, earnings opacity will be calculated as follows:

OPACITY = AbsV(DiscAcc t-1) + AbsV(DiscAcc t-2) + AbsV(discAcc t-3)

The optional accruals of 3 years ago are considered as an index of earnings opacity.

Operating cash flow sensitivity

Another independent variable of the present research is operating cash flow sensitivity and here by cash flows (cfo) we mean cash flow resulting
from operational activities which are gained from the first stage of cash flow statements. To quantify the risk of operating cash flows based on
Nekra's (2008) research we calculate the standard deviation of cash flow resulting from the civil engineering activities during 5 previous periods
before the year intended which is as follows:

683

Cash Flows, Earnings Opacity and Stock Price Crash Risk in Tehran Stock Exchange
International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

)
5

Control variables
Regarding the model presented by Ray Dick & Witted (2009) and Cheng & et al (2012) these two variables are considered as control variables.
Firm size: there are different criteria to measure the variable 'firm size' which are as follows: total amount of assets, sales' amount, and the
number of staff. But in the present research we have calculated by using 1n assets.
Assets return rate: it is calculated by dividing net income into total assets.

4.

Research findings

The descriptive statistics of independent variables, static, and control variables are represented in the table below:
Table 1. The results of descriptive analysis of research data
Variable
Operating cash flow sensitivity
earnings opacity
Assets return rate
Firm size
stock price crash risk

symbol
Sensitivity
Opacity
ROA
SIZE
Crash Risk

N
740
740
740
740
740

Mean
Median
Max
63268
24037
2409826
0.038
-0.015
1.551
0.12
0.1003
0.595
12.87
12.763
17.635
Company's stock price crash
risk
Without Company's stock price
crash risk

Min
178.5
-2.115
-0.32
9.230

Std. Deviation Skewness

171627
8.684
0.357
-0.345
0.1481
0.4881
1.287
0.604
310. 50%

Kurtosis
100.55
6.981
4.209
3.780

310. 50%

To study the normality of the variables and residuals we have used Kolomogorov-Smirnov test. If the probability amount related to this test is
more than 0.05, we can approve the normality of variables' distribution and if not, the results of this test are being represented in table 2.

Table 2. Kolomogorov-Smirnov test to measure normality of the data

J
Asymp(sig)

Operating cash flow sensitivity

646.10
0.000

earnings opacity
421.77
0.000

Assets return rate

6.393
0.068

Firm Size
5.513
0.087

Spearman's correlation matrix test is a test which is utilized to determine the amount of the correlation between the data. For example, in table
(3) and in an assurance level of %95, there is a positive and meaningful relationship between firm size and operating cash flows sensitivity. This
relationship has been achieved through correlation coefficient (0.483) through Spearman's correlation test and it shows that there is a positive
relationship between firm size and operating cash flows sensitivities amounting to %48.3.
Table 3. Spearman's co-relational matrix
variable
Operating cash flow sensitivity
Firm size
Assets return rate
earnings opacity

symbol
Sensitivity
SIZE
ROA
Opacity

Sensitivity
1
**0.483
-0.012
**0.143

SIZE

ROA

Opacity

1
-0.067
0.077

1
-0.007

Results of testing the hypotheses

The outputs resulted from testing the first, second, and third hypotheses are as follows:
Results of testing the first hypothesis
According to the first hypothesis, earnings opacity affects the risk of stock price crash.
Regarding the results of testing the first hypothesis which have been presented in table (4-4), the meaningfulness level of LR (0.000) is less than
acceptable error level (%5) and the whole regression model is meaningful. The results of Nikoee adjustment test (HL & Andrews' tests) also
show that the regression pattern presented has had a desirable level of adjustment. Regarding the low amount of probability level of Z statistics
from the acceptable error level, for the coefficient 1, the test results showed that earnings opacity has had a positive and meaningful effect on
stock price crash risk. Therefore, we can not reject the first research hypothesis in an assurance level of %95. Also the research results showed
that the control variables entered into the regression such as firm size and return of assets have had a direct and negative effect on stock price
crash risk in error level of %5, respectively. The McFadden R-SQ shows that the variables entered in the regression have been able to describe
%25.2 of the changes in stock price crash risk.

Mohammad Reza Jafari *, Eskandar Vaziri

684

International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

Table 4. The results of testing first hypothesis

variable
earnings opacity
Firm size
Assets return rate
Constant

Symbol
1 (Opacity)
2(SIZE)
3 (ROA)
C
(LR Test ) statistic
(Prob.)
HL statistic
(Prob.)
(Andrews Statistic) statistic
(Prob.)
McFadden R-SQ statistic

Coefficient
4.352
0.316
-1.626
-4.055

Z statistic
11.166
4.128
-2.429
-4.048

Prob.
0.000
0.000
0.014
0.000
217.347
0.000
20.699
0.000
21.695
0.000
0.252

Results of testing the second hypothesis

According to the second hypothesis, operating cash flow sensitivity affects the risk of stock price crash.

Table 5. The results of testing second hypothesis

variable
operating cash flows sensitivity
Firm size
Assets return rate
Constant

symbol
1 (sensitivity)
2(SIZE )
3 (ROA)
C
(LR Test ) statistic
(Prob.)
HL statistic
(Prob.)
(Andrews Statistic) statistic
(Prob.)
McFadden R-SQ statistic

Coefficient
4.5
0.161
-1.588
-2.118

Z statistic
3.357
2.223
-2.724
-2.291

Prob.
0.000
0.025
0.006
0.021
42.284
0.000
22.648
0.000
21.689
0.000
0.149

Regarding the results of testing the second hypothesis which have been presented in table (4-5), the meaningfulness level of LR (0.000) is less
than acceptable error level (%5) and the whole regression model is meaningful. The results of Nikoee adjustment test (HL & Andrews' tests) also
show that the regression pattern presented has had a desirable level of adjustment. Regarding the low amount of probability level of Z statistics
from the acceptable error level, for the coefficient 1, the test results showed that operating cash flow sensitivity has had a positive and
meaningful effect on stock price crash risk. Therefore, we can not reject the first research hypothesis in an assurance level of %95. Also the
research results showed that the control variables entered into the regression such as firm size and return of assets have had a direct and negative
effect on stock price crash risk in error level of %5, respectively. The McFadden R-SQ shows that the variables entered in the regression have
been able to describe %14.9 of the changes in stock price crash risk.

5.

Conclusion

Regarding the hypotheses analyses presented earlier, the following overall conclusions were made for the present research:
Due to the theoretical foundations mentioned above, the research findings also showed that earnings opacity and the operating cash flows
sensitivity have had a direct and meaningful effect on stock price crash risk and increase it. Regarding the first hypothesis we can say that when
a manager uses optional accruals, the probability of earnings management increases and this will finally lead to the creation of a reporting
environment which entails opacity. Also managers have incentives to hide a part of losses to preserve their job. This process, lack of disclosure
of real losses, continues throughout the presence of the manager in the company. After the manager leaves the company a great deal of
unrevealed losses will enter the market and this will lead to stock price crash risk. Additionally, in a reporting environment with opacity, the
investors are not able to recognize and discover the projects which incur losses. The inability of the investors in differentiating between the
profitable projects and those incurring losses causes the loss imposing projects to be continued and pass of time increases their losses. The
negative return of these projects is accumulated within the company and when the related information is revealed, the stock price will
extensively reduce. Finally when managers manipulate earnings to avoid showing bad news the entities are valuated more than their real values
but when managers can not hide bad news a considerable price fall happens. Regarding the second hypothesis we can say that operating cash
flow risk is considered to be another type of the risk through which a reduction in operating cash flows results in a major change in costs of the
business entity and the investments. Also the business unit feels the danger much more than the bankruptcy. Therefore, this factor can also result
in increasing stock price reduction risk. Also some suggestions based on the research results are as follows: 1- It is suggested that the users of
financial statements should pay attentions especially to variables such as earnings opacity and operating cash flows sensitivity when they analyze
financial statements to purchase the stocks of companies regarding the results gained from the present research. 2- Regarding the fact that
managers aim at gaining the trust of owners it is suggested to try to remove the presuppositions formed in the minds of the beneficiaries about
earnings' manipulation by reducing earnings opacity and operating cash flow sensitivity. 3- It is suggested to Stock Exchange Organization to
devise rules and regulations to reduce earnings opacity and operating cash flow sensitivity as much as possible to reduce the contradictions
created by the managers and investors, regarding the positive relationship between earnings opacity and operating cash flow sensitivity and stock
price crash risk to determine the real value of the companies, to make the information transparent, and to create a better understanding of the
performances.

685

Cash Flows, Earnings Opacity and Stock Price Crash Risk in Tehran Stock Exchange
International Journal of Economy, Management and Social Sciences Vol(3), No (11), November, 2014.

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