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Track Paper

Journal of Accounting,
Auditing & Finance
Usefulness of Accounting 2017, Vol. 32(1) 123–135
ÓThe Author(s) 2016
Estimates: A Tale of Two Reprints and permissions:
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Countries (China and India) DOI: 10.1177/0148558X16657756
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Li Li Eng1 and Thanyaluk Vichitsarawong2

Abstract
This is an exploratory study to examine the quality or usefulness of accounting estimates of
companies in China and India over time. Specifically, we examine how well the accounting
estimates are able to predict future earnings and cash flows during the period 2003-2013.
The results for India indicate that the out-of-sample earnings and cash flow predictions
derived are more accurate and more efficient in the more recent period (2010-2013) than
the earlier period (2003-2006). In contrast, the out-of-sample earnings and cash flow pre-
dictions for China are generally more biased, less accurate, and less efficient. The results
indicate abnormal returns earned on hedge portfolios formed on earnings (cash flow) pre-
dictions for India in the recent period. In contrast, none of the portfolios for China earn
positive returns. The results suggest that the accounting estimates in India in recent years
have become better predictors of future earnings and cash flow than accounting estimates
in the earlier period. However, the accounting estimates in China are not relevant for pre-
dicting earnings and cash flows over the years in the sample period.

Keywords
prediction models, earnings, cash flows, international financial reporting standards,
accounting systems

Introduction
This article examines the quality or usefulness of accounting estimates of companies in
China and India. Quality is measured as to how well the accounting estimates are able to
predict future earnings and cash flows. Specifically, we examine the quality of earnings
and cash flows as reported by Chinese and Indian firms during the period 2003 through
2013. The sample period excludes the financial crisis of 2007-2009; according to the U.S.
National Bureau of Economic Research (NBER), the U.S. recession began in December
2007 and ended in June 2009, and the financial crisis appears to have ended about the

1
Missouri University of Science and Technology, Rolla, MO, USA
2
Chulalongkorn University, Bangkok, Thailand

Corresponding Author:
Li Li Eng, Associate Professor, Department of Business and Information Technology, Missouri University of Science
and Technology, Fulton Hall, Rolla, MO 65401, USA.
Email: engl@mst.edu
124 Journal of Accounting, Auditing & Finance

same time. We separate the sample period to pre-financial crisis (2003-2006) and post-
financial crisis (2010-2013).
This is an exploratory study. There is relatively little research about these emerging
economies, so this would be an initial step toward understanding accounting quality in
these countries. China and India are among two of the emerging economies of BRIC
(Brazil, Russia, India, and China); China is the largest emerging economy, and India is the
second largest. Accounting standards in India and China are in the process of convergence
to International Financial Reporting Standards (IFRS), but both jurisdictions do not permit
application of IFRS yet.
We use four accounting prediction models—earnings; operating cash flows; operating
cash flows and accruals; and operating cash flow components. We regress earnings (operat-
ing cash flows) on previous year’s accounting variables in the four prediction models to
obtain regression estimates. The estimated coefficients are used to calculate firm specific
predicted values for earnings and operating cash flows in the following year. We then cal-
culate the difference between the actual and predicted values of earnings (operating cash
flows) to obtain firm specific prediction error. Prediction performance metrics are calcu-
lated for pre- and post-financial crisis periods in India/China. We determine whether
accounting estimates are better at predicting future earnings and cash flows in the post-
period than the pre-period.
Overall, the results for India indicate that the out-of-sample earnings and cash flow pre-
dictions derived from the four prediction models are more accurate and more efficient after
2010. However, we find opposite results in China. The out-of-sample earnings predictions
for China are generally more biased, less accurate, and less efficient. We then examine
whether out-of-sample earnings and cash flow predictions based on accounting data in four
models contribute to predictable stock returns during the pre- and post-periods in India and
China. The results indicate that accounting estimates in India in the post-period are better
predictors of future earnings than accounting estimates in the pre-period. In contrast, the
findings for China indicate that none of the portfolios earn positive returns; the accounting
estimates in China are not relevant for predicting positive future earnings. It is interesting
that although accounting standards in India and China are converging to IFRS, they differ
in quality or usefulness of accounting estimates in predicting future earnings or cash flows;
there is an improvement in predictive quality of accounting estimates in India, but improve-
ment is not evident in China. The results are interesting for users of accounting information
in China and India who may be interested in assessing the data for predicting future earn-
ings and cash flows.
The remainder of the article is organized as follows. ‘‘Literature Review and
Methodology’’ section presents a summary of prior literature and the methodology.
‘‘Sample and Data’’ section discusses the sample and data. The results are presented in
‘‘Results’’ section. Finally, ‘‘Conclusion’’ section concludes the article.

Literature Review and Method


We summarize prior research on accounting in China and India in the table that follows.
Since April 2010, the Securities Exchange Board of India (SEBI) has provided an option
to listed entities having subsidiaries to submit their consolidated financial results either in
accordance with the accounting standards specified in Section 211(3C) of the Companies
Act, 1956, or in accordance with IFRS (with required reconciliations). The IFRS converged
Indian Accounting Standards (referred to as Ind AS) have been issued but the effective
Eng and Vichitsarawong 125

Summary findings
Research on China
Wang, Chen, Lin, and Wu (2008) Frequency and magnitude of earnings management have
gone up during the post-2000 period.
Chen, Chen, Lobo, and Wang (2011) Non-state-owned enterprises have higher earnings
management (lower quality) than state-owned
enterprises.
S. Qu, and Zhuang (2011) Family ownership in China is associated with lower
earnings quality.
Li, Abeysekera, and Ma (2014) Accrual quality, earnings predictability, and earnings
smoothness are significantly different between healthy
and bankrupt firms, but not earnings persistence.
Research on India
Sarkar, Sarkar, and Sen (2008) Board quality is important for reducing opportunistic
earnings management but board independence has no
significant relation with discretionary accruals.

application date of these standards has been deferred to April 2016 for larger firms and
April 2017 for other firms.
China has not adopted IFRS. China’s new accounting standards of 2006 have become
substantively convergent with IFRS (Y. Ding & Su, 2008). Firms that issue A-shares
(which can only be owned and traded by Chinese citizens) are required to comply with
Chinese domestic accounting standards that have gone through changes to converge with
IFRS. Firms that issue B-shares (which can be owned and traded by foreigners, Chinese citi-
zens, or both) are mandated to comply with International Accounting Standards (IAS)/IFRS.
Those that issue both A- and B-shares are required to issue two sets of annual reports, one
with Chinese standards and the other with IFRS (Peng, Tondkar, van der Laan Smith, &
Harless, 2008). We select only A-share listing firms for the Chinese sample because these
firms are required to comply with Chinese domestic accounting standards. This sample will
reduce confounding effects from using different sets of accounting standards.

Prediction Models
We examine usefulness of accounting estimates as the ability to predict future earnings and
cash flows. We use four prediction models similar to Lev, Li, and Sougiannis (2010) and
Li and Sougiannis (2014). The models are earnings, operating cash flows, operating cash
flows and accruals, and operating cash flow components.

EARNt + 1 = b0 + b1 EARNt + et , ð1Þ

EARNt + 1 = b0 + b1 CFOt + et , ð2Þ

EARNt + 1 = b0 + b1 CFOt + b2 ACCRUALSt + et , ð3Þ

EARNt + 1 = b0 + b1 CFOt + b2 DARt + b3 DINVt + b4 DAPt + b5 DPt + b6 OTHERt + et , ð4Þ


126 Journal of Accounting, Auditing & Finance

where EARN = earnings before extraordinary items; CFO = net cash flow from operations;
ACCRUALS = EARN 2 CFO; DAR = change in accounts receivable; DINV = change in
inventory; DAP = change in accounts payable; DP = depreciation and amortization
expenses; OTHER = other accruals defined as EARNðCFO + DAR + DINVDAPDPÞ:
All variables are scaled by beginning total assets. We run regression of these models to
obtain sample estimates.

Out-of-Sample Prediction of Earnings (Cash Flows)


From the regression models above, we use the estimated coefficients to calculate firm-spe-
cific predicted values for operating cash flow and earnings in the following year. We then
calculate the difference between the actual and predicted values of operating cash flow
(earnings) to obtain firm specific prediction error. The following is an example of the pre-
diction of earnings for year 2005 using Model 1.

1. Estimate the following regression for each country:

EARN2004 = b0 + b1 EARN2003 + et :

2. Use the country-specific estimated coefficients (b0 and b1) to predict earnings,
Est(EARN), for each firm in the country:

EstðEARN2005 Þ = Estðb0 Þ + Estðb1 Þ3EARN2004 :

3. Determine prediction error (PE) for each firm in a given country:

PE2005 = EARN2005  EstðEARN2005 Þ:

We repeat the procedure for every firm and sample year.

We use the metrics in Lev et al. (2010) and Li and Sougiannis (2014) to evaluate the
out-of-sample prediction performance. MPE is the average prediction error, the difference
between actual and predicted values, indicating prediction bias. MAPE (mean absolute pre-
diction error) is the average absolute difference between actual and predicted values, indi-
cating the accuracy of the prediction. RMSE (root mean square prediction error) also
measures prediction accuracy. We obtain ALPHA (the intercept), BETA (the slope coeffi-
cient), and the adjusted R2 from the Mincer and Zarnowitz (1969) regressions of actual
values on predicted values. ALPHA indicates prediction bias, BETA indicates the correla-
tion between actual and predicted values, and the adjusted R2 measures how well the pre-
dicted values are related to the actual values. Theil’s U statistic, defined as the square root
of S(Actual 2 Predicted)2 / S(Actual)2, measures overall accuracy of the forecast. A lower
U statistic indicates better prediction.
We test for the significance of the change in MPE and MAPE from the pre- to post-peri-
ods using t statistics. We apply a bootstrapping approach in testing for differences in
RMSE, ALPHA, BETA, and R2 between the pre- and post-periods. For example, to test
whether the change in R2 is significantly different from zero, we randomly select, with
replacement, observations from each subsample to generate representative samples and
Eng and Vichitsarawong 127

compute the measure. The procedure is repeated 1,000 times to obtain the empirical distri-
butions of the difference between R2 between two periods, and t statistics are calculated.

Hypothesis 1: Accounting estimates perform better in predicting future earnings


(cash flows) in the recent period (2010-2013) than the earlier period (2003-2006)
as accounting standards converge with IFRS.

Sample and Data


We obtain the data from Datastream database. The sample firms are actively listed on the
main stock exchanges in India or China during 2003-2013. The main stock exchanges in
India are Bombay Stock Exchange and Indian National Stock Exchange. The main stock
exchanges in China are Shanghai Stock Exchange and Shenzhen Stock Exchange. Table 1,
Panel A shows our sample selection procedure. We start with 44,253 and 25,245 observa-
tions from India and China, respectively. We exclude sample with missing data and
exclude firms that do not use local accounting standards.1 We then eliminate observations
that are financial service, real estate, and insurance companies from the sample because
these firms have to comply with specific rules and regulations. All variables are winsorized
at the top and bottom one percentile of each variable to reduce the effects of outliers. We
require our sample to have data available in all years during the study periods. Our final
sample consists of 2,266 firm-year observations (206 firms) from India and 7,425 firm-year
observations (675 firms) from China. To avoid confounding effects from the financial
crisis, we exclude the financial crisis period (2007-2009) from the sample years. Hence,
our sample periods cover 2003-2006 (pre-financial crisis) and 2010-2013 (post-financial
crisis).
Table 1, Panel B shows our sample distribution by industry. We classify all firms into
15 industries based on Datastream classification. The leading industries in India are indus-
trial goods, peripheral, chemical, basic resources, construction, and health care industries,
which together make up 69.9% of the sample. The leading industries in China are industrial
goods, basic resources, chemical, health care, and retail industries, which together make up
60.8% of the sample.
Table 2 provides descriptive statistics in pre- and post-financial crisis. Panel A shows
the descriptive statistics of the Indian sample. The averages of all variables in the post-
period are significantly lower than in the pre-period, except the average accruals
(ACCRUALS). We find no significant difference in the average other accruals (OTHER)
between pre- and post-periods. Table 2, Panel B reports descriptive statistics of Chinese
sample. In general, the averages of variables in post-period are significantly higher than in
pre-period. However, the average cash flow from operations and depreciation (DP) are sig-
nificantly reduced over the post-period. We find no statistical difference in the average of
changes in accounts payable (DAP) and changes in inventory (DINV) between pre- and
post-crisis periods.

Results
Table 3 presents Pearson correlation coefficients among variables for India and China in
Panels A and B, respectively. Most of the correlation coefficients are statistically signifi-
cant. Earnings are more persistent (have higher correlation coefficients with future earn-
ings) than cash flow from operations (have lower correlation coefficients with future cash
128 Journal of Accounting, Auditing & Finance

Table 1. Sample.

Panel A: Sample Selection.


India China
Firm–year observation Firm–year observation
Initial sample 44,253 25,245
Less: Missing data 29,387 8,856
Less: Accounting standards are unknown 59 618
or not local GAAPs
Less: Financial service, real estate, and insurance 561 1,077
Less: Firms not available in all years 11,980 7,269
Final sample 2,266 7,425
Final sample (No. of firms) 206 675

Panel B: Sample Distribution by Industry.


India China
Industry Firm–year observation % of total Firm–year observation % of total
Automobile 198 8.7 385 5.2
Basic resources 209 9.2 836 11.3
Chemical 264 11.7 781 10.5
Construction 209 9.2 429 5.8
Food and beverage 77 3.4 484 6.5
Health care 209 9.2 660 8.9
Industrial goods 407 18.0 1,617 21.8
Media and entertainment 55 2.4 77 1.0
Oil and gas 99 4.4 44 0.6
Peripheral 286 12.6 407 5.5
Retail 0 0.0 616 8.3
Technology 132 5.8 396 5.3
Telecommunication 22 1.0 22 0.3
Travel and leisure 55 2.4 187 2.5
Utility 44 1.9 484 6.5
Total 2,266 100.0 7,425 100.0

Note. GAAP = Generally Accepted Accounting Principles.

flows) in the pre- and post-periods. Concurrent cash flow from operations and accruals are
negatively correlated. The correlation coefficient between cash flows and next period earn-
ings is higher than that between accruals and next period earnings, consistent with the
lower persistence of accruals relative to cash flows as reported in prior studies (e.g., Li &
Sougiannis, 2014; Richardson, Sloan, Soliman, & Tuna, 2005; Sloan, 1996).

Out-of-Sample Prediction
Table 4 provides results from the out-of-sample prediction of 1-year ahead earnings,
EARNt + 1. Panel A of Table 4 reports results for India during pre- and post-periods. MAPE
and RMSE are lower in the post-period indicating an increase in the overall accuracy.
However, Theil’s U is higher in the post-period indicating lower prediction accuracy. MPE
Eng and Vichitsarawong 129

Table 2. Descriptive Statistics.

Pre-period Post-period M difference


Variable M Median M Median Pre 2 Post
Panel A: India
EARN 0.0969 0.0803 0.0763 0.0592 0.0206***
CFO 0.1151 0.1025 0.0809 0.0731 0.0342***
ACCRUALS 20.0184 20.0190 20.0059 20.0080 20.0125***
DAR 0.0310 0.0191 0.0205 0.0179 0.0104***
DAP 0.0284 0.0197 0.0148 0.0111 0.0136***
DINV 0.0285 0.0173 0.0243 0.0144 0.0042*
DP 0.0447 0.0420 0.0334 0.0317 0.0114***
OTHER 20.0040 20.0037 20.0034 20.0038 20.0006
Panel B: China
EARN 0.0320 0.0271 0.0370 0.0287 20.0050***
CFO 0.0684 0.0624 0.0499 0.0452 0.0185***
ACCRUALS 20.0372 20.0350 20.0125 20.0149 20.0247***
DAR 0.0124 0.0077 0.0270 0.0119 20.0147***
DAP 0.0165 0.0087 0.0181 0.0086 20.0016
DINV 0.0274 0.0125 0.0273 0.0105 0.0001
DP 0.0337 0.0302 0.0321 0.0277 0.0016***
OTHER 20.0257 20.0197 20.0161 20.0113 20.0097***

Note. All variables are deflated by beginning total assets and are defined as follows: EARN = earnings before
extraordinary items; CFO = net cash flow from operations; ACCRUALS = defined as EARN 2 CFO; DAR = a change
in accounts receivable; DAP = change in accounts payable; DINV = a change in inventory; DP = depreciation and
amortization expenses; OTHER = other accruals defined as EARN 2 (CFO + DAR + DINV 2 DAP 2 DP).
*Statistical significance at 10% level. ***Statistical significance at 1% level.

has mostly negative values across all models in both periods except for Model 2 in the pre-
period; actual earnings are less than predicted earnings, that is, the models give an optimis-
tic bias. The bias is greater in the post-period than the pre-period. ALPHA values are
slightly higher in the post-period, indicating more bias. BETA is in the range close to 1.0
indicating that the predicted value is close to the actual value. The efficiency of forecast is
higher after crisis as suggested by the higher adjusted R2 in Models 2 to 4. Overall, the
out-of-sample forecasts derived from the four models indicate that accounting numbers in
India may be more accurate and more efficient but more biased in more recent years (post-
period) compared with earlier years (pre-period).
The out-of-sample prediction results in China during pre- and post-periods are reported
in Table 4, Panel B. RMSE and Theil’s U are higher in the post-period indicating a
decrease in the overall accuracy. We find no difference in MAPE between pre- and post-
periods. The sign for MPE is opposite in the pre- and post-periods. It has mostly positive
values across all models except for Model 2 in the pre-period; actual earnings are higher
than predicted earnings. The sign for MPE is negative in post-period; actual earnings are
less than predicted earnings. The bias is pessimistic in pre-period and optimistic in post-
period. ALPHA values are slightly higher in the post-period, indicating more bias. BETA
is lower in the post-period indicating that lower correlation between the predicted value
and the actual value. The efficiency of forecast is lower after crisis as suggested by the
lower adjusted R2. Overall, the out-of-sample forecasts derived from the four models do
130 Journal of Accounting, Auditing & Finance

Table 3. Correlations.
Panel A: India.

EARN CFO ACCRUALS DAR DAP DINV DP OTHER EARNt + 1 CFOt + 1

India (Pre)
EARN 1
CFO .652*** 1
ACCRUALS .227*** 2.565*** 1
DAR .168*** 2.098*** .332*** 1
DAP .098*** .174*** 2.093*** .509*** 1
DINV .165*** 2.081** 0.294*** .226*** .411*** 1
DP .005 .248*** 2.342*** 2.018 2.014 .028 1
OTHER .054 2.290*** .426*** 2.379*** 2.098*** 2.194*** 2.111*** 1
EARNt + 1 .770*** .564*** .084** .038 2.004 .072** .009 .008 1
CFOt + 1 .534*** .581*** 2.192*** 2.020 2.032 2.057 .189*** 2.116*** .614*** 1
India (Post)
EARN 1
CFO .693*** 1
ACCRUALS .201*** 2.531*** 1
DAR .195*** 2.073** .352*** 1
DAP .142*** .173*** 2.049 .419*** 1
DINV .210*** 2.028 .322*** .214*** .449*** 1
DP 2.020 .176*** 2.283*** .023 .055 .082** 1
OTHER .024 2.230*** .316*** 2.425*** 2.025 2.231*** 2.045 1
EARNt + 1 .733*** .603*** .075** .115*** .110*** .134*** 2.015 2.033 1
CFOt + 1 .568*** .541*** 2.052 .055 2.004 .014 .172*** 2.049 .687*** 1

Panel B: China.

EARN CFO ACCRUALS DAR DAP DINV DP OTHER EARNt + 1 CFOt + 1

China (Pre)
EARN 1
CFO .423*** 1
ACCRUALS .196*** 2.794*** 1
DAR .208*** 2.118*** .255*** 1
DAP .169*** .146*** 2.066*** .301*** 1
DINV .218*** 2.135*** .264*** .181*** .426*** 1
DP .212*** .378*** 2.271*** .048** .061*** .013 1
OTHER 2.006 2.339*** .384*** 2.428*** 2.072*** 2.452*** 2.043** 1
EARNt + 1 .624*** .373*** .011 .084*** .075*** .087*** .191*** 2.049** 1
CFOt + 1 .227*** .291*** 2.164*** .029 2.003 2.022 .367*** 2.071*** .395*** 1
China (Post)
EARN 1
CFO .372*** 1
ACCRUALS .265*** 2.782*** 1
DAR .228*** 2.912*** .260*** 1
DAP .170*** .113*** 2.005 .459*** 1
DINV .163*** 2.173*** .292*** .222*** .430*** 1
DP .025 .274*** 2.268*** .022 .036* 2.042** 1
OTHER .032* 2.346*** .363*** 2.423*** 2.172*** 2.505*** .035* 1
EARNt + 1 .562*** .321*** .043** .120*** .067*** .046*** 2.009*** 2.062*** 1
CFOt + 1 .224*** .405*** 2.270*** 2.013 2.045** 2.133*** .224*** 2.093*** .432*** 1

Note. Pearson correlation coefficients are presented. Variable definitions are under Panel B of Table 2. EARN =
earnings before extraordinary items; CFO = net cash flow from operations; ACCRUALS = defined as EARN 2 CFO;
DAR = a change in accounts receivable; DAP = change in accounts payable; DINV = a change in inventory; DP =
depreciation and amortization expenses; OTHER = other accruals defined as EARN 2 (CFO + DAR + DINV 2 DAP
2 DP).
*Statistical significance at 10% level. **Statistical significance at 5% level. ***Statistical significance at 1% level.
Eng and Vichitsarawong 131

Table 4. Out-of-Sample Prediction, Forecast of EARNt + 1.

Panel A: India.
Model MAPE MPE RMSE ALPHA BETA ADJ R2 Theil’s U
India (Pre)
1 0.0411 20.0079 0.0621 2.0026 0.9534 .6142 0.4207
2 0.0562 0.0040 0.0799 .0094 0.9495 .3623 0.5367
3 0.0421 20.0067 0.0640 2.0009 0.9489 .5902 0.4329
4 0.0458 20.0026 0.0683 .0104 0.8841 .5345 0.4640
India (Post)
1 0.0382 20.0102 0.0596 2.0029 0.9315 .5526 0.5777
2 0.0503 20.0112 0.0697 2.0095 0.9708 .3868 0.6550
3 0.0357 20.0078 0.0531 2.0080 1.0313 .6434 0.5095
4 0.0392 20.0133 0.0571 2.0097 0.9738 .5892 0.5488
Pre – Post
1 0.0028 0.0022 0.0025*** .0003*** 0.0218*** .0616*** 20.1570***
2 0.0059 0.0151*** 0.0102*** .0189*** 20.0213*** 2.0245*** 20.1182***
3 0.0064** 0.0011 0.0109*** .0071*** 20.0824*** 2.0533*** 20.0767***
4 0.0066* 0.0108** 0.0112*** .0202*** 20.0898*** 2.0547*** 20.0848***

Panel B: China.
Model MAPE MPE RMSE ALPHA BETA ADJ R2 Theil’s U
China (Pre)
1 0.0273 0.0054 0.0394 .0044 0.9458 .4313 0.7349
2 0.0336 20.0010 0.0481 2.0059 1.1433 .1551 0.8363
3 0.0279 0.0042 0.0395 .0015 1.0135 .4307 0.7305
4 0.0296 0.0025 0.0418 .0005 1.0215 .3620 0.7531
China (Post)
1 0.0294 20.0020 0.0443 .0023 0.9287 .2844 0.7840
2 0.0349 20.0045 0.0494 2.0068 1.0853 .1078 0.8178
3 0.0294 20.0019 0.0437 .0017 0.9315 .3036 0.7657
4 0.0298 20.0021 0.0446 .0043 0.8341 .2752 0.7592
Pre 2 Post
1 20.0021 0.0074*** 20.0049*** .0022*** 0.0171*** .1469*** 20.0491***
2 20.0013 0.0035* –0.0014* .0008*** 0.0579*** .0473*** 0.0185***
3 20.0015 0.0061*** 20.0042*** 2.0001*** 0.0820*** .1272*** 20.0352***
4 20.0002 0.0046*** 20.0027*** 2.0038*** 0.1874*** .0868*** 20.0060***

Note. Model 1: earnings only, Model 2: cash flow from operations only, Model 3: cash flow from operations and
accruals, Model 4: cash flow from operations, change in accounts receivable, change in accounts payable, change in
inventory, depreciation and amortization expenses, and other accruals. EARN = earnings before extraordinary
items; MAPE = mean absolute prediction error; MPE = mean prediction error, with prediction error calculated as
(actual-forecast); RMSE = root mean square prediction error; ALPHA = the intercept from the Mincer and
Zarnowitz (1969) regressions of actual values on predicted values; BETA = the slope coefficient from the Mincer–
Zarnowitz regressions of actual values on predicted values; ADJ R2 = the adjusted R2 from the Mincer–Zarnowitz
regressions of actual values on predicted values; Theil’s U = Theil’s U statistic, defined as the square root of
S(Actual 2 Predicted)2 / S(Actual)2. The Mincer–Zarnowitz regressions are run for each year and the averages of
the intercept, the regression coefficient, and adjusted R2 are reported for each period. Theil’s U statistic is
calculated for each year, and the averages are reported for each period.
*Statistical significance at 10% level. **Statistical significance at 5% level. ***Statistical significance at 1% level.
132 Journal of Accounting, Auditing & Finance

not show improvement in accuracy, bias, and efficiency of accounting numbers in China in
more recent years (post-period) compared with earlier years (pre-period).
Table 5, Panel A provides the results from the out-of-sample prediction of CFOt + 1 for
India. MPE and ALPHA values are lower in the post-period compared with the pre-period,
indicating less bias over time. The decline in MAPE and RMSE for all models after 2010
suggests an increase in the overall accuracy. However, Theil’s U is higher in the post-
period indicating lower prediction accuracy. The efficiency of forecast is higher after 2010
as can be seen from the higher adjusted R2. In sum, the results of the prediction of CFOt + 1
indicate that accounting estimates are better at predicting future earnings and cash flows in
the post-period in India.
Table 5, Panel B reports the out-of-sample predictions of CFOt + 1 for China. RMSE and
Theil’s U are higher in the post-period indicating a decrease in the overall accuracy. The
sign for MPE is positive in both periods; actual earnings are higher than predicted earnings;
that is, the forecast bias is pessimistic. ALPHA values are slightly higher in the post-
period, indicating more bias. BETA is lower in the post-period indicating lower correlation
between the predicted value and the actual value. The results for efficiency of forecast are
mixed as indicated by mixed levels of adjusted R2 across the four models between pre- and
post-periods; adjusted R2s are higher for Models 2 and 3 and lower for Models 1 and 4 in
the post-period. Overall, the out-of-sample forecasts derived from the four models do not
show improvement in accuracy, bias, and efficiency of accounting numbers in China in
more recent years (post-period) compared with earlier years (pre-period).

Portfolio Analysis
We further examine whether out-of-sample earnings and cash flow predictions based on the
accounting data in the four models contribute to predictable stock returns during the pre-
and post-periods in India and China. We rank the sample based on the earnings (cash flow)
predictions each period and form five portfolios based on the predicted earnings (cash
flow). We then calculate market-adjusted returns from holding these portfolios over 90,
180, 270, and 365 days after the fiscal year end. We form zero-investment portfolios by
investing (going long) in the top earnings (cash flow) portfolio and selling (shorting) the
bottom portfolio and calculate the abnormal returns earned on hedge portfolios. If account-
ing estimates perform better in predicting future earnings (cash flows) in the post-period
than pre-period, then post-period portfolios would earn higher returns than pre-period
portfolios.
The results (not reported) support Hypothesis 1 that accounting estimates in India in the
more recent period are better predictors of future earnings (and future cash flows) than
accounting estimates in the earlier period; post-period returns are significantly higher than
pre-period returns for all four models. However, these results do not support Hypothesis 1
for China. We find no significant difference in returns between pre- and post-periods for
most of the other models and holding periods.

Conclusion
This is an exploratory study to examine the quality or usefulness of accounting estimates of
companies in China and India in the periods 2003-2006 (pre-period) and 2010-2013 (post-
period), excluding the financial crisis years of 2007-2009. The results for India indicate
that the out-of-sample earnings and cash flow predictions derived from the prediction
Eng and Vichitsarawong 133

Table 5. Out-of-Sample Prediction, Forecast of CFOt + 1

Panel A: India.
Model MAPE MPE RMSE ALPHA BETA ADJ R2 Theil’s U
India (Pre)
1 0.0758 20.026 0.0972 2.009 0.8775 .2960 0.6211
2 0.0732 20.016 0.0940 2.010 0.9638 .3409 0.5898
3 0.0714 20.022 0.0917 2.011 0.9228 .3733 0.5834
4 0.0700 20.022 0.0896 2.011 0.9196 .4015 0.5715
India (Post)
1 0.0582 20.0404 0.0818 .003 0.9150 .3198 0.6825
2 0.0581 20.004 0.0810 2.008 1.0418 .3337 0.6726
3 0.0544 20.002 0.0767 2.004 1.0274 .4018 0.6363
4 0.0545 20.006 0.0755 2.001 0.9294 .4192 0.6349
Pre 2 Post
1 0.0176*** 20.022*** 0.0154*** 2.012*** 20.0375*** 2.0237*** 20.0614***
2 0.0151*** 20.012* 0.0130*** 2.003*** 20.0780*** .0072*** 20.0828***
3 0.0170*** 20.020*** 0.0150*** 2.008*** 20.1047*** 2.0285*** 20.0529***
4 0.0155*** 20.016*** 0.0141*** 2.010*** 20.0098*** 2.0177*** 20.0634***

Panel B: China.
Model MAPE MPE RMSE ALPHA BETA ADJ R2 Theil’s U
China (Pre)
1 0.0547 0.0066 0.0735 .0014 1.0738 .0815 0.7095
2 0.0547 0.0027 0.0726 2.0228 1.3881 .1014 0.7038
3 0.0535 0.0047 0.0721 2.0067 1.1809 .1151 0.6968
4 0.0512 0.0034 0.0700 .0078 0.9382 .1680 0.6733
China (Post)
1 0.0575 0.0019 0.0785 .0112 0.7823 .0336 0.8458
2 0.0545 0.0012 0.0736 2.0135 1.1998 .1499 0.8123
3 0.0544 0.0021 0.0739 2.0069 1.1021 .1435 0.8142
4 0.0538 0.0015 0.0736 .0039 0.8990 .1507 0.8072
Pre 2 Post
1 20.0027 0.0048 20.0050*** 2.0098*** 0.2915*** .0478*** 20.1363***
2 0.0002 0.0015 20.0009*** 2.0092*** 0.1883*** 2.0486*** 20.1085***
3 20.0009 0.0027 20.0018*** .0003*** 0.0789*** 2.0284*** 20.1174***
4 20.0026 0.0019 20.0036*** .0038*** 0.0392*** .0173*** 20.1339***

Note. Model 1: earnings only, Model 2: cash flow from operations only, Model 3: cash flow from operations and
accruals, Model 4: cash flow from operations, change in accounts receivable, change in accounts payable, change in
inventory, depreciation and amortization expenses, and other accruals. CFO = net cash flow from operations;
MAPE = mean absolute prediction error; MPE = mean prediction error, with prediction error calculated as (actual-
forecast); RMSE = root mean square prediction error; ALPHA = the intercept from the Mincer and Zarnowitz
(1969) regressions of actual values on predicted values; BETA = the slope coefficient from the Mincer–Zarnowitz
regressions of actual values on predicted values; ADJ R2 = the adjusted R2 from the Mincer–Zarnowitz regressions
of actual values on predicted values; Theil’s U = Theil’s U statistic, defined as the square root of S(Actual 2
Predicted)2 / S(Actual)2. The Mincer–Zarnowitz regressions are run for each year, and the averages of the
intercept, the regression coefficient, and adjusted R2 are reported for each period. Theil’s U statistic is calculated
for each year, and the averages are reported for each period.
*Statistical significance at 10% level. **Statistical significance at 5% level. ***Statistical significance at 1% level.
134 Journal of Accounting, Auditing & Finance

models are more accurate and more efficient in the post-period. In contrast, the out-of-
sample earnings predictions for China are generally more biased, less accurate, and less
efficient in the post-period.
We then examine whether earnings and cash flow predictions based on accounting data
contribute to stock returns during the pre- and post-periods in India and China. The results
indicate abnormal returns earned on hedge portfolios formed on earnings (cash flow) pre-
dictions in the post-period for India. We find that the accounting estimates in India in the
post-period are better predictors of future earnings than accounting estimates in the pre-
period. In contrast, none of the portfolios for China earn positive returns; the accounting
estimates in China are not relevant for predicting future returns earnings in the pre- and
post-periods.
This article provides a preliminary understanding of the usefulness of accounting esti-
mates for firms in China and India. Accounting estimates in India are useful in predicting
future earnings and cash flows, but accounting estimates in China are not. The results in
this article are consistent with the findings in La Porta, Lopez-de-Silanes, Shleifer, and
Vishny (1998); Ball, Robin, and Wu (2003); and Li and Sougiannis (2014) that accounting
quality varies with accounting systems and legal enforcement. Accounting standards in
China and India are converging to IFRS, but both countries have not fully implemented
IFRS. Future research may extend this research to examine quality of accounting estimates
in China and India after both countries have fully implemented IFRS.

Declaration of Conflicting Interests


The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/
or publication of this article.

Funding
The author(s) received no financial support for the research, authorship, and/or publication of this
article.
Note
1. We use accounting standard identification by Datastream database. We eliminate firms that do not
use local GAAPs or whose accounting standards are not identified by Datastream database. There
was a lot of missing data in the early years, particularly before 2007.

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