Financial Distress and Unexpected Cash-Flows

Casella for invaluable guidance during my program. I would also like to thank Professors Peter Wilson, Vic Bernard and Tom Stober for their willingness to answer questions and offer advice. Financial support from the Arthur Andersen Foundation, the Social Sciences and Humanities Research Council of Canada, and the UW/SSHRC grant program during various stages of this work was greatly appreciated. Comments received from the following accounting workshops were appreciated and helped in the evolution of this paper: and the doctoral seminar at Florida State University were also appreciated. This paper examines the effect of financial distress on the information contained in the cash-flow and accrual components of earnings, as opposed to that of earnings alone. mixed evidence about whether knowledge of the the cash-flow and accrual-components of earnings is important for valuing firms' securities. Wilson [1987] and Bernard and Stober [1989] used short-window event-study methodologies to examine this relationship. Their results are mixed with respect to whether the relationship between unexpected cash-flow and abnormal stock returns is statistically significant after controlling for the information contained in the earnings announcement. After not finding any significant association, Bernard and Stober hypothesize that the relationship may be contextual with respect to firm-specific or macroeconomic characteristics. The current study examines partitions of the population of firm-quarter observations to determine whether the relationship between unexpected cash-flows and abnormal returns is affected by a firm-specific measure of financial distress. Evidence is provided that the association between unexpected cash-flows and abnormal returns is affected by the firm's level of financial distress. Financial distress is measured using the Ohlson [1980] model of probability of default within one year. The relationship between unexpected cash-flow and abnormal return is stronger for firms that exhibit high levels of financial distress. Wilson [1987] provides evidence of a statistically significant stock-price reaction to the release of firms' financial statements that is associated with unexpected cash-flow realizations. Because earnings (the sum of cash-flows and accruals) are known to investors through the usual earnings announcement prior to the release of financial statements, this finding suggests that cash-flow and accrual components of earnings are valued differently. 2 Bernard and Stober [1989] examined the robustness of the Wilson [1987] result. Their findings suggest that the relationship between unexpected cash-flow and abnormal returns is not robust across the population of all firms. 1 Bernard and Stober argue that, " it is not obvious that cash flows should be …