Literature Review

The accounting information is crucial as the investors use to determine the investment
decision from the financial aspect in the capital market. This literature review study to the paper
“accrual reliability, earnings persistence, and stock prices” written by Richardson, et al. (2005)
states less reliable accruals result in lower earnings persistence will lead to the security mispricing.
The motivation of this chapter is to analyze the effect of accrual basis, earnings persistence and
cash flow to the shares price by studying the past research. Accounting information provides the
financial reports consist of income statement, retained earnings, statement of financial position,
and cash flow. Most of the companies recognize the revenues and expenses under the accrual basis
method. The reliable financial reports in accounting indicates the company has fulfilled the
standard of Accepted Accounting Principle (GAAP).

The purpose of accounting studies in the context of capital market is to investigate the
reaction of users when using financial report and accounting information towards the securities. In
addition, as with the financial researches in the Indonesian capital market, the study is also directed
to examine the adherence of developing theories in the context of advanced capital markets. The
development of capital market-based accounting research is inseparable from the development of
positive accounting theory initiated by Watts and Zimmerman (1986). Although there are pros and
cons, positive accounting theory has contributed greatly to knowledge of the capital market.

Accounting research on capital markets in developing countries occurs due to a reaction to

the inaction of accounting information in decision making when investing in securities. The tide
of Indonesia capital market development indicates the uniqueness of one of emerging market
character, that is developing as a consequence of growth or growth of economic activity. In other
words, this research makes the capital market a means of verifying that accounting information
has a function when making investment decisions. On the other hand, capital markets in developed
countries become more stable because of domestic investors who have many shares, so the lack of
bias on accounting information. Lev and Ohlson (1982) define capital market-based accounting
research as an attempt to find the relationship between published accounting information and the
consequences for the use of that information by its users. This definition puts accounting as an
information system that potentially influences investors' decisions when it comes to investing.
 Stock market-based accounting research developed in Indonesia in the mid-90s. In that
period, one of the issues that received attention was the publication of PSAK number 2 (two) on
the cash flow statement by the Indonesian Institute of Accountants (IAI). The rule was officially
enacted on 1 January 1995. If prior accounting research is more focused on profit, the enforcement
of this provision has led to the role of cash flow statements very important as a reference for
valuing securities for users of financial statements. Based on research from Baridwan (1997) on
value added cash flow information shows a high correlation between cash flow information with
profit information. Nevertheless, from the different test results identified the statistical differences
between the two. This indicates that cash flow information and earnings information do have
different functions. As a result, the public company must provide both information so that the users
are able to get the optimal benefits from the publication of accounting information.

Baridwan (1997) research results encourage the development of information content

research in the context of the capital market. One of the research that developed the idea of the
empirical findings is the study of Triyono and Hartono (2000). This study investigates the value
added cash flow information for investors in Indonesia capital market through the relationship
between cash flow information and earnings information with stock returns. This research
documented evidence in line with the findings of Baridwan (1997). Disaggregation of cash flows
into three components, among others, operations, investments, and financing turned out to be
related to stock returns. This indicates the added value of information on cash flow. In contrast,
this study found no relationship between earnings information and stock returns. According to
Kothari (2001), one of the problems in the relationship of earnings and stock prices is the price
lead earnings. This problem arises when stock prices are perceived to be more informative than
profit. In addition, accounting conservatism causes profit to be less informative.

One form of study on the issue is testing the theory of signaling to explain the phenomenon
of dividends in Indonesia. Sartono and Asih Studies (2002) generally find no data support for the
alleged validity of signaling theory in dividend policy in Indonesia. In the context of its origin,
dividend policy is used as a signal to indicate the company's financial condition. Meanwhile,
dividend practices in Indonesia have different conditions. Most of the dividend payout decisions
are the result of the General Meeting of Shareholders (GMS). Thus, dividends are no longer a
management signal, as they are the shareholders' demands. Therefore, the use of signaling theory
to explain dividend policy in Indonesia may not be appropriate, given the difference in dividend
payment decision mechanisms with the context used to build the concept of signaling itself.

The study of Efficient Market Hypothesis (EMH) has an important role in the development
of efficiency in the capital market in each country. There are three models of testing to prove the
efficient capital markets such as weak-form test, semi-strong form test, and strong-form test. Fama
(1991) states an “efficient” in the capital market operations when no one, both individual investors
and institutional investors will be able to obtain the abnormal return after adjusted with the risk
because of the availability of market information. In respond the efficient capital markets, the
semi-strong from testing is preferable rather than weak-form and strong-form testing. The
available information in the market is coming from the past information and public information.
The private information can be accessed only by big investors and close relationship with the
owner and management. The public companies only release the report that required by the capital
market regulator. The efficient price of securities occurs because of fully reflect to the available
markets information and react instantaneously to the new information.

Every investor expects the high return towards the portfolio of investment. Fama and
French (1992) define returns as a result of investment. Without the benefits of an investment that
he did, certainly investors will not make investments that have no results. Every investment, both
short-term and long term, has the primary goal of gaining a profit called return, either directly or
indirectly. According to Jogiyanto (2015) stock return can be divided into two types, namely
realized return and expected return. Return realization is a return that has occurred and calculated
based on historical data. Return realization can be used as one of the company's performance
measurement and can be used as a basis for determining future return on risk and expectation,
while expected return is expected return in the future and still uncertain. The difference between
the return realization with the return of this expectation which will become a benchmark investor
in assessing the achievement or rate of return that has been obtained from investment in a company.

I. Accrual Basis

In recognizing revenues and expenses, accrual-based accounting methods are more often
applied. IASC (2000) describes the accrual basis one of the basic accounting assumptions related
to the accounting process that affects the recognition of financial transactions in the period of
occurrence rather than just focusing on cash receipts or payments. Based on the accrual basis,
accounting information that includes the financial position and financial performance of a
company will be useful in decision making. Information about the earnings of a company based
on accrual basis has an indication of the company's ability to generate better current and future
cash flows than information that is limited to the financial aspects of cash receipts and
disbursements only.

Decisions and Dichev (2002) the amount of accrual is the amount of revenue recognized
when the business unity rights arise because of the delivery of goods to an outsider and the cost is
recognized when the obligation arises because of the use of economic resources attached to the
delivered goods. Accrual income is based on two accounting principles, namely revenue
recognition and matching principles. The income recognition principle requires the company to
recognize revenue when it has exercised all or one substantial portion of the services to be provided
and the cash receipt of the transaction is certain. The matching principle requires the company to
recognize all costs associated with revenue in the same period in which revenue is recognized.

II. Cash Flow

Kieso (2008) states that cash as the most liquid asset, is the standard and basic medium of
exchange and measurement basis and accounting for all other items. This cash flow statement will
provide information about the company's ability to generate cash from operating activities,
investing, paying off liabilities and paying dividends. Hery (2016) states that the main focus of
financial reporting is profit and information on profit which is a good indicator to determine or
assess the company's ability to generate cash in the future. However, a cash flow statement is still
needed because the profit rate does not reflect the actual company condition.

The cash flow statement can provide information that allows users to evaluate changes in
the company's financial structure. Dechow and Dichev (2002) The volatility of cash flows is the
degree of dispersion of cash flows or the distributing index of the company's cash flow distribution.
To measure the quality of earnings requires a stable cash flow information, in the sense of having
small volatility. If cash flow fluctuates sharply then it is very difficult to predict cash flows in the
future. The cash flow volatility indicates a different measure of the operating environment
volatility and larger deviations of usage approximations and estimates.

III. Earnings Persistence

 The information about earnings listed in the financial statements has a very important role
for the interested parties of the company. The definition of profit persistence according to Scott
(2009) is the revision of expected future earnings which is indicated by the earnings innovation of
the current year which is associated with changes in stock prices. Internal and external parties often
use profits as a basis for decision making such as bonuses of managers and employees, measuring
performance or achievement of management and the basis of determining the amount of tax to be
paid. The profits shown must be qualified, i.e. profits that can reflect sustainable earnings in the
future. According to Sloan (1996) earnings persistence is a measure that explains the ability of the
company to maintain the amount of current profits until one future period. Profit persistence is
often categorized as one measure of earnings quality because profit persistence contains predictive
value elements so that it can be used by users of financial statements to evaluate events in past,
present and future.

Earnings persistence and cash flow based on accruals lead to an accrual anomaly.
According to Elbert (2012) anomaly accrual is where the abnormal return on corporate with low
accrual practices higher compared to corporate with high accrual practices. The first accrual
anomaly was documented by Sloan in 1996. Sloan (1996) found that the predictability of stock
returns correlated with the persistent difference between the accrual component and the cash flow
of current earnings. Accruals show a faster return than cash flow and are negatively correlated with
future stock returns. It shows that low accruals will result in positive future returns. High accrual
rates lead to overprice of stock prices, while low accruals will lead to underprice. In the future,
high-risk stocks will experience a negative correction, and vice versa.

Accrual anomaly will impact on the emergence of abnormal return, then the measurement
of accrual anomaly can be seen from the abnormal return that occurs at a certain accrual level. The
abnormal return indicates how much market error in assessing information to predict future
earnings. According to Rowland (2009) the explanation of financial behavior theories about
accrual anomalies are high operational accruals described as standard deviations between earnings
and cash flow calculations. It raises an over-optimism about future earnings for naive investors as
it fails to pay attention separately to the cash flow and accrual components of earnings.

According to Sloan (1996) the market tends to put a high value on the company with high
accrual components and low cash flow. Sloan (1996) further proves that improper weighting is
given to the accruals component and the cash component will reflect market inefficiency. Prices
will be corrected in the future for high-quality accrual companies. As a result, the company's
earnings are not as large as predicted so that the stock price falls back. In addition, the low-
performing firms are more profitable than expected so that their stock price rises beyond
prediction. In other words, society gives an overweight weight on the accrual component.

Ball and Brown (1968) and Beaver (1968) tested the post announcement of stock return
behavior and tentatively concluded that market efficiency was a reasonable approximation of
empirical results. Current research has reexamined market efficiency and some have concluded
that capital markets are inefficient with respect to at least three areas including post-earnings
announcement drift, market to book ratios, and contextual accounting issues. Research in areas of
contextual accounting issues has tested market efficiency based on several key features of financial
reporting. Sloan (1996) study is an excellent example of exploiting accounting knowledge on one
of the financial reporting features of accrual accounting. Lee (1995) mentions that one branch of
research that extends previous research on the relationship of price-earnings is the area of cash
flow and accruals.

Bernstein (1993) in the paper of Sloan (1996) states that the accrual component of current
earnings tends to be less recurrent for future earnings periods because it is based on accruals,
deferred, allocations and assessments that have subjective distortions. Some analyzes prefer to link
operating cash flows as a check for the quality of income. There is also the notion that the accruals
and operating cash flows of current earnings have different implications for the assessment of
future earnings. Some of the earlier studies that focused on accruals and cash flow analysis were
Wilson (1987), Bernard and Stober (1989) and Sloan (1996). Wilson (1987) examines incremental
information content of accrual components and cash flow from earnings. The content of the
information is measured using regression and portfolio approach and the results indicate that the
total incremental accrual and cash flows from the operations together have an incremental
information content in earnings and there is a positive relationship between this component
information and stock return.

Based on Ball and Brown (1968) several studies have documented a positive contemporary
relationship between stock returns and earnings. This is generally attributed to earning ability to
summarize value relevant to information. Nevertheless, some studies provide evidence that
investors are not using correctly the information available in estimating future earnings
performance. Such evidence increases the likelihood that the relationship between earnings and
stock returns may reflect naive fixation by investors against reported earnings. Earnings
expectation according to Sloan (1996) can be used to reflect the overall persistence level in
earnings performance but hypothesized does not reflect the difference in persistence rates that can
be attributed to the accruals and earnings cash flow. The results of Sloan (1996) study indicate an
accrual pricing anomaly and the market tends to overestimate the persistence of the accrual
component of earnings.

Therefore, the accrual basis, earnings persistence and cash flow are the indicators of
accounting information that affect the price shares. The accrual component is the profit generated
from the accounting policy to recognize an economic transaction as profit without cash flow first.
Information on profit and book value is an accounting variable that is considered able to explain
the market value and stock price variability. In addition, probability of accounting information also
provides other information such as risk and investment management capabilities. The component
of cash flow earnings also affects investors in making investment decisions. Thus, then the
question arises whether the cash flow information, basic accruals, and profit persistence are really
having a crucial influence as an indicator of accounting information for investors to invest in the
Indonesian capital market.