Earnings reported under IFRS improve the prediction of future Cash Flows? Evidence from European Banks

This paper examines the relative costs and benefits of International Financial Reporting Standards (IFRS) adoption in the European Union by testing the ability of earnings computed under IFRS to predict future cash flows. The study considers the contribution of net income, comprehensive income and other comprehensive income to the usefulness of earnings to predict cash flows, and it compares IFRS with domestic Generally Accepted Accounting Principles (GAAP). Evidence from a sample of Continental-European banks shows that IFRS improve the ability of net income to predict future cash flows. Comprehensive income, too, provides relevant information to predict future cash flows, although with a measurement error, which is higher than that in net income for greater lags of time. In our interpretation, these findings are consistent with unrealized gains and losses recognized in other comprehensive income being more transitory and volatile in nature. Overall, our results are relevant to academics and standard-setters debating the merits of IFRS adoption and to those who use financial statements and adopt reported earnings to form expectations about future cash flows.