A finance student states, "I don't understand why anyone pays any attention to accounting earnings numbers, given that a ‘clean' number like cash from operations is readily available.". Do you agree? Why or why not?

Answer 1

There are several reasons why we should pay attention to accounting earnings numbers. First, net income predicts a company's future cash flow better than current cash flow does. Net income aids in predicting future cash flows by reporting transactions with cash consequences at the time when the transactions occur, rather than when the cash is received or paid. Net income is computed on the basis of expected, not necessarily actual, cash receipts and payments.
Second, net income is potentially informative when there is information asymmetry between corporate managers and outside investors. Note that corporate managers with superior information choose accounting methods and accrual estimates which determine the net income number. Because accrual accounting requires managers to record past events and to make forecasts of future effects of theses events, net income can be used to convey managers' superior information. For example, a company's decision to capitalize some portion of current expenditure, which increases today's net income, conveys potentially informative signals to outside investors about the company's ability to generate future cash flows to cover the capitalized costs.