Test of Functional Fixation Hypothesis; To Separate Accrual and Cash Flow Component of Earning

Abstract

This paper examines the functional fixation hypothesis from the viewpoint of separation of cash flows and accrual components of earnings by investors. The functional fixation hypothesis states that investors interpret earnings regardless of related accounting method. The accrual reversal phenomenon argues that accrual component has less persistence than cash component and accrual growth in current period leads to low returns in future. To test the hypothesis, data from 153 firms listed in TSE from 2003 to 2010 have been collected. The results reject the hypothesis, however, examination of the relation of unexpected changes in accruals and cash flows with current return shows that the rejection is due to different weight of news related to expected cash flows and market discount rate in accruals and cash flows.

Keywords

• functional fixation
• Accruals
• Cash flows
• unexperienced investor
• return of accrual components