IAS 7 and value relevance: the direct method versus the indirect method

Abstract

We identify and predict circumstances where the direct method statement of cash flows is expected to provide more value relevant information to financial statement users. We predict the direct method is more informative when earnings are of lower quality (earnings are less permanent or companies report losses), companies are in a more stable state (proxied by small absolute changes in accruals/operating cash flow), and when cash flows/accruals are measured with more error using the indirect method. Direct method disclosure is also predicted to be more useful for small companies, where investors have fewer alternative sources of information beyond financial statements. We analyze Australian companies because they are required to report the direct and indirect method, and we further decompose the sample into industrial, mining, and company size to account for unique features of the Australian market. Our results are consistent with our predictions. This suggests the indirect method is as informative as the direct method on average but the direct method incrementally informs stock returns in specific circumstances. We also identify operational factors that significantly increase estimation error when estimating direct method line items for cash receipts and cash payments.

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Notes

  1. 1.

    Australian listed companies could elect to apply IAS 7 beginning on or after January 2005 but before July 1, 2007.

  2. 2.

    Until 2011, Australian Accounting Standards Board (AASB) 107 required that Australian companies report a reconciliation of net income to operating cash flow in the notes to the accounts when they reported the direct method. This reconciliation is effectively the indirect method.

  3. 3.

    FASB board members were not in agreement when previously enacting the Statement of Financial Accounting Standards No. 95 in 1987. Two out of the seven board members dissented regarding the permitted use of the indirect method for preparing the operating activities section of the cash flow statement (FASB 1987).

  4. 4.

    IASB and FASB standards refer to the ability of market participants to estimate operating cash flow components using additional financial statement information (FASB 1987; IASB 2010).

  5. 5.

    Following Barth et al. (2001), we control for disaggregated accruals for all tests that compare the usefulness of the direct and indirect method.

  6. 6.

    Following Clinch et al. (2002), all tests in our study are completed separately for industrial (nonmining) and mining companies, and this includes any subsample testing. The informational role of operating cash flows is likely to differ for mining companies because exploratory activities create a greater lag in operating cash flows due to long horizon projects. In comparison to industrial companies, mining companies experience greater share price volatility, earnings volatility and report losses more frequently than Australian industrial companies (O’Shea et al. 2008).

  7. 7.

    Following Dickinson (2011), cash flow patterns are used to create subsamples based on a firm’s life cycle.

  8. 8.

    Discontinued operations are frequently considered a component of divestitures, although we distinguish between discontinued operations and divestitures. We define discontinued operations as the ceasing of a component or section of the business as opposed to a divestiture, which occurs when a firm divests a company asset.

  9. 9.

    Discontinued operations is frequently considered a component of divestitures, although we distinguish between discontinued operations and divestitures. For example, Hribar and Collins (2002) use discontinued operations as a proxy for divestitures because of data limitations in Compustat.

  10. 10.

    We use the absolute value for cash receipt error and change in accounts receivable in Eq. (6). All other variables in Eq. (6) are inherently positive.

  11. 11.

    We use absolute values for cash payment error and change in aggregate accruals; all other variables are inherently positive.

  12. 12.

    The frequency of losses reported in our sample of industrial companies is similar to U.S. industrial companies for the same period. From 2007 to 2017, U.S. industrial companies reported losses approximately 44 percent of the time, compared to 39 percent for Australian listed industrial companies.

  13. 13.

    We discuss medians for absolute annual changes in aggregate accruals and operating cash flow, because of the large variation in means reported for ABSCHGACC and ABSCHGOCF by Australian industrial companies.

  14. 14.

    Small U.S. and Australian industrial companies report losses more frequently and are more likely classified in the decline stage of their life cycle. U.S. industrial companies report similar associations between EARNPERM and company size to those identified in ASX listed companies. Moreover, U.S. industrial companies report a gradual decline in changes for ABSCHGACC and ABSCHGOCF as company size increases, consistent with Australian industrial companies.

  15. 15.

    We conduct pooled cross-sectional regressions, and this approach can result in time series dependence. Regressions are also completed using the Fama–MacBeth method with operating cash flow coefficients reporting qualitatively similar amounts to pooled cross-sectional regression coefficients for industrial companies.

  16. 16.

    We do not test mining companies with short operating cycles, because few mining companies report length of operating cycle in the Capital IQ database. Our total sample of mining companies includes 2,482 firm year observations and 1,495 of these observations report a zero balance for length of operating cycle.

  17. 17.

    To identify the 90 percent most accurate estimations for cash receipts and cash payments, we sort the sample based on the total error of each observation for cash receipts and cash payments. That is, we add the estimation error for cash receipts plus the estimation error for cash payments to calculate the total error for each firm year observation.

  18. 18.

    The high correlation results from a small proportion of loss companies reporting limited operating cash flow and therefore their earnings are predominantly made up of aggregate accruals.

  19. 19.

    Loss observations reported in our study for industrial and mining companies are consistent with the Australian market for the period from 2007 to 2017.

  20. 20.

    Orpurt and Zang (2009) report that the IS_IM method creates less estimation error than the IS_BM method. Their result is based on a 1 percent to 3 percent sample of U.S. companies with 437 observations for IS_IM and 470 observations for IS_BS. We also find in our sample that the IS_IM method creates less estimation error than the IS_BS method.

  21. 21.

    The median (mean) error for estimated cash receipts is 6.41 (12.90) percent.

  22. 22.

    The median (mean) error for estimated cash payments is 7.76 (12.87) percent.

  23. 23.

    For example, Clinch et al. (2002) and Orpurt and Zang (2009) evaluate the direct and indirect method using a cross-sectional approach.

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Kent, R., Birt, J. IAS 7 and value relevance: the direct method versus the indirect method. Rev Account Stud (2021). https://doi.org/10.1007/s11142-021-09584-x

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Keywords

  • Cash flows
  • Direct method
  • Indirect method
  • Value relevance

JEL classification

  • M41