Does the Presentation Format of the Statement of Cash Flows
Affect Analysts’ Cash Flow Forecast
Lijuan Zhao, Department of Accounting, College of Business and Economics,
California State University, Los Angeles, USA
ABSTRACT
There is a long-term debate over the direct method or indirect method to present the statement of
cash flows. Statement of Financial Accounting Standards No. 95 allows business to use either direct
method or indirect method to present the statement of cash flows and a small group of business is using
direct method. Compared to indirect method, direct method has been shown to provide incremental
information in predicting future cash flows. This study investigates whether the direct method is useful for
analysts’ cash flow forecast. This study finds that the analysts are more likely to issue the cash flow
forecast for the firms using direct method.
INTRODUCTION
Statement of Financial Accounting Standards No. 95 (SFAS 95) allows firms to use either direct
method (DM) or indirect method (IM) to present the statement of cash flows. However, in US, only a
small group of business is using DM. Therefore, the purpose of this study is to investigate whether the
format of the statement of cash flows has influence on analysts cash flow forecast.
Compared to IM, prior literature finds that DM is useful in predicting firms’ future earnings and
cash flows (Krishnan and Largay 2000; Orpurt and Zang 2009). AIMR (1993) argues that DM helps
analysts evaluate the firms’ performance. However, no empirical study examines this issue. In order to fill
the gap, this study investigates how the DM and IM influence analysts’ behaviors. This study predicts that
the analysts will be more likely to issue cash flow forecasts for DM firms.
This study is motivated by the on-going debate in various standards setting jurisdictions concerning
the most appropriate method to prepare the statement of cash flows, especially regarding the usefulness of
the operating cash flow information disclosed by DM and IM. DM reports the cash receipts and cash
payments from operating activities and the difference between these two amounts is the net cash flow
from operating activities. While the IM starts with net income and converts it to net cash flow from
operating activities by adjusting the non-cash items. IM actually explains why the net cash flows from
operating activities are different from net income. Financial Accounting Standards Board (FASB) and
International Accounting Standards Board (IASB) allow both methods but highly recommend the DM
(FASB 1987; IASC 1992). A joint research project was initiated in 2005 by FASB and IASB, which
identified that the DM statement of cash flows as an important, pertinent and timely research topic to
standard setters. In addition, financial analysts also show the preference to the DM. Association for
Investment Management and Research (AIMR) issued a report in 1993 and indicated that DM will help
analysts evaluate firms’ financial conditions (AIMR 1993).
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HYPOTHESIS DEVELOPMENT
There is a long-term debate over the benefits and costs of DM disclosures and IM disclosures. In
October 16, 2008, FASB and ISAB issued a joint discussion paper titled “Preliminary Views on Financial
Statement Presentation”. The purpose of the discussion paper is to seek the comments on whether the
financial statement presentation format proposed improve the usefulness of information provided by
business and help users make decisions. The discussion paper indicates that an entity should disclose the
cash receipts and payments from the operating activities (DM), rather than just adjusting net income
(losses) to the net operating cash flows (IM). DM is more consistent with the proposed purpose of the
presentation format of financial statements than IM. They also state that “Presenting cash receipt and cash
payment line items in the operating category provides a more useful disaggregation of cash flow
information. In addition, a direct method presentation helps users relate information about operating
assets and liabilities and operating income and expenses to operating cash receipts and payments” (FASB
2008, paragraph S12).
In this section, this study summarizes the advantages and disadvantages of DM and IM.
(1) DM
The proponents of DM disclosure method claim that DM provides incremental information of
predicting future cash flows and also improves the comparative ability of individual component of cash
receipts and cash payments across similar firms over times (Krishnan and Largay 2000; Orpurt and Zang
2009; Richardson 1991). In addition, DM is more consistent with the purpose of cash flow statement that
provides relevant information about the cash receipts and cash payments of an enterprise during a period
(SFAS 95, para 4). The DM information is valuable to evaluate firms’ ability to generate future cash flows,
to meet dividend and debt obligations, which assists investors and creditors access the liquidity, financial
flexibility and solvency of an entity. However, DM has been criticized to be more costly to implement.
(2) IM
IM explains why the net cash flows from operating activities are different from net income; it is less
costly and more convenient to implement. However, the IM format has been criticized to confuse users.
IM links the cash flows from operating activities to the results in accrual accounting income statements.
The CFA Institute claimed that even a skilled analyst cannot reconstruct DM items based on the
information provided by IM (CFA-Institute 2007), which indicate that computing the DM components is
not a simply mechanically work. Various studies also provide evidences that DM items cannot be
accurately reconstructed by the information disclosed by IM.
Drtina and Largay Iii (1985) demonstrate that cash flows from operations (CFO) calculated by IM
cannot be accurately converted to the actual cash flows. Bahnson et al. (1996) examine 9,757 public
financial statements from COMPUSTAT and find that there is an unexpected difference between
expected CFO and actual amounts presented in the statement of cash flows. Different with Drtina and
Largay Iii (1985) and Bahnson et al. (1996), Krishnan and Largay (2000) examine the usefulness of
DM. They use the NAARS database to search firms that use DM from 1988 to 1993. Using 405 firm-year
observations to examine the DM components from balance sheet and income statement information, they
find that the articulation errors1 exist in U.S. firms.
1
Articulation errors are the difference between direct method components and the estimations for the same components based on
indirect method with balance sheet or income statement (Orpurt and Zang 2009).
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The Journal of International Management Studies, Volume 8 Number 2, August, 2013
Orpurt and Zang (2009) give an example to show that the DM items cannot be reliably estimated
from the IM and income statement or IM and balance sheet. Orpurt and Zang (2009) was the first paper
to include these articulation errors in their model and show that this articulation errors do incorporate
information that improve the predictions of future operating cash flows.
Some studies claim that DM is useful in predicting future cash flows, lowering costs of capital or
increasing stock price. For instance, Krishnan and Largay (2000) compare the forecast errors by DM
and IM prediction models when forecasting one-period-ahead CFO. They find that DM produces smaller
forecast errors than IM. Miller and Bahnson (2002) employ case studies to indicate that DM provides
better information to investors, creditors and managers.
In summary, all the above studies provide evidence that DM components cannot be accurately
converted from IM and DM information enhances the predictive ability of future cash flows. However,
none of these studies provide empirical evidence about whether the DM information is useful for analysts
cash flow forecast. Therefore, this study is expecting that analysts will be more likely to issue cash flow
forecast for firms with DM disclosure.
Hypothesis: Analysts are more likely to forecast cash flows for firms using DM.
SAMPLE SELECTION
This study collects the sample of firms choosing DM in Lexis/Nexis from 1989 through 2009. This
study uses the following key words to search in the database to identify the firms that use DM:
-Direct method
-Cash collected from customers
-Cash collection from customers
-Cash received from customers
-Cash receipts from customers
-Cash paid to suppliers
-Cash payments to supplier
-Cash paid for interest
-Cash paid for tax
After searching in Lexis/Nexis, this study firstly find that 548 firms use DM over the fiscal years
1989 through 2009. Due to the data constrains on COMPUSTAT, 208 firms were eliminated. In addition,
financial and utility firms with SIC codes between 6,000 and 6,999 and between 4,900 and 4,999 were
excluded from the sample. Therefore, the final full sample consists of 217 DM firms from 1989 to 2009.
Table 1 summarizes the sample selection.
Table 1:Descriptive Analysis of Firms using DM
Fiscal Year
1989
1990
1991
1992
1993
1994
1995
Panel A: Distribution of DM Firms by Year
Number of firms using DM
Proportion of firms using DM
113
4.59
117
4.75
122
4.96
130
5.28
139
5.65
143
5.81
152
6.18
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51
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Total
Fiscal Year
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Total
149
153
144
138
126
118
106
95
96
90
88
83
80
79
2461
6.05
6.22
5.85
5.61
5.12
4.79
4.31
3.86
3.90
3.66
3.58
3.37
3.25
3.21
100
Panel B: Distribution of IM firms by year
Number of firms using IM
Proportion of firms using IM
6445
4.25
6475
4.26
6611
4.35
7005
4.61
7363
4.85
7675
5.06
8498
5.60
8691
5.72
8497
5.60
8714
5.74
8664
5.71
8235
5.42
7679
5.06
7274
4.79
6987
4.60
6785
4.47
6574
4.33
6320
4.16
6014
3.96
5835
3.84
5480
3.61
151821
100
The total IM sample includes 18,716 firm-year observations over the sample period. Panel B of
Table 2 presents the frequency and proportion of IM firms. In addition, actual cash flow value and
forecasted cash flow value are obtained from IBES.
EMPIRICAL RESULTS
Analysts’ cash flow forecast are available after 1993, after merging with the IBES database and
deleting all missing data, the final sample used in Table 2 is 909 observations.
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Table 2: Comparison of Analysts’ Cash Forecast Frequency between DM and IM Firms
DM
IM
Difference
Mean
Mean
T-test P-Value
Cash flow forecast
0.3386
0.3120
0.0105**
** represents statistical significance at the 5% level.
In summary, the results support the hypothesis that analysts will be more likely to issue cash flow
forecasts for DM firms
CONCLUSION
IAS 7 and SFAS 95 recommend firms use DM to present the statement of cash flows, however, DM
information is more useful in forecasting future cash flows. This study finds that the analysts will be more
likely to forecast future cash flows for firms using DM. These results are consistent with prior literature
that DM provides more useful information than IM in predicting future cash flows (Krishnan and Largay
2000; Cheng and Hollie 2008; Orpurt and Zang 2009).
REFERENCES
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research and practice. Accounting Horizons 10 (4):1-15.
CFA-Institute. (2007). A comprehensive business reporting model: financial reporting for investors. Charlottesville, VA: CFA
Institute.
Cheng, C., and D. Hollie. (2008). Do core and non-core cash flows from operations persist differentially in predicting future cash
flows? Review of Quantitative Finance & Accounting 31:29-53.
Drtina, R. H., and J. A. Largay Iii. (1985). Pitfalls in calculating cash flow from operations. Accounting Review 60 (2):314-326.
FASB. (1987). Statement of financial accounting standards No. 95. Norwalk, Connecticut: Financial Accounting Standards Board.
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IASC. (1992). International Accounting Standard 7. London, UK: International Accounting Standards Committee.
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information financial statement users want. Strategic Finance:51-57.
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