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.