Predicting Operating Cash Flows and Earnings Using the Direct Method Compared to the Indirect Method Statement of Cash Flows

Abstract

This study assesses whether the direct method incrementally predicts future operating cash flow and earnings beyond the indirect method. Using a sample of Australian listed companies reporting under International Accounting Standards, results indicate that the direct method predicts future operating cash flows with greater accuracy than the indirect method. Direct method disclosure is incrementally useful for predicting earnings when companies experience low earnings permanence. Findings show that users cannot re-create or estimate direct method line items accurately with mean absolute percentage errors above 3 percent outside the upper 25th percentile for cash receipts from customer and cash payments to suppliers. In fact, estimated direct method line items provide less predictive accuracy for earnings and operating cash flow than an aggregate operating cash flow measure, after controlling for accruals. This result also holds after I truncate estimation errors for direct method disclosures to the upper 90th and 75th percentiles.