The informational impacts of Australian listed companies reporting the direct or indirect method statement of cash flows: cash flow disclosure

Abstract

This thesis examines whether cash flow disclosure under International Accounting Standard (IAS) 7 has an influence on the degree of information asymmetry incurred by market participants. We evaluate the impact of cash flow disclosure for ASX (Australian Securities Exchange) listed companies and its association with value relevance, prediction of future cash flows, earnings and cost of capital. The following three essays in this thesis demonstrate that the type of cash flow disclosure reported by ASX listed companies can change the amount of information asymmetry experienced by investors. Essay 1 examines cash flow disclosure under IAS 7 for ASX listed companies from 2007 to 2014 to assess the value relevance of disclosing the direct or indirect method statement of cash flows. Evidence suggests that Australian investors are at an information advantage when companies report the direct method statement of cash flows. We find that direct operating cash flow components have a higher association with a company’s share price compared to the indirect method. Essay 1 also demonstrates that reported operating cash flow components provide a stronger valuation signal than estimated operating cash flow components. Direct operating cash flow components are incrementally useful for companies with positive net income and operating cash flows, high growth, high market leverage and industry leverage. Moreover, the direct method has a higher association with a company’s share price for large companies and companies with above average length operating cycles. Essay 2 evaluates whether the choice of cash flow disclosure under International Financial Reporting Standards (IFRS) 7 influences the ability of market participants to predict the operating cash flow and earnings of following years. Using Australian listed companies from 2007 to 2014 our results indicate that users can predict future operating cash flows and earnings more accurately using the direct method statement of cash flows. Essay 2 also demonstrates that operating cash flow is a more accurate measure for predicting future operating cash flows and earnings compared to estimated operating cash flow components. This result implies there is no benefit to investors for estimating operating cash flow components. Direct operating cash flow components also forecast operating cash flows more accurately for companies with transient earnings. Similarly, the direct method predicts earnings and operating cash flows more accurately for companies with moderate cash flows and transient earnings. Essay 3 examines whether the choice of cash flow disclosure under IAS 7 has an influence on the cost of capital incurred by ASX listed companies. A matched pairs sample is created using replacement to assess whether cost of debt or equity is associated with cash flow disclosure. Companies reporting the indirect method on average pay a higher cost of debt by 100 basis points although this result is not significantly different from companies reporting the direct method. Company size and interest coverage are both significant at a 1 per cent level in explaining the cost of debt. Return on assets (ROA) and leverage are also significant at the 10 per cent level for cost of debt. Cost of equity is examined using the Capital Asset Pricing Model (CAPM) with no evidence to suggest that cash flow disclosure is associated with a company’s cost of equity. Overall, Essay 3 demonstrates that the cost of capital incurred by ASX listed companies is not related to their choice of cash flow disclosure.