Cash Flow Disclosure Research Articles

Free Cash Flow Disclosure in Earnings Announcements

ABSTRACT More companies are disclosing free cash flow in their earnings announcements. Companies choose a range of definitions, almost none of which correspond to the theoretical finance definition. The most common definition (in 40 percent of free cash flow disclosures) is operating cash flow minus gross capital expenditures. From discussions with managers, this definition is chosen largely to keep things simple, especially given the lack of time to explain subtle complexities to investors. There is evidence of both opportunistic and information motives in the choice to disclose. Information variables, such as capital intensity and low-quality earnings, explain at least as much of the disclosure decision as opportunism variables in all estimations. Opportunism is relatively more evident within initial disclosures, which are more likely when earnings decline and free cash flow is positive or increasing.

Stock compensation expense, cash flows, and inflated valuations

This paper reviews the statement of cash flow implications of stock compensation expense and the effect it can have on valuations. The paper suggests that treating stock compensation as a noncash item in the statement of cash flows can be misleading from internal decision-making and external valuation perspectives. This is important, given the increasing role of non-GAAP cash flow disclosures in financial reporting as well as their use internally by managers. The paper quantifies the potential size of the problem and suggests potential solutions, including treating stock compensation expense as an operating cash outflow and a financing cash inflow, adding further descriptive disclosures to the financial statements, or both. Finally, the paper also highlights a similar issue that occurs with the cash flow implications of finance leases.

Formation of information on cash flows for the purpose of investment decisions

Importance. The article explores the usefulness of cash flow information disclosed in financial and corporate reports and its relevance to the information needs of the investment community. The analytical capabilities of financial reporting for forecasting and financial modeling purposes are limited by the insufficient completeness of disclosures necessary for the development of forecast models. Along with financial reporting indicators, investors, analysts and companies themselves are actively using alternative indicators of cash flows or non-GAAP indicators. The variety of approaches to the determination of non-GAAP indicators reduces the reliability of the investment analysis, on the one hand, and creates conditions for data manipulation, on the other. Objectives. A comprehensive author's study of the forming reliable information about the business ability to create cash flows in the interest of making investment decisions. Methods. In the research process, we used the methods of logical, statistical, comparative, as well as linguistic analysis. As the main objects of comparative analysis, we considered indicators of profit indicators before interest, taxes and depreciation, free cash flow, net debt and their ratios. In order to characterize the significance of these indicators for assessing the investment attractiveness of issuers, we provided the analysis of the metallurgical companies` dividend policy and its connection with considering metrics. Results. The results of the study include recommendations on the cash flow disclosure in order to increase the validity of investment decisions. We focused on those aspects of cash flow disclosures that could significantly affect the investment assessment. Conclusions and Relevance. The study showed that the methodology for the formation of cash flow indicators in the organizations is affected by different factors. In order to provide information for cash flow forecast and modelling, reporting companies should disclose data on strategies, business models, sources of cash flows and directions of their use. Non-GAAP indicators` disclosure should be based on the same principles that apply in preparing financial statements. All material adjustments carried out with the calculation of the non-GAAP indicators should be presented to users.

The effects of operating cash flow disclosure on earnings comparability, analysts' forecasts, and firms’ investment decisions during the Pre-IFRS era

We examine the effects of the availability of operating cash flow (OCF) information disclosed by firms operating in 15 international countries during the pre-IFRS era on: (1) the comparability of these firms' disaggregated earnings to those of U.S. firms for equity valuation purposes, (2) the properties of analysts' earnings forecasts, and (3) the efficiency of firms' investment decisions. We find that the comparability of disaggregated earnings improves after company-disclosed OCF information is available. We also find decreases in analysts' forecast errors and dispersion and a decrease in firms’ tendency to over- or under-invest when they are predisposed to do so.

Stock Compensation Expense, Cash Flows and Inflated Valuations

This paper reviews the statement of cash flow implications of stock compensation expense and the effect it can have on valuations. The paper suggests that treating stock compensation as a non-cash item in the statement of cash flows can be misleading from internal decision making and external valuation perspectives. This is important given the increasing role of non-GAAP cash flow disclosures in financial reporting as well as their use internally by managers. It quantifies the potential size of the problem and suggests potential solutions including treating stock compensation expense as an operating cash outflow and a financing cash inflow and/or adding further descriptive disclosures to the financial statements. Finally, the paper also highlights a similar issue that occurs with the cash flow implications of finance leases.

Developing the analytical procedures to identify risks of material misstatement in cash flow disclosures

Developing the analytical procedures to identify risks of material misstatement in cash flow disclosures

The importance of cash flow disclosure and cost of capital

AbstractWe examine whether the choice of cash flow disclosure under International Accounting Standard 7 has an influence on the cost of capital incurred by Australian listed companies. Results indicate that indirect method companies incur a significantly higher ex‐ante cost of equity than direct method companies using a combined equity model approach. We also demonstrate that using an optimal weighted combination of equity models reduces model variance and bias compared to using a single equity model. Our findings support mandating the direct method and have the potential to induce companies to report the direct method to increase company value.

Free Cash Flow Disclosure in Earnings Announcements

More companies are disclosing free cash flow in their earnings announcements. Companies choose a range of definitions for disclosed free cash flow, none of which correspond to the theoretical definition. The most common definition (in 38% of free cash flow disclosures) is operating cash flow minus capital expenditures. We provide evidence that opportunistic motives are a factor affecting the disclosure decision, especially for initial disclosures; initial disclosure is more likely when earnings decline and free cash flow increases. However, disclosure is more strongly associated with our proxies for information; firms are more likely to disclose when we expect free cash flow to be a more useful metric such as when the firm is capital intensive and when earnings do a poorer job of communicating performance. Conditional on disclosure, individual adjustments are also related to several of our proxies for information. Our overall conclusion is that, although there is some evidence of opportunism, free cash flow disclosure is primarily driven by the goal of providing better information to investors.

The Relevance of Tax Cash Flow and Tax Expense

Empirical evidence on the relevance of cash flows and accruals, and changes in relevance over time is mixed. We extend this literature by examining the relevance of tax cash flow and tax expense. Income taxes offer a strong setting to study relevance because firms report both an accrual-based and cash flow-based measure of tax. We find the incremental predictive power of current-period tax cash flow for future tax cash flow is greater than that of current-period tax expense for future tax cash flow. Tax cash flow also dominates tax expense in explaining returns. Together, these results suggest tax cash flow is more relevant than tax expense. Our study extends the value relevance literature by demonstrating that specific accruals behave differently than aggregate accruals. Our study also informs the FASB’s decision about whether to require increased tax cash flow disclosure.

Audit risk and articulation errors from different cash flow disclosures: evidence from China

We investigate the effects of articulation errors on audit opinions and fees, and moderating effects of the auditor size and different litigation regimes on the relationships between articulation errors on audit opinions and fees in China. We find that auditors are more likely to issue modified audit opinions (MAOs) and charge higher audit fees from their clients with higher absolute articulation errors, especially for big auditors and in high litigation risk regime. We also find that auditors who do not issue MAOs to clients with abnormal articulation errors receive higher fees than auditors who do issue MAOs.

Dynamic Effects of Information Disclosure on Investment Efficiency

This paper studies how information disclosure affects investment efficiency and investor welfare in a dynamic setting in which a firm makes sequential investments to adjust its capital stock over time. We show that the effects of accounting disclosures on investment efficiency and investor welfare crucially depend on whether such disclosures convey information about the firm's future capital stock (i.e., balance sheet) or about its future operating cash flows (i.e., earnings). Specifically, investment efficiency and investor welfare unambiguously increase in the precision of disclosures that convey information about the future capital stock, since such disclosures mitigate the current owners' incentives to underinvest. In contrast, when accounting reports provide information about future cash flows, the firm can have incentives to either under- or overinvest depending on the precision of accounting reports and the expected growth in demand. For such disclosures, investment efficiency and investor welfare are maximized by an intermediate level of precision. The two types of accounting disclosures act as substitutes in that the precision of capital stock disclosures that maximizes investment efficiency (and investor welfare) decreases as cash flow disclosures become more informative and vice versa.

Limited attention, statement of cash flow disclosure, and the valuation of accruals

We test for the effect of limited attention on the valuation of accruals by comparing the immediate and long-term market reactions to earnings announcements between a subsample of firms that disclose only the balance sheet with a subsample of firms that disclose both the balance sheet and the statement of cash flows (SCF) in the earnings press release. Information about accruals generally can be inferred from comparative balance sheets, but the availability of the SCF makes accruals more salient and easier to process for investors with limited attention. Controlling for potential additional information and endogeneity of SCF disclosure, we find strong evidence that SCF disclosure enables more efficient pricing of accruals. Further analyses using a proxy for investor sophistication suggest that when SCF is absent from the earnings press release, less sophisticated investors fail to discount accruals but sophisticated investors do.

Do voluntary cash flow disclosures and forecasts matter to value of the firms?

Purpose – Two stylized facts emerge from cash flow literature. One explores the link between free cash flow (FCF) to firm value (Jensen, 1986) and establishes that FCF increases firm value. The other posits FCF may be value decreasing as firms tend to over invest when there is high level of FCF (Richardson, 2006). Two camps have opposing views yet together they establish that FCF is value relevant. If FCF or cash flow, in general, is value relevant then managers will be motivated to present forecasts to investors. The paper aims to discuss these issues. Design/methodology/approach – The authors hand collect data from each firm’s press releases and earnings announcements and perform an event study around this date to see how firm forecast and disclosure policies affect firm value. Findings – The analysis demonstrates that disclosures and forecasts do have significantly positive relation with tech firms suggesting that firms in the technology industries are more forthcoming with cash flow disclosures and forecasts in their earnings announcements. The authors further show that these disclosures and forecasts negatively affect the firm value of tech firms. Originality/value – This paper contributes to the literature that there is empirical evidence that cash flow disclosures and forecasts matter to the value of the firm. Further, it posits that unlike understanding the existing views as opposing each other, may be the authors will be better served if they view both of them as right depending on the optimality of forecasts. The future efforts will be directed toward exploring the optimality of cash flow disclosures.

Limited Attention, Statement of Cash Flow Disclosure, and the Valuation of Accruals

Limited Attention, Statement of Cash Flow Disclosure, and the Valuation of Accruals

Do Analysts Use Their Cash Flows Forecasts When Setting Target Prices?

This study examines whether analysts’ decisions to issue cash flows forecasts depend endogenously on their decision to use these forecasts to set target prices. An endogenous switching regression model, with analyst report regimes of disclosure and non-disclosure of cash flow forecasts, shows that cash flow revisions are more important than earnings revisions in explaining the magnitude of target price revisions in the cash flow disclosure regime. Cash flow forecasts influence and are influenced by analyst valuation choices. Additional analysis shows that cash flow-based pseudo-target prices play a greater role in explaining target price implied returns than do earnings-based pseudo-target prices. These findings provide insights into analysts’ valuation decision processes.

Australasian cash flow reporting regulation: value relevant?

PurposeThis paper provides empirical support for the introduction of cash flow disclosure regulation issued by Australasian accounting bodies, AASB and NZICA (formerly NZSA), between 1987 and 1992.Design/methodology/approachThe empirical analysis uses a long window event study format on a panel of 5,368 firm‐year observations between 1996 and 2005.FindingsThe cash flow disclosures required in the regulation are associated with significant abnormal return responses. These effects are robust to the inclusion of other factors linked to abnormal returns such as movements in profitability, size and leverage. We also find support for the proposition that the cash flow effects are conditioned on the quality of the firm, as proxied by q. The market is better and more easily informed with the information required under the revised reporting regime.Research limitations/implicationsThe analysis would have been improved with better access to pre‐reform period data.Originality/valueThere is no other study on Australasian markets which looks at the value impacts of cash flow information in relation to this regulatory change. Such a study has also never been done on New Zealand companies.

Do Direct Cash Flow Disclosures Help Predict Future Operating Cash Flows and Earnings?

ABSTRACT: Motivated by recent FASB, IASB, and CFA Institute comments, we explore the predictive value of direct method cash flow disclosures. A primary stated purpose of the direct method is to better forecast future performance. To examine this purpose, we first document that direct method line items, such as cash received from customers, are not reliably estimable using income statements and either balance sheets or indirect method statements of cash flows. When these stimation (articulation) errors are included in cash flows and earnings forecasting models, forecasting performance significantly improves. In addition, employing a future ERC (FERC) methodology, we find evidence suggesting that market participants utilize direct method disclosures for their stated purpose: to better forecast future operating performance. After conducting several tests for self-selection concerns, we conclude that the direct method is valuable to investors when forecasting future cash flows and earnings.

Evidence on the Usefulness of Components of Cash Flows from Operating Activities in Predicting Future Cash Flows

This paper investigates the relevance of the actual components of Cash Flows from Operating Activities (CFO) in predicting future CFO. We find evidence that receipts from customers and payments to suppliers have incremental information content (relative to aggregate CFO) in predicting CFO. Further, utilising the disclosure of both interest received and interest paid (rather than the net interest paid or received) we find that a models incorporating both variables provide incremental information for cash flow prediction. These results remain robust after controlling for accruals information. Consistent with Dechow (1994) further tests show variation in company's operating cycles affects the predictive ability of cash flow components and also substantially enhance the explanatory power of the model when current CFO alone performs poorly as a predictor for future cash flow. These results have potential relevance to investors' concerned with estimates of future CFO and regulators current deliberations on cash flow disclosure.

Disclosure requirements and voluntarily reporting of cash flow information in Greece

Purpose – To review the disclosure requirements for cash flow reporting in Greece and the willingness of Greek companies to voluntarily disclose cash flow information. Design/methodology/approach – The empirical research was conducted on a sample of 97 Greek firms listed in the Athens Stock Exchange by examining the relation between cash flows and other measures of profitability for year 1994 when IAS No. 7 was set in effect. Findings – The results show that despite the fact that cash flows are more informative than an accruals definition of profits, in deciding about financial policy issues Greek companies show an increased preference to funds flows defined in terms of working capital. Practical implications – The publication of a cash flow statement may reveal that many listed companies in Greece are not as robust as the balance sheet and the income statement potentially indicates. Thus, the main conclusion of the paper is that publication of the cash flow statement in Greece should become mandatory. Originality/value – The present study shows that, despite the desire of the regulatory authorities that investors receive adequate and relevant information, voluntarily cash flow disclosure is not apparent in Greece because cash flows reveal financial problems that other measures of performance do not. Thus, it provides directions for standard setters in making mandatory the publication of cash flow statement in Greece.

The Impact of Mandated Cash Flow Disclosure on Bid‐Ask Spreads

Abstract: This study provides evidence that mandatory cash flow disclosure required by Approved Australian Accounting Standard AASB 1026, Statement of Cash Flows(June 1992) was associated with a decline in bid‐ask spreads following the introduction of the regulation, even after controlling for changes in trading volume and price volatility. More pronounced decreases in bid‐ask spreads were associated with firms having lower correlations between reported CFO and estimates of CFO using balance sheet reconstructions. We conclude that mandatory cash flow disclosure reduces information asymmetry across market participants.