Direct Cash Flow Research Articles

Further Evidence on the Usefulness of Direct Method Cash Flow Components for Forecasting Future Cash Flows

Based on pre-IFRS data from Australia, we provide further evidence that disaggregating operating cash flow into its components enhances the predictive ability of aggregate operating cash flow in forecasting future cash flows. We also find that cash received from customers and cash paid to suppliers and employees complement each other in enhancing the overall predictive ability of cash flow components. The results are robust to a battery of sensitivity tests, including control for industry membership, firm size, profitability, negative cash flows, and the length of the operating cash cycle. Our results contribute to the policy debate as to whether reporting of the direct method cash flow statement should be mandatory.

Further evidence on the usefulness of cash flow components for forecasting future cash flows

Based on within-sample and out-of-sample tests on 348 listed Australian companies over 1992–2004, we find that direct method cash flow components have greater predictive ability than for aggregate operating cash flows of future cash flows. Unlike prior research, we use actual direct method cash flow data instead of estimated data in our forecasting models. The results are robust to a battery of sensitivity tests, including control for firm size, industry membership, profitability, negative cash flows, and the length of the operating cash cycle. Moreover, our results remain qualitatively similar for forecast horizons up to six years. Our findings directly contribute to the policy debate on whether standard setters should mandate direct method cash flow statements.

Cash Flows at Amazon.com

ABSTRACT:This instructional case illustrates how Amazon.com's strategy has evolved over time and how these characteristics are reflected in the financial statements. A particular emphasis is placed on the cash flow statement. Students evaluate the cash flow statement and examine its articulation with the other financial statements. Students create a direct method cash flow statement in the year of Amazon.com's initial public offering using the information available in the financial statements.

A Review of Academic Research on the Reporting of Cash Flows from Operations

We provide a comprehensive review of academic research related to direct method cash flow presentation. While many financial statement users have stated a preference for the direct method, few accounting standard setters around the world have required it, and, given a choice, most entities present operating cash flows using the indirect method. Our review indicates that academic research has generally found direct method cash flow information to be decision useful. Also, research finds that direct method information is reflected in stock prices indicating that users appear to utilize this information when available. However, there are, as of yet, no studies detailing how this information makes its way into stock prices. Finally, the evidence we review suggests that direct method information is economically significant and that the recurring benefits than many firms derive from providing direct method information likely exceed recurring costs. Our review should be of interest to academics researching cash flow reporting and also to policy makers as they continue debating the merits of the direct method presentation of operating cash flows.

Direct or Indirect Cash Flow Statements?

The Australian Accounting Standards Board (AASB) and the Financial Reporting Standards Board (FRSB) have issued a joint proposal that will allow reporting entities to choose between the direct and indirect method of reporting cash flow statements. This evidence presented in this paper indicates that the direct cash flow reporting format, relative to the indirect method, leads to better prediction of future firm performance and has a stronger association with share prices. The AASB and the FRSB have to decide whether to support high quality reporting or harmonisation.

A Note on Willingness to Spend and Customer Lifetime Value for Firms with Limited Capacity

The paper draws a distinction between customer lifetime value (CLV) and willingness to spend (WTS). By WTS we mean the maximum amount the firm should be willing to spend to acquire (retain) the customer relationship. In order to avoid the double counting of cash flows when summing the CLVs of customers, we suggest including only direct cash flows in the formulation of CLV. This convention means that CLV will equal WTS if (and, for the most part, only if) the firm's relationships with customers are independent. By independent we mean that the acquisition (retention) of Jane Doe has no effect on the cash flows of any other current or future customers. In contrast to well-understood demand-side dependencies among customer relationships (such as referrals), this paper highlights a particular kind of supply-side dependency—that created when the firm is limited in the number of customers it can serve. Using an extended version of the model of Blattberg and Deighton (“Manage Marketing by the Customer Equity Test,” Harvard Business Review, July–August 1996, 136–144) of customer equity, we demonstrate that, for a firm at capacity (in this model), CLV is no longer relevant to marketing spending decisions and the firm can prefer a lower-CLV customer.

Discretionary accruals and the predictive ability of earnings in the forecast of future cash flows: Evidence from Australia

We examine whether discretionary and non-discretionary accruals improve the predictive ability of earnings for forecasting future cash flows in an Australian context. Using both within-sample and out-of-sample forecasting tests; we demonstrate that discretionary accruals improve the predictive ability of earnings in the forecast of future cash flows. Further, discretionary and non-discretionary accruals and direct method cash flow components together are more useful than (i) aggregate earnings, (ii) aggregate cash flow from operations and total accruals, and (iii) aggregate cash flow from operations, discretionary accruals and nondiscretionary accruals.

Stochastic interest rates in the analysis of energy investments: Implications on economic performance and sustainability

A systematic impact assessment of stochastic interest and inflation rates on the analysis of energy investments is presented. A real-options algorithm has been created for this task. Constant interest rates incorporating high risk premium have been extensively used for economic calculations, within the framework of traditional direct cash flow methods, thus favouring immediate, irreversible investments in the expense of, sometimes, insubstantially low anticipated yields. In this article, not only incomes and expenses but also interest and inflation rates are considered stochastically evolving according to specific probabilistic models. The numerical experiments indicated that the stochastic interest rate forecasts fluctuate in such low levels that may signal delayed investment entry in favour of higher expected yields. The implementation of stochastically evolving interest rates in energy investment analysis may have a controversial effect on sustainability. Displacements of inefficient plants may be significantly delayed, thus prolonging high CO2 emission rates. Under the current CO2 allowance prices or their medium-term forecasts, this situation may not be improved and flexible policy interventions may be necessitated.

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.

What Drives Stock Price Movement?

A central issue in asset pricing is whether stock prices move because of revisions of expected future cash flows or expected discount rates, and by how much of each. Using direct cash flow forecasts, we show that there is a significant component of cash flow news in stock returns, and its importance compared to discount rate news increases with the investment horizon. For horizons over two years, cash flow news is more important than discount rate news. These conclusions hold at both the firm and aggregate levels, and diversification plays only a secondary role in affecting the relative importance of cash flow and discount rate news. Overall, the findings demonstrate the importance of cash flow in asset pricing.

Do the Components of Cash Flow and Accruals Enhance the Forecast of Future Cash Flows? Australian Evidence

This paper investigates the role of operating cash flow components and accrual components in forecasting future cash flows. Based on a sample of 348 Australian firms over 1992-2004 (4,520 firm-years), we find that cash flow components, reported under the direct method, enhance the predictive ability of cash flow from operations. We also find accrual components provide incremental predictive ability beyond that provided by the direct cash flow data. Further, disaggregating earnings into the components of both cash flow and accruals enhances the ability of earnings to forecast future cash flows. These results are robust to several control factors, including the length of the operating cash cycle, industry membership, firm profitability and firm size.

The Predictive Ability of Direct Method Cash Flow Information

The Predictive Ability of Direct Method Cash Flow Information

Product Development and Market Expansion: a Real Options Model

This paper develops a model that values complementary and substitute projects, with potentially correlated revenues, that must be developed sequentially. The problem can be thought of as a sequential development of two simple projects with an option to exchange. The initial project has limited direct value because it is assumed that competition limits its direct cash flows. There is however an indirect benefit from the lead project in that its implementation is necessary before investment in a follow-on high value project can be undertaken. The follow-on project has significant value because there is a period of limited competition (ensured for instance by a patent). Whether the products are partial substitutes or complements, we find that the value of the combined projects and the time value of the option to invest in the initial project are increasing functions of correlation, and the probability of investing in the initial product is a decreasing function. If the products are substitutes, correlation can have a negative impact on the value of the combined projects and the time value of the option to invest in the initial project. The effect of correlation increases when the value of the initial product is relatively more uncertain. Moreover, the lower the correlation between the products, the higher the likelihood that the optimal timing for investing in the follow-on product is separated from that of the initial product. Regardless of the level of correlation, a higher degree of substitutability increases the value of the combined projects but reduces the time value of the option to invest in the initial one, thus increasing the probability of investing. Finally, we show that despite greater uncertainty during the phase of limited competition, the firm is more likely to invest earlier.

Analysts' dividend forecasts

Dividends have direct cash flow implications for firms and investors, and are important for signaling reasons. Consequently, investors, analysts, and managers typically forecast future dividends and report them in various ways. We examine the accuracy of consensus dividend forecasts of Australian sell-side financial analysts published by BARCEP between 1985 and 1998. Although analysts' dividend forecasts are optimistically biased, we find they are less biased and more accurate than their earnings counterparts. Forecast accuracy is positively correlated with proxies for the amount of information available about the firm, and negatively correlated with proxies for the level of uncertainty about its future operating performance. These proxy variables and other variables that control for institutional change, notably occasioned by amendments to the Australian Corporations Law, explain 10–15% of the cross-sectional variation in the accuracy of analysts' dividend forecasts over the period 1991–1998, which is about half the explanatory power of a similar model fitted to BARCEP consensus earnings forecasts.

The Usefulness of Direct and Indirect Cash Flow Disclosures

We investigate the ability of disclosed operating cash flow and indirect accruals components to explain annual returns for a sample of Australian firms. Consistent with claims made by accounting standard setters, we find evidence of significant explanatory power for disclosed operating cash flow components beyond aggregate operating cash flows when they also have significant incremental predictive power for future (one year ahead) operating cash flows. Accrual components also have incremental explanatory power for returns. In addition, we find evidence of significant explanatory power for operating cash flow components beyond estimates of the components (based on other financial statement disclosures) for firms with large differences between disclosed and estimated components.

The Usefulness of Direct and Indirect Cash Flow Disclosures

We investigate the ability of disclosed operating cash flow and indirect accruals components to explain annual returns for a sample of Australian firms. Consistent with claims made by accounting standard setters, we find evidence of significant explanatory power for disclosed operating cash flow components beyond aggregate operating cash flows when they also have significant incremental predictive power for future (one year ahead) operating cash flows. Accrual components also have incremental explanatory power for returns. In addition, we find evidence of significant explanatory power for operating cash flow components beyond estimates of the components (based on other financial statement disclosures) for firms with large differences between disclosed and estimated components.

Earnings Management and Its Pricing Implications: Evidence from Banks' Adjustments to the Valuation Allowance for Deferred Tax Assets under SFAS 109

SFAS 109, Accounting for income taxes, was criticized for allowing firms to set arbitrarily high valuation allowances against deferred tax assets at adoption as hidden reserves that firms could use in future periods to manage earnings. Consistent with these claims, bank managers make discretionary decreases in the valuation allowance, which represents an increase in earnings, when earnings before adjustment are below the consensus analyst forecast. The magnitude of the discretionary adjustment increases in the deviation from forecast. Abnormal returns around the 10-K filing date suggest that the market attributes value to these discretionary earnings even though they presumably have no direct cash flow implications. However, additional tests indicate that the association between returns and discretionary changes in the valuation allowance are related to reductions in earnings volatility which provide indirect, but real, cash flow benefits in the regulated banking industry.

The accuracy of management dividend forecasts in Australia

Dividends have direct cash flow consequences for investors and are important for signalling reasons. Consequently, investors, analysts and managers typically forecast future dividends and report them in various ways. Yet the accuracy of dividend forecasts has been largely neglected in empirical finance. We examine the accuracy of managers' dividend forecasts in Australian IPO prospectuses (a companion paper examines the analysts' dividend forecasts). Managers' dividend forecasts are optimistically biased. Nevertheless, they are substantially more accurate and less biased than their earnings counterparts. Differences in retained ownership and the predictability of earnings help explain why some dividend forecasts are more accurate than others.

The Predictive Ability of Direct Method Cash Flow Information

This research examines the predictive ability of direct method cash flow information for firms that use the direct method in their cash flow statements. We use cross sectional and pooled time series regressions to predict operating cash flow data and assess relative predictive ability. Principal findings are: (1) past period direct method cash flow data predict future operating cash flow better than indirect method cash flow data; (2) past period direct method gross operating cash flows predict future net operating cash flow better than past period net operating cash flow; (3) measurement error exists in estimates of direct method operating cash flows from other financial statement data; (4) past operating cash flows predict future operating cash flows better than earnings and accruals.

Assessing the value and cost implications of manufacturing information and data systems: an empirical study

Although manufacturing information and data systems (MIDS) form an integral part of a manufacturing organization's infrastructure, the growth of corporate IT expenditure has left many companies questioning the value of their MIDS deployment. The use of traditional appraisal techniques to justify investments in MIDS typically relies on measures based on direct cost savings and incremental future cash flows. These techniques are considered no longer appropriate because of the largely intangible cost and benefit dimensions of many IT projects. This paper presents the results of a research study based on interviews in eighteen manufacturing companies, which investigated the methods used to assess the value and cost of MIDS investments. After showing that the concepts used to justify value vary significantly between respondents, the research indicates that intuition plays an important role in value prediction and assessment. A comparison between small and large companies indicates that the systems implementations are perceived in a better light in smaller companies. The results obtained are then compared with recent research.