IDEAS home Printed from https://ideas.repec.org/a/spr/reaccs/v26y2021i4d10.1007_s11142-021-09584-x.html
   My bibliography  Save this article

IAS 7 and value relevance: the direct method versus the indirect method

Author

Listed:
  • Richard Kent

    (University of Michigan)

  • Jacqueline Birt

    (The University of Western Australia)

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.

Suggested Citation

  • Richard Kent & Jacqueline Birt, 2021. "IAS 7 and value relevance: the direct method versus the indirect method," Review of Accounting Studies, Springer, vol. 26(4), pages 1532-1586, December.
    • Handle: RePEc:spr:reaccs:v:26:y:2021:i:4:d:10.1007_s11142-021-09584-x
    DOI: 10.1007/s11142-021-09584-x
    as

    Download full text from publisher

    File URL: http://link.springer.com/10.1007/s11142-021-09584-x
    File Function: Abstract
    Download Restriction: Access to the full text of the articles in this series is restricted.
    File URL: https://libkey.io/10.1007/s11142-021-09584-x?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Freeman, Rn & Tse, Sy, 1992. "A Nonlinear Model Of Security Price Responses To Unexpected Earnings," Journal of Accounting Research, Wiley Blackwell, vol. 30(2), pages 185-209.
    2. Yixin Liu & Yixi Ning & Wallace N. Davidson III, 2010. "Earnings Management Surrounding New Debt Issues," The Financial Review, Eastern Finance Association, vol. 45(3), pages 659-681, August.
    3. Philip Gray & Ping‐Sheng Koh & Yen H Tong, 2009. "Accruals Quality, Information Risk and Cost of Capital: Evidence from Australia," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(1‐2), pages 51-72, January.
    4. Mary E. Barth & Wayne R. Landsman & Mark H. Lang, 2008. "International Accounting Standards and Accounting Quality," Journal of Accounting Research, Wiley Blackwell, vol. 46(3), pages 467-498, June.
    5. Holger Daske & Günther Gebhardt, 2006. "International financial reporting standards and experts’ perceptions of disclosure quality," Abacus, Accounting Foundation, University of Sydney, vol. 42(3‐4), pages 461-498, September.
    6. Philip Gray & Ping-Sheng Koh & Yen H Tong, 2009. "Accruals Quality, Information Risk and Cost of Capital: Evidence from Australia," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(1-2), pages 51-72.
    7. Neal Arthur & Marco Cheng & Robert Czernkowski, 2010. "Cash flow disaggregation and the prediction of future earnings," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 50(1), pages 1-30, March.
    8. Dechow, Patricia M., 1994. "Accounting earnings and cash flows as measures of firm performance : The role of accounting accruals," Journal of Accounting and Economics, Elsevier, vol. 18(1), pages 3-42, July.
    9. Divesh S. Sharma & Jagdish Sidhu, 2001. "Professionalism vs Commercialism: The Association Between Non‐Audit Services (NAS) and Audit Independence," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 28(5‐6), pages 563-594, June.
    10. Dechow, Patricia M. & Kothari, S. P. & L. Watts, Ross, 1998. "The relation between earnings and cash flows," Journal of Accounting and Economics, Elsevier, vol. 25(2), pages 133-168, May.
    11. Dechow, Patricia & Ge, Weili & Schrand, Catherine, 2010. "Understanding earnings quality: A review of the proxies, their determinants and their consequences," Journal of Accounting and Economics, Elsevier, vol. 50(2-3), pages 344-401, December.
    12. C.S. Agnes Cheng & Simon S.M. Yang, 2003. "The Incremental Information Content of Earnings and Cash Flows from Operations Affected by Their Extremity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(1‐2), pages 73-116, January.
    13. Christine Yap, 1997. "Users' perceptions of the need for cash flow statements — Australian evidence," European Accounting Review, Taylor & Francis Journals, vol. 6(4), pages 653-672.
    14. Gopal V. Krishnan & James A. Largay III, 2000. "The Predictive Ability of Direct Method Cash Flow Information," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 27(1&2), pages 215-245.
    15. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    16. Rayburn, J, 1986. "The Association Of Operating Cash Flow And Accruals With Security Returns," Journal of Accounting Research, Wiley Blackwell, vol. 24, pages 112-133.
    17. Dan S. Dhaliwal & Kyung J. Lee & Neil L. Fargher, 1991. "The association between unexpected earnings and abnormal security returns in the presence of financial leverage," Contemporary Accounting Research, John Wiley & Sons, vol. 8(1), pages 20-41, September.
    18. Bhushan, Ravi, 1989. "Firm characteristics and analyst following," Journal of Accounting and Economics, Elsevier, vol. 11(2-3), pages 255-274, July.
    19. Habib, Ahsan, 2008. "The role of accruals and cash flows in explaining security returns: Evidence from New Zealand," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 17(1), pages 51-66.
    20. Nelson, Karen K. & Barth, Mary E. & Cram, Donald, 2001. "Accruals and the Prediction of Future Cash Flows," Research Papers 1594r, Stanford University, Graduate School of Business.
    21. Andreas Charitou & Colin Clubb & Andreas Andreou, 2001. "The Effect of Earnings Permanence, Growth, and Firm Size on the Usefulness of Cash Flows and Earnings in Explaining Security Returns: Empirical Evidence for the UK," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 28(5-6), pages 563-594.
    22. Robert E. Carpenter & Bruce C. Petersen, 2002. "Is The Growth Of Small Firms Constrained By Internal Finance?," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 298-309, May.
    23. Barth, ME & Clinch, G, 1998. "Revalued financial, tangible, and intangible assets: Associations with share prices and non-market-based value estimates," Journal of Accounting Research, Wiley Blackwell, vol. 36, pages 199-233.
    24. C. Cheng & Dana Hollie, 2008. "Do core and non-core cash flows from operations persist differentially in predicting future cash flows?," Review of Quantitative Finance and Accounting, Springer, vol. 31(1), pages 29-53, July.
    25. Michael Bradbury, 2011. "Direct or Indirect Cash Flow Statements?," Australian Accounting Review, CPA Australia, vol. 21(2), pages 124-130, June.
    26. Paul Hribar & Daniel W. Collins, 2002. "Errors in Estimating Accruals: Implications for Empirical Research," Journal of Accounting Research, Wiley Blackwell, vol. 40(1), pages 105-134, March.
    27. Alex Frino & Stewart Jones, 2005. "The Impact of Mandated Cash Flow Disclosure on Bid-Ask Spreads," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(7-8), pages 1373-1396.
    28. Richard Lambert & Christian Leuz & Robert E. Verrecchia, 2007. "Accounting Information, Disclosure, and the Cost of Capital," Journal of Accounting Research, Wiley Blackwell, vol. 45(2), pages 385-420, May.
    29. Iain Clacher & Alan Duboisée Ricquebourg & Allan Hodgson, 2013. "The Value Relevance of Direct Cash Flows under International Financial Reporting Standards," Abacus, Accounting Foundation, University of Sydney, vol. 49(3), pages 367-395, September.
    30. Wael Mostafa & Rob Dixon, 2013. "The impact of earnings extremity on information content of cash flow," Review of Accounting and Finance, Emerald Group Publishing Limited, vol. 12(1), pages 81-104, February.
    31. Shadi Farshadfar & Reza Monem, 2013. "The usefulness of operating cash flow and accrual components in improving the predictive ability of earnings: a re-examination and extension," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 53(4), pages 1061-1082, December.
    32. Andreas Charitou & Colin Clubb & Andreas Andreou, 2001. "The Effect of Earnings Permanence, Growth, and Firm Size on the Usefulness of Cash Flows and Earnings in Explaining Security Returns: Empirical Evidence for the UK," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 28(5‐6), pages 563-594, June.
    33. Haw, In-Mu & Qi, Daqing & Wu, Woody, 2001. "The nature of information in accruals and cash flows in an emerging capital market: The case of China," The International Journal of Accounting, Elsevier, vol. 36(4), pages 391-406, 012.
    34. Gopal V. Krishnan & James A. Largay III, 2000. "The Predictive Ability of Direct Method Cash Flow Information," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 27(1‐2), pages 215-245, January.
    35. Alex Frino & Stewart Jones, 2005. "The Impact of Mandated Cash Flow Disclosure on Bid‐Ask Spreads," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(7‐8), pages 1373-1396, September.
    36. Freeman, Robert N., 1987. "The association between accounting earnings and security returns for large and small firms," Journal of Accounting and Economics, Elsevier, vol. 9(2), pages 195-228, July.
    37. C.S. Agnes Cheng & Simon S.M. Yang, 2003. "The Incremental Information Content of Earnings and Cash Flows from Operations Affected by Their Extremity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(1-2), pages 73-116.
    38. Ali, A, 1994. "The Incremental Information-Content Of Earnings, Working Capital From Operations, And Cash Flows," Journal of Accounting Research, Wiley Blackwell, vol. 32(1), pages 61-74.
    39. Fama, Eugene F & French, Kenneth R, 1996. "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
    40. Cheng, CSA & Liu, CS & Schaefer, TF, 1996. "Earnings permanence and the incremental information content of cash flows from operations," Journal of Accounting Research, Wiley Blackwell, vol. 34(1), pages 173-181.
    41. Gort, Michael & Klepper, Steven, 1982. "Time Paths in the Diffusion of Product Innovations," Economic Journal, Royal Economic Society, vol. 92(367), pages 630-653, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Richard Anthony Kent & Di Bu, 2020. "The importance of cash flow disclosure and cost of capital," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(S1), pages 877-908, April.
    2. Habib, Ahsan, 2008. "The role of accruals and cash flows in explaining security returns: Evidence from New Zealand," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 17(1), pages 51-66.
    3. C.S. Agnes Cheng & Simon S.M. Yang, 2003. "The Incremental Information Content of Earnings and Cash Flows from Operations Affected by Their Extremity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(1‐2), pages 73-116, January.
    4. Takashi Obinata, 2002. "Concept and Relevance of Income," CIRJE F-Series CIRJE-F-171, CIRJE, Faculty of Economics, University of Tokyo.
    5. Shadi Farshadfar & Reza Monem, 2013. "The usefulness of operating cash flow and accrual components in improving the predictive ability of earnings: a re-examination and extension," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 53(4), pages 1061-1082, December.
    6. Baljit K. Sidhu & CHUAN YU, 2021. "Direct Method Operating Cash Flow Disclosures: Determinants and Incremental Usefulness," Abacus, Accounting Foundation, University of Sydney, vol. 57(3), pages 421-467, September.
    7. Iain Clacher & Alan Duboisée Ricquebourg & Allan Hodgson, 2013. "The Value Relevance of Direct Cash Flows under International Financial Reporting Standards," Abacus, Accounting Foundation, University of Sydney, vol. 49(3), pages 367-395, September.
    8. Sompong Pornupatham & Hun-Tong Tan & Thanyaluk Vichitsarawong & G-Song Yoo, 2023. "The Effect of Cash Flow Presentation Method on Investors’ Forecast of Future Cash Flows," Management Science, INFORMS, vol. 69(3), pages 1877-1900, March.
    9. Pütter, Jonas, 2023. "Is Cash (the only) King? – Eine kritische Analyse der Aussagekraft von Kapitalflussrechnungen nach IAS 7 [Is Cash (the only) King? – A critical analysis of the relevance of Cashflow figures accordi," Junior Management Science (JUMS), Junior Management Science e. V., vol. 8(1), pages 219-236.
    10. C. Cheng & Dana Hollie, 2008. "Do core and non-core cash flows from operations persist differentially in predicting future cash flows?," Review of Quantitative Finance and Accounting, Springer, vol. 31(1), pages 29-53, July.
    11. Miranda-Lopez, Jose & Tama-Sweet, Isho, 2024. "The impact of corporate governance on the information content of earnings and cash flows: Evidence from Brazil," International Review of Financial Analysis, Elsevier, vol. 93(C).
    12. Mary E. Barth & Greg Clinch & Doron Israeli, 2016. "What do accruals tell us about future cash flows?," Review of Accounting Studies, Springer, vol. 21(3), pages 768-807, September.
    13. Farshadfar, Shadi & Monem, Reza, 2013. "Further Evidence on the Usefulness of Direct Method Cash Flow Components for Forecasting Future Cash Flows," The International Journal of Accounting, Elsevier, vol. 48(1), pages 111-133.
    14. Dechow, Patricia & Ge, Weili & Schrand, Catherine, 2010. "Understanding earnings quality: A review of the proxies, their determinants and their consequences," Journal of Accounting and Economics, Elsevier, vol. 50(2-3), pages 344-401, December.
    15. De Andrés Fazio, Salvador & Urquía Grande, Elena & Pérez Estébanez, Raquel, 2022. "The “secret life” of the Statement of Cash Flow: A bibliometric analysis," Cuadernos de Gestión, Universidad del País Vasco - Instituto de Economía Aplicada a la Empresa (IEAE).
    16. Kothari, S. P., 2001. "Capital markets research in accounting," Journal of Accounting and Economics, Elsevier, vol. 31(1-3), pages 105-231, September.
    17. Tami Dinh Thi & Wolfgang Schultze, 2011. "Capitalizing research & development and ‘other information’: the incremental information content of accruals versus cash flows," Metrika: International Journal for Theoretical and Applied Statistics, Springer, vol. 22(3), pages 241-278, November.
    18. Li Yu (Colly) He & Sue Wright & Elaine Evans, 2018. "Is fair value information relevant to investment decision-making: Evidence from the Australian agricultural sector?," Australian Journal of Management, Australian School of Business, vol. 43(4), pages 555-574, November.
    19. Tahat, Yasean A. & Alhadab, Mohammad, 2017. "Have accounting numbers lost their value relevance during the recent financial credit crisis?," The Quarterly Review of Economics and Finance, Elsevier, vol. 66(C), pages 182-191.
    20. Jing Jia & Zhongtian Li, 2022. "Corporate sustainability, earnings persistence and the association between earnings and future cash flows," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 62(1), pages 299-336, March.

    More about this item

    Keywords

    Cash flows; Direct method; Indirect method; Value relevance;
    All these keywords.

    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:spr:reaccs:v:26:y:2021:i:4:d:10.1007_s11142-021-09584-x. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.springer.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.