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

• Main Authors: Orpurt, Steven Francis, Zang, Yoonseok
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2007
• Subjects: Direct Cash Flows; statement of cash flows; direct method; forecasting future cash flows and earnings; future earnings response coefficient (FERC); stock price informativeness; Accounting; Corporate Finance
• Online Access: https://ink.library.smu.edu.sg/soa_research/167; https://ink.library.smu.edu.sg/context/soa_research/article/1166/viewcontent/OZ_DCF1_080207.pdf
• Institution: Singapore Management University

Motivated by recent FASB, IASB and CFA Institute comments, we extend the scant literature on direct method cash flow disclosures by exploring their predictive ability. A primary stated purpose of the direct method is to better forecast future operating performance. To test this purpose, we use a FERC (future ERC) methodology, finding that firms voluntarily producing direct method statements reflect more information about future earnings in their current stock returns than other firms. Supporting our FERC analysis, we document that substantial articulation errors exist when direct method cash flow components are estimated from either indirect method cash flow statements or balance sheets, indicating that the direct method is not redundant. These estimation errors are statistically significant when predicting future operating cash flows. After conducting several tests for self selection concerns, we conclude that the direct method is valuable to investors when predicting future cash flows and earnings.