Does the Presentation Format of the Statement of Cash Flows Affect Analysts’ Cash Flow Forecast Lijuan Zhao, Department of Accounting, College of Business and Economics, California State University, Los Angeles, USA

ABSTRACT There is a long-term debate over the direct method or indirect method to present the statement of cash flows. Statement of Financial Accounting Standards No. 95 allows business to use either direct method or indirect method to present the statement of cash flows and a small group of business is using direct method. Compared to indirect method, direct method has been shown to provide incremental information in predicting future cash flows. This study investigates whether the direct method is useful for analysts’ cash flow forecast. This study finds that the analysts are more likely to issue the cash flow forecast for the firms using direct method. INTRODUCTION Statement of Financial Accounting Standards No. 95 (SFAS 95) allows firms to use either direct method (DM) or indirect method (IM) to present the statement of cash flows. However, in US, only a small group of business is using DM. Therefore, the purpose of this study is to investigate whether the format of the statement of cash flows has influence on analysts cash flow forecast. Compared to IM, prior literature finds that DM is useful in predicting firms’ future earnings and cash flows (Krishnan and Largay 2000; Orpurt and Zang 2009). AIMR (1993) argues that DM helps analysts evaluate the firms’ performance. However, no empirical study examines this issue. In order to fill the gap, this study investigates how the DM and IM influence analysts’ behaviors. This study predicts that the analysts will be more likely to issue cash flow forecasts for DM firms. This study is motivated by the on-going debate in various standards setting jurisdictions concerning the most appropriate method to prepare the statement of cash flows, especially regarding the usefulness of the operating cash flow information disclosed by DM and IM. DM reports the cash receipts and cash payments from operating activities and the difference between these two amounts is the net cash flow from operating activities. While the IM starts with net income and converts it to net cash flow from operating activities by adjusting the non-cash items. IM actually explains why the net cash flows from operating activities are different from net income. Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) allow both methods but highly recommend the DM (FASB 1987; IASC 1992). A joint research project was initiated in 2005 by FASB and IASB, which identified that the DM statement of cash flows as an important, pertinent and timely research topic to standard setters. In addition, financial analysts also show the preference to the DM. Association for Investment Management and Research (AIMR) issued a report in 1993 and indicated that DM will help analysts evaluate firms’ financial conditions (AIMR 1993).

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HYPOTHESIS DEVELOPMENT There is a long-term debate over the benefits and costs of DM disclosures and IM disclosures. In October 16, 2008, FASB and ISAB issued a joint discussion paper titled “Preliminary Views on Financial Statement Presentation”. The purpose of the discussion paper is to seek the comments on whether the financial statement presentation format proposed improve the usefulness of information provided by business and help users make decisions. The discussion paper indicates that an entity should disclose the cash receipts and payments from the operating activities (DM), rather than just adjusting net income (losses) to the net operating cash flows (IM). DM is more consistent with the proposed purpose of the presentation format of financial statements than IM. They also state that “Presenting cash receipt and cash payment line items in the operating category provides a more useful disaggregation of cash flow information. In addition, a direct method presentation helps users relate information about operating assets and liabilities and operating income and expenses to operating cash receipts and payments” (FASB 2008, paragraph S12). In this section, this study summarizes the advantages and disadvantages of DM and IM. (1) DM The proponents of DM disclosure method claim that DM provides incremental information of predicting future cash flows and also improves the comparative ability of individual component of cash receipts and cash payments across similar firms over times (Krishnan and Largay 2000; Orpurt and Zang 2009; Richardson 1991). In addition, DM is more consistent with the purpose of cash flow statement that provides relevant information about the cash receipts and cash payments of an enterprise during a period (SFAS 95, para 4). The DM information is valuable to evaluate firms’ ability to generate future cash flows, to meet dividend and debt obligations, which assists investors and creditors access the liquidity, financial flexibility and solvency of an entity. However, DM has been criticized to be more costly to implement. (2) IM IM explains why the net cash flows from operating activities are different from net income; it is less costly and more convenient to implement. However, the IM format has been criticized to confuse users. IM links the cash flows from operating activities to the results in accrual accounting income statements. The CFA Institute claimed that even a skilled analyst cannot reconstruct DM items based on the information provided by IM (CFA-Institute 2007), which indicate that computing the DM components is not a simply mechanically work. Various studies also provide evidences that DM items cannot be accurately reconstructed by the information disclosed by IM. Drtina and Largay Iii (1985) demonstrate that cash flows from operations (CFO) calculated by IM cannot be accurately converted to the actual cash flows. Bahnson et al. (1996) examine 9,757 public financial statements from COMPUSTAT and find that there is an unexpected difference between expected CFO and actual amounts presented in the statement of cash flows. Different with Drtina and Largay Iii (1985) and Bahnson et al. (1996), Krishnan and Largay (2000) examine the usefulness of DM. They use the NAARS database to search firms that use DM from 1988 to 1993. Using 405 firm-year observations to examine the DM components from balance sheet and income statement information, they find that the articulation errors1 exist in U.S. firms.

                                                              1

Articulation errors are the difference between direct method components and the estimations for the same components based on indirect method with balance sheet or income statement (Orpurt and Zang 2009).

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Orpurt and Zang (2009) give an example to show that the DM items cannot be reliably estimated from the IM and income statement or IM and balance sheet. Orpurt and Zang (2009) was the first paper to include these articulation errors in their model and show that this articulation errors do incorporate information that improve the predictions of future operating cash flows. Some studies claim that DM is useful in predicting future cash flows, lowering costs of capital or increasing stock price. For instance, Krishnan and Largay (2000) compare the forecast errors by DM and IM prediction models when forecasting one-period-ahead CFO. They find that DM produces smaller forecast errors than IM. Miller and Bahnson (2002) employ case studies to indicate that DM provides better information to investors, creditors and managers. In summary, all the above studies provide evidence that DM components cannot be accurately converted from IM and DM information enhances the predictive ability of future cash flows. However, none of these studies provide empirical evidence about whether the DM information is useful for analysts cash flow forecast. Therefore, this study is expecting that analysts will be more likely to issue cash flow forecast for firms with DM disclosure. Hypothesis: Analysts are more likely to forecast cash flows for firms using DM. SAMPLE SELECTION This study collects the sample of firms choosing DM in Lexis/Nexis from 1989 through 2009. This study uses the following key words to search in the database to identify the firms that use DM: -Direct method -Cash collected from customers -Cash collection from customers -Cash received from customers -Cash receipts from customers -Cash paid to suppliers -Cash payments to supplier -Cash paid for interest -Cash paid for tax After searching in Lexis/Nexis, this study firstly find that 548 firms use DM over the fiscal years 1989 through 2009. Due to the data constrains on COMPUSTAT, 208 firms were eliminated. In addition, financial and utility firms with SIC codes between 6,000 and 6,999 and between 4,900 and 4,999 were excluded from the sample. Therefore, the final full sample consists of 217 DM firms from 1989 to 2009. Table 1 summarizes the sample selection. Table 1:Descriptive Analysis of Firms using DM

Fiscal Year 1989 1990 1991 1992 1993 1994 1995

Panel A: Distribution of DM Firms by Year Number of firms using DM Proportion of firms using DM 113 4.59 117 4.75 122 4.96 130 5.28 139 5.65 143 5.81 152 6.18

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1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total

Fiscal Year 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total

149 153 144 138 126 118 106 95 96 90 88 83 80 79 2461

6.05 6.22 5.85 5.61 5.12 4.79 4.31 3.86 3.90 3.66 3.58 3.37 3.25 3.21 100

Panel B: Distribution of IM firms by year Number of firms using IM Proportion of firms using IM 6445 4.25 6475 4.26 6611 4.35 7005 4.61 7363 4.85 7675 5.06 8498 5.60 8691 5.72 8497 5.60 8714 5.74 8664 5.71 8235 5.42 7679 5.06 7274 4.79 6987 4.60 6785 4.47 6574 4.33 6320 4.16 6014 3.96 5835 3.84 5480 3.61 151821 100

The total IM sample includes 18,716 firm-year observations over the sample period. Panel B of Table 2 presents the frequency and proportion of IM firms. In addition, actual cash flow value and forecasted cash flow value are obtained from IBES. EMPIRICAL RESULTS Analysts’ cash flow forecast are available after 1993, after merging with the IBES database and deleting all missing data, the final sample used in Table 2 is 909 observations.

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Table 2: Comparison of Analysts’ Cash Forecast Frequency between DM and IM Firms DM IM Difference Mean Mean T-test P-Value Cash flow forecast 0.3386 0.3120 0.0105** ** represents statistical significance at the 5% level.

In summary, the results support the hypothesis that analysts will be more likely to issue cash flow forecasts for DM firms CONCLUSION IAS 7 and SFAS 95 recommend firms use DM to present the statement of cash flows, however, DM information is more useful in forecasting future cash flows. This study finds that the analysts will be more likely to forecast future cash flows for firms using DM. These results are consistent with prior literature that DM provides more useful information than IM in predicting future cash flows (Krishnan and Largay 2000; Cheng and Hollie 2008; Orpurt and Zang 2009). REFERENCES AIMR. (1993). Financial reporting in the 1990s and beyond. Charlottesville: VA. Bahnson, P. R., P. B. W. Miller, and B. P. Budge. (1996). Nonarticulation in cash flow statements and implications for education, research and practice. Accounting Horizons 10 (4):1-15. CFA-Institute. (2007). A comprehensive business reporting model: financial reporting for investors. Charlottesville, VA: CFA Institute. Cheng, C., and D. Hollie. (2008). Do core and non-core cash flows from operations persist differentially in predicting future cash flows? Review of Quantitative Finance & Accounting 31:29-53. Drtina, R. H., and J. A. Largay Iii. (1985). Pitfalls in calculating cash flow from operations. Accounting Review 60 (2):314-326. FASB. (1987). Statement of financial accounting standards No. 95. Norwalk, Connecticut: Financial Accounting Standards Board. (2008). Preliminary views on financial statement presentation. Norwalk: CT: FASB. IASC. (1992). International Accounting Standard 7. London, UK: International Accounting Standards Committee. Krishnan, G. V., and J. A. Largay. (2000). The predictive ability of direct method cash flow information. Journal of Business Finance & Accounting 27 (1&2):215-245. Miller, P. B. W., and P. R. Bahnson. (2002). Fast track to direct cash flow reporting: It's easier than you think to provide the information financial statement users want. Strategic Finance:51-57. Orpurt, S., and Y. Zang. (2009). Do direct cash flow disclosures help predict future operating cash flows and earnings? Accounting Review 84 (3):893-935. Richardson, P. B. (1991). Does FASB Statement No. 95 Really Help Lenders? The Journal of Commercial Bank Lending 73 (7):49-54.

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