IAS 7 and Value Relevance: The Direct Method Versus the Indirect Method

Review of Accounting Studies, Forthcoming

63 Pages Posted: 30 Sep 2020

See all articles by Richard Kent

Richard Kent

University of Michigan Dearborn

Jacqueline Birt

The University of Western Australia

Date Written: August 13, 2020

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 less 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 take into account the 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 payment.

Keywords: cash flows, direct method, indirect method, value relevance

JEL Classification: M41

Suggested Citation

Kent, Richard and Birt, Jacqueline, IAS 7 and Value Relevance: The Direct Method Versus the Indirect Method (August 13, 2020). Review of Accounting Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3673333 or http://dx.doi.org/10.2139/ssrn.3673333

Richard Kent (Contact Author)

University of Michigan Dearborn ( email )

4901 Evergreen Road
Dearborn, MI 48128-1491
United States
7346790806 (Phone)
48170-2794 (Fax)

Jacqueline Birt

The University of Western Australia ( email )

35 Stirling Highway
Crawley, Western Australia 6009
Australia

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