The Effects of Financial Statement and Informational Complexity on Cash Flow Forecasts

Abstract

We characterize the operating-activities section of the indirect-approach statement of cash flows as backwards because it presents reconciling adjustments in a way that is opposite from the intuitively appealing, future-oriented, Conceptual Framework definitions of assets, liabilities and the accruals process. We propose that the reversed-accruals orientation required in the currently mandated indirect-approach statement of cash flows is unnecessarily complex, causing increased cash-flow forecast error and dispersion. We also predict that the mixed pattern (i.e., /-, -/ ) of operating cash flows and operating accruals reported by most companies also impedes investors' ability to learn the time-series properties of cash flows and accruals. We conduct a carefully controlled experiment and find that (1) cash-flow forecasts have lower forecast error and dispersion when the indirect-approach statement of cash flows starts with operating cash flows and adds changes in accruals to arrive at net income and (2) cash-flow forecasts have lower forecast error and dispersion when the cash flows and accruals are of the same sign (i.e., / , -/-) with the sign-based difference attenuated in the forward-oriented statement of cash flows. We also conduct a quasi-experiment to test our mixed-sign versus same-sign hypotheses using an archival sample of publicly available Value Line cash-flow forecasts. We find that Value Line analysts' cash-flow forecasts exhibit the same pattern of forecast error as documented in our experiment.

Keywords: analysts, cash flows, forecasting, complexity, judgment and decision making

JEL Classification: G12, G29, M41, M44, C91