The usefulness of disclosing both direct and indirect cash flows: An empirical study

In the field of cash flow disclosures, there is a contradiction between standard setters' position and academic literature on the one side, and accounting practice on the other. Standard setters often argue that by decomposing operating cash flow (OCF) into cash receipts and cash payments, the direct method provides a better prediction on the future OCF. Several academic studies support this view. However, in accounting practice, the predominant method is the indirect one that decomposes the current OCF into potential cash flow (funds from operations) and short-term accruals.In this study we investigate the ability of these two decompositions of OCF to predict one year ahead OCF. Chinese accounting regulation offers a unique dataset since listed firms must disclose both the direct and indirect components of OCF since 1998. With a sample of over 1,000 Chinese listed firms on a 7-year period (1998-2004), we find that the indirect method offers a better prediction of future OCF than the direct method in general. Nevertheless, we show that the predictive ability of each method depends on the stability of firm's business, proxied by the growth variability. The indirect method has a significantly greater predictive ability than the direct one when the business of the firm is volatile. When the business is stable, there is no predominant method. We conclude that, by requiring the disclosure of both decompositions, accounting regulators help investors to better assess the future performance of the firm.