Why the numbers add up for direct cash flow statements

by Dr Iain Clacher, and Dr Alan Duboisée de Ricquebourg, Leeds University Business School

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17 Dec 2013

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A set of mathematical symbols

TO THEIR DETRACTORS they are time-consuming, costly and may give your rivals competitive advantage. To supporters, they are a source of information which enables investors to better understand and value your business. Direct cash flow statements may sound relatively innocuous but their proposed introduction has polarised some in the world of business.

Direct cash flow statements are - in theory - relatively simple. They show the cash that a business receives, and how much it pays out to suppliers, employees, and in taxes. This information is useful to anyone assessing the financial health of a listed company at a given point, and is particularly favoured by analysts, who regard it as value relevant, in that its disclosure enables investors to more accurately assess the value of a business.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) are proposing that direct cash flow statements be made mandatory for all companies. This has alarmed some in the UK and US, who argue that the current requirements for disclosure as set-out by International Financial Reporting Standards (IFRS) are adequate and that these statements will be (yet another) costly and time-consuming distraction. There is also a risk, unless all companies report precisely the same data, in the same format and at the same time, some may be disadvantaged by inadvertently revealing information, which could be used by their rivals.

But this is no theoretical debate, as the experiences of the Chicago Central and Pacific Railroad Company in 1987 made clear. At the time, the company was facing collapse but was able to withdraw from Chapter 11 bankruptcy after it presented direct cash flow statements which made clear the variances in its income, and which ultimately meant it was able to secure a much-needed credit facility.

Academic research has already cast some light on the use of these statements. Early studies have shown that direct cash flow statements are value relevant under Generally Accepted Accounting Principles (GAAP). However, until now, no-one has looked at whether direct cash flow statements remain of use to investors under IFRS, which is a fundamental issue if they are to be mandated in an IFRS reporting environment.

In Australia, businesses have reported direct cash flow information under the Australian Generally Accepted Accounting Principles (AGAAP), and since 1 January 2005, under IFRS. This makes Australia a unique country to assess the value relevance of the statements under different reporting regimes.

We therefore analysed data on more than 450 industrial and mining companies listed on the Australian Stock Exchange (ASX) between 2000 and 2010 - covering the period before and after the introduction of IFRS. The list includes consumer goods and services companies as well as, healthcare, industrials, technology and telecommunications firms. Extractive or mining firms, which have grown considerably in number over the period fuelled by the country's mining boom, were included.

We found that information from direct cash flow statements was captured by the share prices of industrial and extractive firms under both AGAAP and IFRS, but more so for industrial firms under IFRS. For example, on average, $1 of net cash under AGAAP explained 94 cents of the share price. Under IFRS, however, $1 of net cash explained $6.17 of the share price. Investors, therefore, placed greater value on direct cash flow information within an IFRS reporting framework, than they had previously done under AGAAP. These results are consistent with the proposition that direct cash flows play a reinforcing role that complements the more complex IFRS accounts.

Our findings provide strong evidence to support the mandatory introduction of direct cash flow statements. The detractors of these statements may argue that this does not address the issue of the costs involved and competitive disadvantage. However, we would argue these costs would decrease over time, and that the risk of competitive disadvantage would be minimised if the statements were bought in on a phased, mandatory basis. We hope that our study may dispel some of businesses' concerns.

The benefits arising from increased transparency would, we believe, be considerable. Investors would have access to a valuable source of additional information about businesses. Moreover, a company which is financially sound would have few reasons to be concerned about releasing this information. In times of market instability, greater disclosure would enable the market to distinguish between the weak and the strong - the better companies would be safe, and the worse would be more exposed.

The likelihood is that in due course, the IASB and the FASB will get their way and that it will become mandatory for all companies to disclose direct cash flow statements. It's difficult to see why it wouldn't happen when you consider the benefits. It is telling that when Australian firms were given the choice in 2008 of continuing to disclose direct cash flow information or to change the method of disclosure, almost all opted to continue. They recognised that the cost and time associated with preparing these statements was outweighed by the advantages that greater disclosure offered.

It is time for the detractors to take a step back and recognise that disclosure will bring benefits, not just for investors and analysts, but for businesses too.

Dr Iain Clacher, and Dr Alan Duboisée de Ricquebourg, Leeds University Business School

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