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Cash flow reporting is, historically, the oldest form of accounting for transactions, dating back to medieval times. However, it was not until 1963 that the APB in the U.S. issued the first standard to govern the reporting of cash flows in the form of Opinion No.

3“The Statement of Source and Application of Funds”. Australia and the U.K. followed suit around ten years later and issued Technical Bulletin F1: The Funds Statement in 1971 andSSAP 10: Statements of Source and Application of Fundsin 1975 respectively.

Since their inception, similar problems plagued the various funds flow standards, with the main issues concerning the very vague definition of “funds” and the lack of clear guidance in their application. Addressing these problems, the standard setters in America, U.K. and Australia all issued superseding “cash” flow disclosure requirements towards the end of the 1980’s and start of the 1990’s. America, in the form of SFAS No. 95, having led the way, heavily influenced the standards on cash flow reporting subsequently issued around the world.

In the 1990’s, U.S., Canada, U.K. and Australia, known as the “G4”, committed to the harmonisation of accounting standards, along with the International Accounting Standards Committee (IASC), based on their similar conceptual frameworks (Street and Shaughnessy, 1998). Towards the end of the 20th century cash flow reporting was an area in which the G4 and the IASC had clearly gained rapid consensus, resulting in only minor notable differences between the various standards. More recently, with the growing acceptance and adoption of IFRS around the world, the U.K. and Australia have both been reporting their cash flows according to IAS 7. Australia, however, restricted the choice of disclosing operating cash flows to the direct method until the issue of AASB Amendment Pronouncement (AP) 2007-4, which amended AASB 107, thereby allowing the use of the indirect method of cash flow disclosure.

Operating cash flow disclosure is one area in cash flow reporting that has been the subject of fierce debate by standard setters, preparers and users of financial accounts. Central to this debate is whether to allow or remove the choice of disclosing operating

cash flows “indirectly” or “directly”. Indirect reporting requires a reconciliation between profits and net operating cash flow by adjusting for the effects of accrual accounting and other non-cash transactions. The direct method, however, requires the disclosure of the actual gross cash receipts and payments on the face of the cash flow statement, supported with a supplemental “indirect” reconciliation.

Currently, as part of the continuing harmonisation of U.S. standards with IFRS, both FASB and the IASB have proposed to settle the debate finally by removing the option to disclose operating cash flows using the indirect method and mandate the direct method for all companies. Comments received back in response to the Exposure Draft, entreated the FASB and IASB to reconsider whether the benefits of disclosing operating cash flows “directly” would exceed the associated costs of capturing and recording the requisite information. Establishing, therefore, which approach provides more useful information is not easily resolved.

3

Literature Review

3.1 Introduction

Over the past two decades, there has been growing interest concerning the usefulness of information provided from reporting operating cash flows using the direct method. Even before the standardisation of cash flow disclosures, a number of academic papers, examining various reporting formats for operating cash flows, had each expressed a definitive preference for the direct method (Paton, 1963; Heath, 1978; Lee, 1981; Thomas, 1982; Ketz and Largay III, 1987).

Before and after the regulation of cash flow reporting, there are three distinct avenues within which researchers have sought to measure the usefulness of estimated and reported operating cash flows, in addition to their components. Reviewing the extant literature up to 1990, investigating the usefulness of operating cash flows, Neill

et al.(1991) summarised the published studies into three categories: the effects of cash flows on capital markets; their usefulness in forecasting future cash flows; and finally, their usefulness in predicting corporate failure. However, a crucial area they did not discuss was the benefits of reporting cash flows using the direct method, due to the lack of empirical research examining the usefulness of this information.

Surveys and case studies were the two initial methods used to assess the usefulness of cash flows disclosed using the direct method. Lee (1981) surveyed a group of Chartered Accountants in Scotland, and found that 80% of respondents were in favour of the model cash flow statement using the direct method provided in the paper. Moreover, the remaining respondents actually suggested a more detailed presentation of

operating cash flows (OCF) would be more useful. By contrast, however, a replication of this study on a group of U.S. audit partners, shortly after the release of SFAS No. 95, found that 57% favoured the indirect method (McEnroe, 1989).

Subsequent U.S. surveys, however, contradicted these initial findings, including a follow up study by McEnroe (1996) with increased sample size and diversity, covering academics, accountants, analysts and investors. McEnroe (1996) found 56% of respondents were in favour of reporting OCF using the direct method, a notable shift in preference from the 1989 results. Further, survey results reported by Smith and Freeman (1996) using a group of U.S. finance directors in 1993, provided additional support for the direct method. When compared with the indirect method, most respondents indicated the direct approach presented more concise, better quality, and understandable information. They also indicated support for a hybrid form of cash flow reporting, presenting operating cash flows directly, but also providing a supplementary reconciliation between the operating profit and cash flow for the period.

Similar surveys conducted in Australia, where direct cash flow statements were mandatory, provided further support for the direct method (Joneset al., 1995; Jones and Ratnatunga, 1997; Jones and Widjaja, 1998; Goyal, 2004). Respondents noted, that, the direct method was easier to understand and analyse and, when compared with the indirect method, provided information that was useful to forecast future insolvency more accurately.

More recently, as part of the convergence project between IFRS and U.S. GAAP, the Institute of Chartered Financial Analysts (CFA Institute) surveyed their members for opinions on the usefulness of information reported by direct cash flow statements. Results published in July 2009 show that, out of 541 respondents, 63% either “strongly

agreed” or “agreed” that information provided by the direct method would improve the accuracy of future cash flow forecasts and be useful to measure earnings quality (CFA Institute, 2009). Moreover, 94% voted “Revenue collections from customers”, information only available under the direct method, to be the most important information disclosed under the cash flows from operating activities.

In addition to these surveys, a few case studies have also investigated the decision usefulness of information provided by the direct and indirect method. Soon after the issuance of SFAS No. 95, Klammer and Reed (1990) used a fictitious case of a firm seeking a $5 million bank loan, in order to examine the differential usefulness of direct and indirect cash flow statements. After presenting this case to a group of bank analysts and loan officers, they provided half the group with a direct cash flow statement, and the remainder with an indirect cash flow statement. Their results show far greater consistency in the loan size granted between members using the direct cash flow statement as compared with the members using the indirect cash flow statement.

In a real life scenario, Trout et al.(1993) report that, after providing the bank with a direct cash flow statement, Chicago Central & Pacific Railroad Company received a critical loan that helped resolve their liquidity crisis. Management used the direct cash flow statement to identify the cause of the firm’s cash flow budget variances, enabling a successful negotiation of a recovery package.

However, in contrast to these case studies, Kwok (2002) reported no participants in her behavioural study used information provided by the direct method when arriving at their final lending decision. By using a verbal protocol analysis methodology, she observed the decision making process of a group of twenty loan officers, analysts, academics and auditors. None of the subjects noted the difference between the two

methods of disclosing cash flows. Rather, they based their final lending decisions on information from the balance sheet and notes and derived any cash flow information indirectly.

3.2 Empirically Examining the Usefulness of Operating Cash Flows