Voluntary Direct Method Cash Flow Disclosure in the U.S. ...

Voluntary Direct Method Cash Flow Disclosure in the U.S.:

Determinants and Incremental Usefulness

Abstract

This study explores the determinants and incremental usefulness of the direct method

operating cash flow (CFO) disclosures in a voluntary setting (the U.S.). The net benefits of

disclosure choice come into sharp focus in such a setting, permitting a direct study of the attributes of

firms most likely to benefit from such disclosures. We first investigate firm-level attributes or

economic settings associated with voluntarily adopting firms. Second, we study whether the

disclosed components of CFO in this voluntary setting, are incrementally useful beyond the

estimated analogues in predicting future CFO and earnings. We further explore whether any

incremental usefulness of the disclosed components varies under the different firm level or economic

settings identified in the first stage. Our results show that firms are more likely to adopt the direct

method when they have higher leverage, lower discretionary accruals, longer operating cycles, less

complex business operations, and when they operate in a less competitive market. In addition, we

find that the disclosed direct method components of CFO are incrementally more useful in the

following settings where firms have higher incentives to adopt the DM: more volatile life cycle

stages, large estimation differences, higher reliance on debt financing, and longer operating cycles.

Baljit K. Sidhu

Chuan Yu

1

1. INTRODUCTION

This study explores the determinants and incremental usefulness of the direct method

operating cash flow disclosures in a voluntary setting (the U.S.), where the net benefits of such

disclosures are most likely to pertain. This permits a direct study of the attributes of firms most likely

to benefit from such disclosures.1 We first ask what firm-level circumstances or economic settings

are associated with firms voluntarily adopting the direct method. Second, we investigate whether the

disclosed components2 (of operating cash flows) using the direct method in this voluntary setting, are

incrementally useful beyond the estimated analogues in predicting future operating cash flows (CFO)

and earnings. We pay special attention to exploring whether any incremental usefulness of the

disclosed components varies under the different firm-level and economic settings identified earlier.

Clinch et al., 2002 show it to be incrementally useful in Australia during the mandatory period, an

average result across all firms (with some limited exploration of underlying heterogeneity based on

working capital accruals i.e., accounts receivables, payables and inventory turnover). We seek to

provide further evidence beyond this average result to understand the heterogeneity across firms.

Figure 1 summarizes the overall research design of this study. The first research question

involves comparisons between firms that do and don’t voluntarily adopt the direct method of

disclosing the components of CFO, while the second question explores whether, and the conditions

under which, direct method disclosures are incrementally useful within the voluntarily adopting

firms. Firms exhibit different firm characteristics under different economic settings. Prior studies

have commonly incorporated firm life cycle stages to define distinct phases that significantly alter

firms’ economic fundamentals. Thus, to answer the first research question, we first compare various

firm characteristics between firms that have adopted the direct method and firms that have not (the

indirect method firms) both on average and across different firm life cycle stages. Then, we estimate

1 The direct method was mandatory in at least two countries (Australia and New Zealand) prior to their embracing

International Financial Accounting Standards in 2005. 2 Hereafter, the disclosed components using the direct method are simply referred to as the ‘disclosed components’.

2

a correlated random effects probit model including both the groups (direct and indirect method) firms

to explore whether these characteristics influence firms’ disclosure choices. Our results show that

firms are more likely to adopt the direct method when they have higher leverage, lower discretionary

accruals, longer operating cycles, less complex business operations, and when they operate in a less

competitive market. To address the second research question of incremental usefulness, we focus on

the group of direct method firms only since the disclosed direct method components are not

observable for non-adopting firms. Our results corroborate our earlier evidence on the determinants

of the disclosure choice. Specifically, the incremental usefulness of disclosed direct method

components is more pronounced when a firm is in the growth and decline stages of its life cycles,

which are also the stages in which firms possess characteristics that give them higher incentives to

choose the direct method. We further find that the disclosed direct method components are

incrementally useful when a firm has large estimation differences between disclosed and estimated

components, a higher reliance on debt financing, and longer operating and cash generating cycles.

[Insert Figure 1 Here]

This study is motivated by the following reasons. First, there is an ongoing debate about the

form of disclosing CFO. Standard setters have long advocated the use of the direct method (FASB

1987, para. 4 and 27). As part of the efforts towards international convergence of accounting

standards and levelling the playing field, the Financial Accounting Standards Board (FASB) and the

International Accounting Standards Board (IASB) have worked on a joint project and both issued a

Discussion Paper and an Exposure Draft in 20083 and 2010

4, respectively. These propose to mandate

the presentation of both the direct and the indirect method when disclosing CFO. Although standard

setters have stated the desirability of the former, not many countries have ever mandated it. The

exceptions were Australia and New Zealand, prior to their respective adoption of the relevant

3 See Discussion Paper “Preliminary Views on Financial Statement Presentation” issued by FASB and IASB in October

2008. 4 See Financial Accounting Series Exposure Draft: Proposed Accounting Standards Update: Staff Draft of an Exposure

Draft on Financial Statement Presentation issued by FASB and IASB in July 2010.

3

International Financial Reporting Standard (IFRS) in 2007; subsequently, only the indirect method

was mandated5. Nevertheless, very few Australian firms stopped preparing the direct method cash

flow information subsequent to this change, possibly reflecting ‘sticky’ reporting behaviour since the

reporting systems are already in place. In contrast, the direct method disclosure has always been

voluntary in the U.S. where we observe a relatively low adoption rate of the direct method, of around

two to three percent (Krishnan and Largay III, 2000). Although the adoption rate is low in the U.S.,

the minority of U.S. firms do need to make an active choice to adopt the direct method.

Understanding firms’ choice function and the incremental usefulness of the information will

contribute to the empirical evidence relevant to this debate.

Second, prior studies provide limited evidence on firms’ incentives to choose the direct

method and hence the derived demand for the information. While prior evidence supports the

incremental usefulness of the direct method, rarely have studies looked into firms managerial

incentives. Although Orpurt and Zang (2009) include a probit choice model in their study, this is not

the main focus. Further, a simple probit model is not very likely to capture the unobserved

heterogeneity among firms. In addition, studies that have examined the usefulness of the direct

method components of CFO focus mainly on the average usefulness of such disclosure. Rarely have

studies investigated the underlying heterogeneity. One exception is Clinch et al. (2002), which

identifies several conditions under which the usefulness of disclosed direct method components is

more prominent than their estimated analogues or the indirect method disclosures. Specifically, they

find that disclosed direct method components are incrementally more useful beyond estimated ones,

for industrial (in contrast to mining) firms with a large amount of current receivables or payables.

They also find that disclosed components are more useful than estimated ones for firms with large

estimation errors in the latter (that is, large differences between disclosed and estimated

components). Overall, Clinch et al. (2002) provides some preliminary evidence that the incremental

5 While both countries adopted IFRS in 2005, the relevant IFRS cash flow reporting standard became effective in 2007.

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usefulness of direct method components varies under different circumstances. However, Clinch et al.

(2002) is conducted in Australia, a mandatory disclosure regime where both the direct and indirect

methods were required before 2007. Therefore, it is not possible to observe these firms’ choice

function. However, the U.S. setting overcomes this limitation. Assuming firm managers are rational

market participants, it is reasonable to conjecture that those firms that expect direct method CFO

components to provide additional value will be the ones that voluntarily choose to disclose them6,

especially so if they expect that the benefits of making this choice outweighs the costs of doing so.7

Therefore, this study extends Clinch et al. (2002) by further investigating the heterogeneity of the

usefulness of the disclosed CFO components in a voluntary setting.

This paper contributes toward the gap in our understanding of the direct method CFO

disclosure. While there is general consensus from prior literature that the disclosed direct method

components are incrementally useful on average, the evidence on the cost-benefit tradeoffs and the

underlying heterogeneity in usefulness is still limited. In a recent review, Hales and Orpurt (2013)

also advocate future studies to further investigate the usefulness of the direct method information

under various economic settings. The voluntary setting in this paper offers an ideal opportunity to

isolate the types of settings that regulators can focus on, given it draws out firms that the net benefit

of adopting the direct method is most likely to be positive.

The reminder of the paper is organized as follows: Section 2 reviews relevant prior literature

and develops hypotheses. Section 3 presents the research design. In Section 4, we describe our data

and present the descriptive statistics. The results and main findings are discussed in Section 5.

Section 6 concludes.

6 Studies from the voluntary disclosure literature often claim that firms have incentives to enhance the quality of their

financial disclosures in the interest of reducing their cost of equity and debt capital (see Healy and Palepu, 2001, among

others). The disclosure of the DM cash flow information provides an attractive setting to investigate these arguments in

the voluntary disclosure literature because the disclosure choice is unlikely to be affected by either legislative or

contracting considerations. The focus of this study is to first investigate whether the incremental usefulness does exist

and under what economic settings or circumstances if any. 7 These can include the costs of implementation and potential proprietary costs (Healy and Palepu, 2001).

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2. LITERATURE AND HYPOTHESES

Several papers on the role of cash flow information focus on examining the usefulness of the

disclosed components of CFO using the direct method. In the main, these studies find that disclosed

direct method information is useful in predicting future CFO and earnings (Krishnan and Largay III,

2000; Arthur and Chuang, 2006; Cheng and Hollie, 2008), explaining capital market effects (Clinch

et al., 2002; Jones and Frinos, 2005; Orpurt and Zang, 2009) and facilitating decision making

(Klammer and Reed, 1990; Goyal, 2004; Jones and Widjaja, 1998; Kojima, 2012). Although the

extant literature provides evidence supporting the usefulness of the direct method information, it is

often based on a broad sample of firms and examines the average usefulness of the direct method

information. Earlier work suggests that firms under various economic settings exhibit different

characteristics and firm life cycles are well recognised in the literature as a measure to capture

distinct phases through the evolvement and evolution of firms (Mueller, 1972; Nissim and Penman,

2001). Because of the differential firm characteristics under different firm life cycles, prior studies

incorporating firm life cycle stages find that the value-relevance and usefulness of accounting

performance measures (such as earnings and cash flows) are also different across different life cycle

stages (Black, 1998). However, these settings have rarely been researched in the context of the

voluntary direct method disclosure.

Our study fills this void in the literature by providing additional evidence from two angles.

First, we view the voluntary direct method disclosure decision as a function of the demand from the

investors and supply by managers. Second, given that the incentives for managers to supply direct

method information can vary in different settings, we further hypothesize that the usefulness of direct

method information also varies across these settings. In settings where firms are more likely to make

voluntary direct method disclosure, the incremental usefulness of the direct method components

would also be more pronounced. Section 2.1 and Section 2.2 discuss the relevant literature and

develop hypotheses in relation to the determinants, and the incremental usefulness of voluntary direct

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method disclosure, respectively. Figure 2 provides a summary diagram of how we development our

hypotheses.

2.1 Determinants of Voluntary Direct Method Disclosure

Assuming firms are rational market participants, firms that expect the disclosed direct method

components to provide incremental informational value will be the ones that voluntarily choose to

disclose. Thus, understanding the determinants of the voluntary direct method disclosure is likely to

help standard setters to better assess the benefits and costs of mandating the direct method disclosure.

We follow the framework developed in the voluntary disclosure literature (Beyer et al., 2010) to

explore the determinants of direct method disclosure by analysing the demand and supply of such

accounting information.

The accounting disclosure literature identifies two types of market imperfections, which give

rise to the demand for accounting information (Healy and Palepu, 2001; Beyer et al., 2010). First, ex-

ante, the information asymmetry between firms’ managers and outsiders raise the demand for

accounting information because accounting information assists in the valuation role for shareholders

and creditors to evaluate their investments. Second, ex-post, the separation of ownership and control

can cause agency problems when managers have incentives to act in their own interests instead of in

the shareholders or creditors’ best interests. Thus, accounting information can assist in the

stewardship role to limit managers’ discretion and monitor the use of investors’ capital.

Positive Accounting Theory (PAT) suggests that managers are the party that bears the

ultimate costs of market imperfections (Watts and Zimmerman, 1986), so managers have incentives

to voluntarily supply private information to outsiders in order to mitigate these costs. Prior literature

has developed and tested different hypotheses of managerial incentives addressing both the

information asymmetry and agency problems. Information asymmetry imposes higher uncertainties

for outside market participants about the firms’ underlying performances. As a result, firms may be

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mispriced by the market (Akerlof, 1970; Beyer et al., 2010). In order to reduce costs incurred by

mispricing, managers have incentives to make voluntary disclosures for market participants to assist

them in assessing the value of the firms (Dye, 1985; Verrecchia, 2001). Prior work also establishes

that managers have greater incentives to make voluntary disclosures when they need to access

external financing (Bharath et al., 2008), signal managerial talent (Trueman, 1986), increase stock

liquidity (Kim and Verrecchia, 1994), and reduce cost of capital (Easley and O’Hara, 2004). Studies

that focus on agency problems find that the separation of ownership and control reduces the

decision-making rights of the shareholders or creditors and may become a serious problem when

managers’ interests are not aligned with shareholders and creditors. For example, studies in this area

show that managers have higher incentives to voluntarily disclose good news if they have stock-

based compensation contracts or when they are concerned about executive turnover (Aboody and

Kasznik, 2000; Nagar et al., 2003).

Despite the benefits of voluntary disclosure to mitigate the information asymmetry and

agency problems, there are also costs associated with disclosing additional information to the market.

In fact, a firm’s decision to disclose reflects the joint consideration of the benefits and the costs. Two

commonly discussed costs from prior studies are the costs of preparation and the proprietary costs.

The demand and supply of information on components of CFO using the direct method

One of the primary objectives of external financial reporting is to facilitate users’ decision

making process (FASB, 1978). Assessing firm performance is one of the critical steps in this process.

Investors are more likely to demand additional information when there are greater uncertainties in

assessing firm performance and this demand provides incentives for managers to voluntarily disclose

additional information. We expect investors to find voluntary direct method disclosure more useful

(relative to disclosure under the indirect method or estimated direct method CFO components) in

assessing firm performance when the cash flow information is relatively more important in their

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decision-making process. Although all firms are required to prepare statement of cash flows using

the indirect method, the information in the operating cash flow section is still largely accrual based.

Prior studies find that the value relevance and the usefulness of accruals and cash flow information

vary across firm life cycles (Dechow, 1994; Black, 1998). Thus, we conjecture that the demand for

cash flow information would be higher in certain stages, in which firms exhibit unique firm

characteristics that provide higher incentives for managers to supply the direct method information.

In addition, considerable amount of prior studies have demonstrated that it is highly unlikely to

estimate the direct method components accurately without incurring estimation errors (Austin and

Bradbury, 1995; Bahnson, 1996; Hribar and Collins, 2002; Orpurt and Zang, 2009; Hughes et al.,

2010; Ward et al., 2011)8. As a result, making voluntary direct method disclosure in response to the

demand of cash flow information from investors would be a rational management reaction.

Given the discussion above, the first setting in which we expect that the directly disclosed

CFO components is more important than the indirect CFO components (essentially changes in

accrual items) is in relation to a firm’s debt financing needs. Traditional theories of firms view firm

as a “nexus of contracts” and many of these contracts are created and monitored in terms of

accounting numbers (Jensen and Meckling, 1976; Fama, 1980; Leftwich et al., 1981). According to

the agency theory, the formation of debt contracts establishes the agency relationship between the

lenders or underwriters (the principals) and the managers of the issuing firm (the agents). Lenders,

such as individual investors and financial institutions, try to assess the default risk of borrowing

firms from all available information before supplying the capital. Prior literature suggests that firms

tend to incur higher monitoring costs due to the agency relation formed through debt contract (Beyer

et al., 2010). As a result, firms that rely more heavily on debt financing than equity financing tend to

incur higher monitoring costs, which give these firms greater incentives to voluntarily disclose

8 Among these studies, some of them find that estimating the direct method components using the indirect method cash

flow components results in lower estimation errors compared to using balance sheet (BS) components (Hribar and

Collins, 2002; Orpurt and Zang, 2009). However, the overall results suggest that even the magnitude of estimation errors

from the indirect method cash flow components are too significant to be ignored.

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additional information to reduce these costs (Jensen and Meckling, 1976; Leftwich et al., 1981;

Ahmed and Courtis, 1999). Lenders may especially focus on the probability that the firm is

withholding unfavourable value-relevant information in relation to potential default (Sengupta,

1998). If there are significant discrepancies on understanding the probability of withholding

unfavourable value-relevant information between lenders and managers, lenders may themselves

seek additional information to support their assessments. Cash flow information disclosed through

the direct method components provides critical information to assist lenders in assessing a firm’s

borrowing needs, repayment capacity, and default risk. When the estimation errors from available

financial statements are high, firms with greater reliance on the debt market have higher incentives to

voluntarily supply the direct method information in order to reduce the information gap between

lenders and themselves so they can eventually reduce their costs of debt financing.

H1: Firms that rely more heavily on debt financing are more likely to make voluntary

direct method CFO disclosure.

A second setting in which we expect the cash flow information to provide more informative

disclosures is in relation to the level of discretionary accruals. Accruals contain a significant amount

of management assumptions and estimations that are subject to management discretions. Thus, when

a firm has a significantly large amount of accruals, it imposes larger uncertainties for outside

investors in assessing underlying firm performance. Although the discretionary nature of accruals is

well recognised in the literature, how firms react to large accruals in terms of their voluntary

disclosure behaviour is still unclear. On the one hand, the information asymmetry argument suggests

that firms with large amount of accruals are more likely to adopt the direct method voluntarily so that

the additional cash flow information can help investors decipher the uncertainties embedded in large

accrual numbers. Prior studies show that direct method components are more useful than the

aggregate cash flow information for firms with high current receivables or payables (Clinch et al.,

2002). Firms’ receivables and payables are essential components of firms’ working capital accruals.

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This finding is consistent with the information asymmetry argument in showing that direct method

components provide more useful information when firms have large amount of accruals. Thus, it is

likely that firms with higher accruals are more likely to disclose direct method information in order

to make high accrual numbers more transparent to the market.

Meanwhile, agency theory suggests that managers may opportunistically manage earnings to

meet their own interests through the manipulation of discretionary accruals (DeAngelo et al., 1994;

Guay et al, 1996). In addition, prior studies in earnings management literature show that a large

difference between earnings and operating cash flows, which represent large amount of accruals, is

an indicator of potential misstatement or fraudulent financial statements (Lee et al, 1999). Thus,

firms with managers’ interests better aligned with shareholders (lower agency costs) are more likely

to disclose more faithfully represented financial statements (Warfield et al, 1995). On the contrary, if

a firm discloses a high earnings number through upward manipulation of the discretionary accruals,

it would be less willing to disclose additional cash flow information through the direct method

because the direct method components avoid the use of potentially biased accruals (for indirect

estimations of the same) in seeking a gauge of firms’ cash flow performance (Wasley and Wu,

2006).

In short, the information asymmetry argument suggests that large discretionary accruals

increase the probability of voluntary direct method disclosure. The agency cost argument suggests

the opposite. Thus, the first hypothesis (in null form) is stated without specifying the direction:

H2: Firms’ level of discretionary accruals is unrelated to their probability in adopting

the direct method CFO disclosure.

The third setting we identified is when firms have longer operating and cash generating cycles.

Operating and cash generating cycles reflect how similar the cash flow components are to the

accrual-based components. Long operating and cash generating cycles are indicators of significant

deviations of the cash flow components from the accrual-based components (Clinch et al., 2002). In

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addition, firms with longer operating and cash generating cycles are accompanied by higher amount

of working capital accruals, which impose high level of uncertainties to investors when analysing

firm performance. Prior studies show that working capital accounts are noisy and easy to be

manipulated. For instance, Richardson and Sloan (2005) classify working capital accruals as having

medium level of reliability and uncertainties come largely from current assets such as accounts

receivables and inventory. Similarly, Dechow and Schrand’s (2004) monograph shows that accounts

that are managed the most are accounts receivables, expenses other than cost of goods sold and

inventory. Following the American Institutes of Certified Public Accountants (AICPA)’s

recommendation, prior studies classify key direct method components including cash received from

customers and cash paid to suppliers and employees as core components, which are directly related

to firms’ operating activities such as sales, cost of goods sold, and operating expenses (Cheng and

Hollie, 2008; Arthur and Cheng, 2010). These core components provide critical corroborating

information to understand firms’ working capital accruals as well as the operating and cash

generating cycles. Thus, when a firm has longer operating and cash generating cycles, they are more

likely to adopt the direct method.

H3: Firms with longer operating and cash generating cycles are more likely to make

voluntary direct method CFO disclosure.

Although information asymmetry and agency problems raise the demand for accounting

information, firms do not always voluntarily disclose all the private information due to the potential

disclosure costs (Beyer et al., 2010). Specifically, we expect that the potential disclosure costs in

relation to voluntary direct method disclosure come from two sources: costs of preparation and

proprietary costs. Costs of preparation associated with adopting the direct method raise serious

concerns for firms as they are widely claimed in the lobbing positions put to the FASB and the

IASB. Accrual accounting has been the dominant accounting method adopted worldwide. Since none

of the mandated financial statements (income statement, balance sheet, or the indirect cash flow

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statement) explicitly provide direct information regarding the cash inflow and outflow of a firm’s

operating activities, it is claimed that firms need to incur both one-time upfront investments in new

systems to track cash receipts and payments, plus on-going costs to maintain the systems and provide

training to personnel9,10

. Relatively speaking, the adoption of the direct method is expected to be less

burdensome for firms with less complex business operations than for firms with more complex

business operations. Specifically, we use firm size and foreign operations as proxies for the

complexity of business operations.

H4: Firms with less complex business structure (smaller firm size and less foreign

operations) are more likely to make voluntary direct method CFO disclosure.

Another concern of adopting the direct method is the associated proprietary costs of

disclosure, which could arise when the disclosed information is taken advantage of by other

competitors. Thus, when the market is less competitive, voluntary disclosure of the direct method

information is less likely to harm the disclosing firms.

H5: Firms operating in a less competitive market are more likely to make voluntary

direct method CFO disclosure.

2.2 Incremental Usefulness of the Disclosed Direct Method Components

Following prior literature, we gauge the usefulness of disclosed and estimated direct method

components by assessing their ability to predict one-year ahead operating cash flows and earnings.

As stated in SFAS 95, one of the main objectives of supplying the statement of cash flows is to

facilitate the forecasting of future performance and future cash flows, both important indicators of

9 More detailed arguments in relation to these preparation costs can be found in the comment letters submitted in

response to the FASB and IASB’s joint discussion paper issued in 2008. These costs of preparation are commonly

claimed to be overwhelming if the adoption of the DM is mandated. 10

On the other hand, it is our understanding that even in the settings where the direct method was previously mandated,

companies actually estimate the direct cash flow components from their accruals. Further, such estimations by the firm

are more likely to have lower estimation errors because they possess full information on the impact of problematic items

such as the effect of foreign currency gains/losses, mergers and acquisitions, divestitures and consolidation entries.

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firm performance (FASB 1987, para.4-6).11

The following hypotheses are developed in terms of both

future operating cash flows and earnings in order to better understand the incremental usefulness of

direct method components in predicting future performance.

The costs imposed on firms through the mandating of direct method disclosure would be

difficult to justify if disclosed direct method components are not incrementally useful beyond

estimated ones. Alternatively, direct method disclosure becomes unnecessary if estimated direct

method components provide similar ability to predict firms’ future performance despite the

estimation errors. Our study especially focuses on exploring the heterogeneity of the incremental

usefulness of the direct method information in a voluntary setting, which brings the trade-offs

between the previously mentioned benefits and costs into sharp focus.

In the following Sections, 2.2.1 to 2.2.4, we develop hypotheses to investigate the

heterogeneity in the incremental usefulness of the disclosed direct method components, which has

often been overlooked in prior studies.

2.2.1 Firm’s Life Cycle Stages

We expect that the heterogeneity of the incremental usefulness of the direct method

components mainly comes from the distinct characteristics of firms in the steady versus volatile

stages of their life cycle. Prior evidence points to the properties of accruals varying across a firm’s

life cycle stages. Dechow (1994) find that the relative importance of accruals to cash flows depends

on whether a firm is in a steady (“neither growing nor declining, i.e., neither increasing nor

decreasing sales”) or volatile (either growing or declining) environment. Cash flows and accruals are

close or the same if a firm is in a steady stage (Dechow, 1994)12

. In contrast, when a firm is in a

volatile stage (such as growth and decline stages), the accruals will be significantly different from

11

Nevertheless, empirical evidence suggests that earnings are a superior summary measure of future operating

performance (Dechow, 1994; Barth et al., 2001; Orpurt and Zang, 2009). 12

A ‘steady’ stage is simplified in Dechow (1994) as having no sales growth. However, the concept is also applicable for

firms with other operating activities, such as cost of goods and operating expenses.

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cash flows and additional cash flow information will be more likely to add incremental value. In

commenting on Guay et al. (1996), which evaluates five commonly used discretionary accrual

models, Healy (1996) also suggests taking into account the impact of firm’s life cycles on accrual

patterns.

More interestingly, as suggested by the life cycle literature, the firm characteristics previously

identified in Section 2.1 are considered to be associated with firms in more volatile stages (i.e. the

growth and decline stages); these are the stage in which the incremental usefulness of the direct

method components is expected to be more pronounced. In Section 2.1, we conjecture that the

demand and supply of the direct method information varies across different life cycle stages, and in

turn varying incentives for firms to voluntarily disclose the direct method information. Theories in

the life cycle literature suggest that firms increase their reliance on debt financing (H1) in the growth

stage and focus more on debt repayment and/or renegotiation in the decline stage (Meyers, 1977;

Jensen, 1986; Diamond, 1991; Barclay and Smith, 2005). In addition, Dechow and Ge (2006)

document that the amount of accruals (H2) is significantly different for firms in the ‘growth’ or the

‘decline’ stages, and that this has a significantly different influence on the persistence of earnings.

Furthermore, economists in their early research indicate that a firm’s economic operating decisions

vary across its life cycle stages (Spence, 1977; Spence, 1979; Wernerfelt, 1985). In the accounting

literature, working capital accruals are considered to be closely related to a firm’s operating

decisions. For example, in a discussion of Healy (1985), Kaplan (1985) claims that firms’ “working

capital accounts serve useful economic purposes” because they vary depending on the “economic

circumstances” of the firm. Given that firms’ working capital accounts are closely related to firms’

operating and cash generating cycles (H3), we expect that firms’ operating and cash generating

cycles also vary across firms’ life cycle stages.

To provide initial evidence on our conjecture that life-cycle stage is an important

consideration, we present a graph of earnings persistence coefficients across five life cycle stages in

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Figure 3. In the earnings quality literature, a more persistent earnings number is considered to have

higher quality than a less persistent earnings number, since a more persistent earnings number

provides more valuable inputs to equity valuation models (Dechow et al., 2010). We argue that direct

method components are more likely to add incremental value when earnings persistence is lower.

Interestingly, we note from Figure 3 that the earnings persistence coefficient is the highest in the

maturity stage and the lowest in the decline stage.


Combining the information on direct method CFO components with that on accruals and

earnings for firms in volatile stages, financial statement users can obtain a better understanding of the

operations (Ingram and Lee, 1997). Ingram and Lee (1997) illustrate this point by analysing a

hypothetical firm with increasing sales. An increase or decrease in sales is usually accompanied by

changes in several accruals accounts, such as accounts receivables and payables for inventory and

other operating expenses. Ingram and Lee (1997) emphasize the importance of analysing the

differences between operating cash inflows or outflows and sales or cost of goods sold. This example

illustrates how financial statement users can utilize direct method components in their analysis to

understand the business operation and the stage of a firm. Similar in essence, Mulford and Comiskey

(2005) also emphasize the importance of incorporating the difference between earnings and cash

flows in understanding the persistence of cash flows, which is an important factor for financial

statement users when understanding a business. Mulford and Comiskey (2005) develop a measure

called the Excess Cash Margin (ECM)13

to measure the divergence between earnings and cash flow.

We draw on the concept of the ECM and analyse it across different life cycle stages. In Figure 4, we

see a declining trend in both the mean and median when firms move toward maturity. This trend is

consistent with a firm’s life cycle because operating cash flow is growing slower or declining faster

than earnings as firms move into maturity.

13

ECM is calculated as ((Operating Cash Flows – Earnings)/Revenue)*100.

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We define a firm’s life cycles following Dickinson’s (2011) approach and we apply it at the firm

level. Specifically, depending on the sign of each operating, investing and financing cash flow

activities, we define five distinct life cycle stages including introduction, growth, maturity, shake-

out, and decline14

. We expect that the incremental usefulness of the direct method information will

be more pronounced in more volatile stages of the life cycle such as during the growth and decline

stages. Although prior studies show that accruals are better than cash flows in improving earnings’

ability to measure firm performance under volatile stages, we expect that adding further gross cash

flow information to information in the accruals will provide a more useful information set for market

participants. In addition, we expect that the direct method components will not add incremental value

in the introduction stage usually have a large number of cash outflows related to setup costs and

investment in working capital, but little or no cash inflows (Black, 1998). Thus, supplying the direct

method components is not very likely to make a big difference for financial statement users. The

behaviour of firms in the shake-out period is not easy to be explained (Dickinson, 2011) so we do not

make a prediction in relation to the shakeout stage.

H6a: The incremental usefulness of the disclosed direct method components beyond

estimated ones in predicting one-year ahead operating cash flows (earnings) is

more pronounced for firms in the growth or decline stage compared to the

maturity stage.

H6b: Disclosed direct method components are not incrementally useful beyond

estimated ones in predicting one-year ahead operating cash flows (earnings) when

firms are in the introduction stage.

2.2.2 Estimation Differences between Disclosed and Estimated Direct Method Components

Estimation differences between disclosed and estimated direct method components reflect how

difficult it is to do the estimations using various accruals components. Clinch et al. (2002) argue that

14

See Appendix 2 for more details about how the life cycles are defined.

17

when such estimation differences are large, it is more difficult for financial statement users to

understand the actual underlying cash inflow and outflow activities for that business. Given that a

model with direct method components generally has higher predictive ability (higher explanatory

power and lower forecast errors) as evidenced in prior studies (Krishnan and Largay III, 2000;

Arthur et al., 2010), it is reasonable to conjecture that disclosed direct method components are likely

to be more incrementally useful compared to estimated components when estimation differences are

large (as in Clinch et a., 2002):

H7: The incremental usefulness of the direct method components beyond estimated

ones in predicting one-year ahead operating cash flows (earnings) is more

pronounced when the differences between disclosed and estimated direct method

components are large.

2.2.3 Reliance on Debt Financing

In Section 2.1.2, we argue that firms have higher incentives to voluntarily adopt the direct

method when they rely more heavily on debt financing in order to reduce the associated borrowing

costs. Consistent with this argument, prior studies also show that cash flow information, especially

direct method cash flow information is considered to be especially decision-relevant for loan officers

in evaluating liquidity and solvency of borrowers (Jones and Widjaja, 1998). Thus, we expect that

the disclosed direct method components are of greater importance when firms need to access debt

financing.



pronounced when firms rely more heavily on debt financing.

2.2.4 Operating and Cash Generating Cycles

Prior studies show that current earnings forecast future cash flows better than current cash

flows, when the operating cash cycle is longer (Dechow, 1998). We also know that accruals improve

18

earnings’ ability to measure firm performance when the firm’s operating cycle is longer (Dechow,

1994). Both aspects of this evidence appear to favour accruals as important elements for measuring

performance when the operating cycle is long. However, we also know that cash flows from

operations (the cash flow component of earnings) are more persistent than accruals (Dechow and Ge,

2003). It is an open question whether estimation of direct CFO components are more of a challenge

in such settings. We follow Clinch et al. (2002) to characterise firms’ operating and cash generating

cycles using three proxies (high number of days in receivables and payables, and inventory turnover)

to hypothesise as follows:



pronounced when firms have high numbers of days in

receivables/inventory/payables.

3. RESEARCH DESIGN

This section discusses the research design to test the above hypotheses. Specifically, Sections

3.1 and 3.2 discuss the research design in relation to the determinants and the incremental usefulness

of the voluntary direct method disclosure, respectively.

3.1 Determinants of the Voluntary Direct Method Disclosure

To explore the determinants of voluntary direct method disclosure, we adopt the correlated

random effects probit model. Specifically, because we are modelling the probability of making

voluntary direct method disclosure, the response variable is a binary response. We begin from the

probit model with unobserved heterogeneity and a set of explanatory variables , a 1 K vector as

shown below:

( | ) ( ) ( )

19

where ( ) is the standard normal cumulative distribution function (c.d.f.); are covariates

including year dummies; is the unobserved heterogeneity; is the idiosyncratic error that change

across t and individual i.

There are important recent developments in discrete choice modelling that handle unobserved

heterogeneity and we briefly explain the alternative choices here. First, the traditional fixed effects

model treats the heterogeneity as parameters to be estimated. Although the fixed effects model has

the flexibility to allow the unobserved effect to be correlated with , it has been found to suffer

from the incidental parameters problem for non-linear models (Wooldridge, 2010). In contrast, the

random effects model requires that there is zero correlation between the observed covariants and the

unobserved heterogeneity: ( ) . However, this is too strong an assumption

to hold. To relax the zero correlation assumption in the random effects model, the correlated random

effects (CRE) approach is introduced to nonlinear panel data models. Unfortunately, the CRE

approach requires a balanced panel data structure, which has the same time periods for each cross

section observation. Since the time dimension in our sample of specific to each individual firm (i.e.

firms are funded and dissolved at different point in time), we have an unbalanced panel data

structure. To overcome the balanced panel issue, we follow Wooldridge (2010) and adopt the

heteroscedasticity probit model to apply the CRE approach to our unbalanced panel.

Specifically, to accommodate our unbalanced panel structure, we include only observations

with ( , ) fully observed and assign them the selection indicator ; otherwise, and

we use listwise deletion to exclude these observations. Rather than treating the unobserved effects as

parameters to be estimated, we follow the Mundlak (1978) and Chamberlain (1982) device of

modelling the distribution D( | ) of the unobserved effects. Following Wooldridge (2010), the

average exchangeable function allows E( | ) to be a linear function of the time averages with

different coefficients for each number of periods :

20

( | ) ∑ [ ]

∑ [ ]

( )

Further, because our data is in an unbalanced panel format, we follow Wooldridge (2010) and

specify the variance of to change with . The specification of the variance is:

( | ) ( ∑ [ ]

) ( )

where is the variance for the base group, , and the each is the deviation from the base

group. Assuming D( | ) is normal, we obtain the following probability model:

( | ) [ ∑ [ ]

∑ [ ]

(∑ [ ] )

] ( )

The specification leads to a heteroskedastic probit model where the explanatory variables at

time t are (1, , [ ] , … , [ ] ) and the explanatory variables in the variance are

the dummy variables ( [ ], … , [ ]) 15 which are the number of years that a firm is

observed in the dataset. By including the averages of time-varying variables, the estimated

coefficients under the heteroscedasticity probit model are equal to the estimates from the fixed

effects model.

To apply the heteroscedasticity probit model to our setting, the dependent variable is a

dummy variable (direct method) indicating whether a firm is a direct method or an indirect method

firm. The independent variables are the predicted determinants variables we identified in our

hypotheses plus other control variables. In addition, we also include the averages of all the

independent variables.

15

We dropped observations with because with , for the single time period t with . As a

result, β and ξ cannot be distinguished.

21

( )

∑ ∑ ∑ (

) ( )


The regression models in this Section follow Clinch et al. (2002) to employ both the

disclosed and estimated direct method components to test our hypotheses16

. Operating accruals

(ACC)17

is added for each earnings prediction model following prior literature (Sloan, 1996; Barth et

al., 1999)18

. In the U.S., firms are required to disclose TAXPAID and INTPAID even when they

prepare cash flow statement using the indirect method. In order to take into account the special

disclosure requirements in the U.S., two variations of models are estimated if the model involves

estimated direct method components: (a) model with both disclosed and estimated TAXPAID and

INTPAID and (b) model with disclosed TAXPAID and INTPAID only.

To test our hypotheses, we use Model (2) and Model (3) for cash flow and earnings

prediction, respectively. Model (2) is estimated using both disclosed and estimated direct method

components to predict one-year ahead operating cash flows, and has two variations depending on

whether the estimated TAXPAID and INTPAID are included in the model.

( )19

16

Detailed variable definition is provided in Appendix 1. 17

Operating accruals (ACC) is calculated as earnings minus operating cash flows. 18

Sloan (1996) examines the relationship between current earnings performance and future earnings performance as:

. Earnings can then be decomposed into two components: accruals and

operating cash flows. Thus, the relationship can also be expressed as: . In order to capture this relationship, operating accruals (ACC) is added to each earnings prediction model. 19

Model 1(a) and Model 2(a) leave out CASHOTHER intentionally. Without data and rounding errors, each set of five

estimated and disclosed cash flow components add up to the same amount of operating cash flows. Putting these ten

22

( )

Similarly, Model (2) is the earnings prediction model with the additional term ACC added.

( )

( )

To test H6 in relation to firms’ life cycle stages, we follow Dickinson (2011)20

and partition

our sample into five groups: introduction, growth, maturity, shake-out, and decline. We estimate

each of the two variations of Model (2) and Model (3) separately for each life cycle and test if the

disclosed direct method components are jointly significant beyond estimated direct method

components21

. Another commonly used life cycle measure is from Anthony and Ramesh (1992). We

choose not to use their measures for two reasons22

. First, Anthony and Ramesh’s (1992) measures

variables in one model would make them perfectly linearly dependent. Given the data and rounding errors in the dataset,

the ten variables would not be exactly linearly dependent, but are highly collinear. Thus, only nine variables are included

on the right hand side of the regression models.

20

See Appendix 2 for more details about how Dickinson’s (2011) define the five distinct life cycle stages. 21

Specifically, we test CASHCOLL=CASHSUPP=TAXPAID=INTPAID for Model (1a) and (2a). We only test

CASHCOLL=CASHSUPP=CASHOTHER for Model (1b) and (2b) because TAXPAID and INTPAID would be the same

for disclosed and estimated components. 22

We have also estimate our models using Anthony and Ramesh’s (1992) life cycle measures, but the results are

inconsistent with our hypotheses. The issue that our results are sensitive to these two different life cycle measures should

not be a concern because as pointed out in Dickinson (2011), Anthony and Ramesh’s measures are limited in many ways.

23

are based on sorted portfolio to classify firms in different life cycle stages. Second, Dickinson (2011)

shows that the descriptive statistics such profitability, leverage, and solvency ratios in Anthony and

Ramesh’s (1992) life cycle stages are hard to explain.

H7 to H9 further address the issue of differential incremental usefulness under various

settings. To test H7 to H9, we add interaction terms between cash flow components and the variable

of interest. Specifically, we create three sets of dummy variables as proxies for the settings we

identified. For H7, we follow Clinch et al. (2002) by calculating the average absolute difference

between disclosed and estimated direct method components (deflated by total assets) for each firm-

year observation23

. Then, based on whether a firm’s average is above or below the median of the

sample, a dummy variable DIFF is created and set to one for firms with large average absolute

differences (above median) and zero otherwise (below median). For H8, we first calculate debtfin,

which is the percentage of new debt issuance to total financing (debt and equity issuance) for each

firm-year observation. Then, based on whether a firm’s average debtfin is above or below the median

of the sample, we create a dummy variable debtfindum and set to one for firms with higher

percentage of debt financing, and zero otherwise. Finally for H9, we create three standard financial

analysis ratios to measure firms’ operating and cash generating cycles including days in receivables

(dayrect), days in inventory (dayinv) and days in payables (dayap). Three dummy variables

Receivables, Inventory, and Payables are formed based on whether a particular firm-year

observation’s ratio is above or below the overall median for the sample. Specifically, ratios above the

median are considered high and set equal to one.

To test each of the hypotheses, we perform coefficient equity tests on either disclosed or

estimated direct method components plus the associated interaction coefficient between the direct

method components and the dummy variable. Significant F-statistics of the joint significant tests on

23

In order to minimize estimation errors, the average absolute differences only include differences between disclosed and

estimated CASHCOLL, CASHSUPP, and CASHOTHER. As a result, this set of hypotheses is tested under Model 1(b)

and 2(b) only to avoid the complicated caused by estimated TAXPAID and INTPAID.

24

the disclosed direct method components plus the associated interaction coefficients will indicate that

disclosed components are incrementally useful beyond estimated components in predicting future

operating cash flows and earnings under various settings.

4. DATA AND DESCRIPTIVE STATISTICS

4.1 Sample Selection

The nature of the sample is revealed preference data organized in an unbalanced panel

structure by company and year. The sample consists of all public U.S. firms available on Compustat

database from 1989 to 2012. Fiscal year 1988 was the first year that SFAS No. 95 became effective.

We start from 1989 because some of our variables require prior year data. We exclude financial

companies (two-digit SIC code 60-67) and foreign-incorporated firms because their structures and

operations are different from those of other U.S. companies. All the financial statement variables are

downloaded from North America Compustat database. To identify the group of direct method firms,

we perform a keyword search within firms’ 10-K reports through the Lexis-Nexis Academic

platform. We then read through these 10-K reports and confirm whether the direct method is actually

used. To control for the effect of extreme values, variables are winsorized at top and bottom one

percent. To control for heteroscedasticity, all variables are deflated by average total assets following

Orpurt and Zang (2009)24

.

Table 1 presents our sample selection and distribution. Panel A of Table 1 shows our sample

selection procedure. We lose a large number of observations when matching our hand collected data

with Compustat. Panel B of Table 1 reveals that the number of firms adopting the direct method is

increasing over time until around 1995, and then declines afterwards. Our sample distribution is

largely consistent with Krishnan and Largay III and Orpurt and Zang (2009) with additional years of

24

Prior studies examining the usefulness of DM components also deflate variables by other deflators, such as market

capitalization (Clinch et al., 2002) and common shares outstanding (Krishnan and Largay III, 2000). We have tried these

two deflators as a robustness check and find that the overall results are similar except that the adjusted R2 is much higher

when deflated by common shares outstanding (around 80 percent). Adjusted R2 is slightly lower when deflated by market

capitalization (around 20 percent).

25

observations capturing the decreasing trend of the number of direct method firms, In terms of

industry distribution, although the manufacturing industry has the highest number of firms adopting

direct method, there is no single industry that dominates the direct method sample.

4.2 Descriptive Statistics

4.2.1 Characteristics of direct method and indirect method firms

Table 2 presents the summary statistics of selected firm characteristics. Panel A of Table 2

compares the firm characteristics of direct method firms to IM firms both on average and across

various life cycle stages. Consistent with H1 to H5, results from both the t-test and the Wilcoxon test

suggest that direct method and indirect method firms possess significantly different firm

characteristics. Specifically, direct method firms are found to have significantly higher leverage

ratio (leverage), higher percentage of new debt issuance (debtfin), lower discretionary accruals

(disacc), longer operating cycles (cycle and abncycle), less complex business operations as indicated

by smaller firm size (logat) and less foreign operations (foreign), and compete in less competitive

environment (hhi). In addition, these firm characteristics appear to be especially pronounced in the

growth and decline stages.

4.2.2 The Nature of the Direct Method Disclosure

Panel B of Table 2 provides summary descriptive statistics for each disclosed and estimated

direct method components. Overall, the estimated direct method components have a similar

distribution to the disclosed direct method components. Consistent with Hribar and Collins (2002),

indirect method estimated direct method components are closer to the disclosed direct method

components than the BS estimated components are. More interestingly, comparing disclosed and

estimated direct method components reveals that the disclosed direct method components appear to

convey more favourable news than estimated direct method components do. The disclosed cash

26

collection from customers is larger than the estimated cash collection. The disclosed cash payment to

suppliers and employees are smaller than the estimated cash payment.

5. EMPIRICAL RESULTS

5.1 Determinants of the Voluntary Direct Method Disclosure

Table 3 presents the results for the correlated random effects probit model (Model 1). To

allow for unobserved heterogeneity in the form of correlated random effects, we include the time

averages of all time-varying covariates. The averages of year dummies are also included to

accommodate the unbalanced panel data structure. In addition, both the outcome and variance

equation are allowed to depend on the number of observations within each sub-panel ( ) as shown

in equation (4) above. The results show that after controlling for firm-specific effect and allowing for

the correlation between and , most of the variables of interest are significant and have the

expected sign. Especially, leverage has a significantly positive impact (p=0.003) on firms’ decision

to voluntarily adopt the direct method. The result supports H1 by showing that firms relying more

heavily on debt financing are more likely to adopt the direct method. Discretionary accruals (disacc)

are shown to have a significantly negative impact on the probability of adopting the direct method

(p=0.007). This is consistent with the agency theory side of arguments that firms with larger amount

of discretionary accruals are less likely to adopt the direct method. The p-value for both logat and

foreign are significantly negative (p=0.003 and 0.008, respectively), which strongly support H4 that

firms with less complex business operations are more likely to adopt the direct method. Finally, H5

is marginally supported (p=0.100) that firms operating in less competitive environment are more

likely to voluntarily disclose the direct method components.


5.2.1 Firm Life Cycle Stages

27

In H6, we hypothesize that the incremental usefulness of the direct method components

varies across firms’ life cycle stages. For brevity, only results from indirect method estimated direct

method components are presented in Table 425

. To test the predictive ability of one-year ahead

operating cash flows, we estimate both model (2a) and (2b) but we find inconsistent results between

model (2a) and (2b). As shown in Penal A of Table 4, estimating Model (2a) returns us results that

are inconsistent with our hypotheses.

[Insert Table 4 – Panel A Here]

However, when we estimate Model (2b) as shown in Panel B of Table 8, The F-statistics are

significantly larger in the growth (11.24 with p=0.0000) and decline stages (17.05 with p=0.0000),

which support H6 that the incremental usefulness of the direct method components is more

pronounced in the growth and decline stages. Also consistent with our hypothesis, the coefficient

equity test is insignificant (1.76 with p=0.1757) for firms in the introduction stage. Although the

coefficient equality test is also significant for firms in the maturity stage, the impact is much weaker

(6.49 with p=0.0011) than firms in the growth and decline stages.

[Insert Table 4 – Panel B Here]

The results show identical pattern when running the one-year ahead earnings prediction models.

Under Model (3a) shown in Panel C of Table 8, the results are inconsistent with our hypotheses.

[Insert Table 4 – Panel C Here]

When estimating Model (3b), the coefficient equality tests are significant for both growth (8.22 with

p=0.0004) and decline stages (8.46 with p=0.0006). Interestingly, when predicting one-year ahead

earnings, the incremental usefulness of the direct method components is also stronger in the maturity

stage.

25

We also estimate the same group of models and tests using the BS estimated DM components and the results are of

similar patterns.

28

[Insert Table 4 – Panel D Here]

Overall, the results are consistent with our hypotheses and suggest that the incremental

usefulness of the direct method is most likely driven by improved information content in the growth

and decline stages. Also, the results suggest that the two variations of Model (3) are more suitable in

the U.S. setting.

5.2.2 Estimation Differences between Disclosed and Estimated Direct Method Components

Table 5 presents the results for H7. As explained in previous section, to minimize

unnecessary estimation errors and avoid the complication caused by estimated TAXPAID and

INTPAID, H7 is only tested under Model (2b) and (3b). The results are consistent with H7 that

disclosed direct method components exhibit significant incremental value beyond estimated direct

method components for firms with large average absolute differences between disclosed and

estimated direct method components. When the coefficient equality on disclosed direct method

components plus the associated DIFF interaction coefficients is performed using the cash flow

prediction model (2b), the null hypothesis is strongly rejected using either indirect method

(p=0.0000) or BS (p=0.0000) estimated direct method components. This is consistent with the

hypothesis that direct method components are incrementally useful in predicting one-year ahead

operating cash flows. Similarly, the null hypothesis for the earnings prediction model (3b) is also

strongly rejected using either IM (p=0.0005) or BS (p=0.0000) estimated direct method components.

Overall, we show that disclosed direct method components tend to add more incremental value when

firms have large estimation difference between disclosed and estimated direct method components.

[Insert Table 5 Here]

5.2.3 Reliance on Debt Financing

29

Results in relation to H8 are presented in Table 6. H8 is strongly supported by the coefficient

equality tests on disclosed direct method components plus the associated debtfindum interaction

coefficients. When predicting one-year ahead operating cash flows, disclosed direct method

components are shown to be incrementally useful beyond either IM (p=0.0000) or BS (p=0.0000)

estimated direct method components. Similarly, when predicting one-year ahead earnings, the

incremental usefulness of disclosed direct method components is also more pronounced when firms

rely more heavily on new debt financing (p=0.0003 and p=0.0000 respectively for IM and BS

estimated direct method components).


5.2.4 Operating and Cash Generating Cycles

H9 addresses the impact of operating and cash generating cycles on the incremental

usefulness of disclosed direct method components and the results are presented in Table 7. Column

(1) and (2) of Table 7 presents the results for predicting one-year ahead operating cash flows. The

results show that direct method components are incrementally useful when a firm has a high number

of days in receivables, inventory and payables. The results are not sensitive to whether the estimated

direct method components are from IM (p=0.0000, 0.0272 and 0.0001 respectively for receivables,

inventory, and payables) or BS (p=0.0000, 0.0000 and 0.0000 respectively for receivables,

inventory, and payables). Column (3) and (4) of Table 7 show the results for predicting one-year

ahead earnings. Similarly, despite of how the estimated direct method components are computed, the

disclosed direct method components are found to be incrementally more useful when a firm has a

high number of days in receivables (p=0.0000 and 0.0000 for IM and BS estimated direct method

components), inventory (p=0.0002 and 0.0000 for IM and BS estimated direct method components)

and payables (p=0.0001 and 0.0000 for IM and BS estimated direct method components).


30

6. CONCLUSION

In conclusion, this study investigates two research questions. The first research question

explores the determinants of voluntary direct method disclosure. Different from prior studies that

often implement a simple probit model to explore firms’ managerial incentives, this study adopts the

correlated random effects probit model to better capture the observed and unobserved heterogeneity.

The results suggest that firms are more likely to adopt the direct method when they rely more heavily

on debt financing, when they have lower discretionary accruals, when they have longer operating and

cash generating cycles, and when they compete in a less competitive market. Instead of looking at

the average incremental usefulness, the second research question focuses on the heterogeneity of the

incremental usefulness of disclosed direct method components. Especially, we find that the

incremental usefulness is more pronounced under circumstances where firms have greater incentives

to disclose the direct method components. Specifically, we find that disclosed direct method

components are incrementally more useful when firms are in more volatile life cycle stages, such as

the growth and decline stages, when the estimation differences are large, when firms issue new debt,

and when firms have longer operating and cash generating cycles.

31

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35

Appendix 1 Variable Definition

nyear Number of years that a firm has observations

DM Dummy Variable: 1 for firms that adopt the DM, and 0 otherwise

logat It is the natual log of total assets (Compustat item "AT")

firmage It is measured (in years) as the current year minus the first year the firm is available on the

Compustat database.

foreign It indicates whether a firm has foreign opeartions. It equals 1 if the firm has foeign

opeartions, and 0 otherwise. Foreign opearions is proxied by Compustat item "FCA".

debtfin It is the percentage of new debt financing to total capital issuance. It is measured by

Compustat items "DLTIS" / ("SSTK"+"DLTIS")

leverage It is the leverage ratio of a firm, measured by Compustat items "DLTT" / ("DLTT" +

"CSHO" * "PRCC_F")

dayrect Days in receivables as one of the efficiency ratios is calculated using Compustat items

"RECT" / ("SALE"/365)

dayinv Days in inventory as one of the efficiency ratios is calculated using Compustat items

"INVT" / ("COGS"/365)

dayap Days in payables as one of the efficiency ratios is calculated using Compustat items "AP"

/ ("SALE"/365)

cycle Cash generating cycle calculated as 'dayrect' + 'dayinv' - 'dayap'

abncycle Industry-adjusted cycle. An industry is defined based on two-digit SIC code.

abnroa Industry-adjusted ROA where ROA is calculated using Compustat items

"IB"/("AT(t)"+"AT(t-1)"/2). An industry is defined based on two-digit SIC code.

hhi It is the Herfindahl Index calculated as the sum of squares of the squares of the market

shares (Compustat item "SALE") of the firms within each 2-digit SIC code industry

disacc Discretionary accruals estimated from the Modified Jones Model

lifecycle Categorical variable to define a firm's life cycle stages according to Dickinson (2011).

Introduction=1/Growth=2/Maturity=3/Shake-Out=4/Decline=5

Disclosed and Estimated DM Components

CASHCOLL Cash received from customers hand collected from 10-K reports

36

CASHPAID Cash paid to suppliers and employees collected from 10-K reports

INTPAID Net interest paid collected from 10-K reports

TAXPAID Income tax paid collected from 10-K reports

CASHOTHER Other disclosed cash flow components not included above collected from 10-K reports

Est_CASHCOLL Estimated cash recived from customers: sales – change in accounts receivable

IM Calculated using Compustat items "SALE"-(-"RECCH")

BS Calculated using Compustat items "SALE"-("RECT"-"RECT"(t-1))

Est_CASHPAID

Estimated cash paid to suppliers and employees: cost of goods sold (excluding

depreciation) + change in inventory – change in accounts payable + change in other assets

– change in other current liabilities – change in other liabilities

IM Calculated using Compustat items "COGS"-"INVCH"-"APALCH"+("AO"-"AO"(t-

1))+"XSGA"-("LCO"-"LCO"(t-1))-("LO"-"LO"(t-1))

BS Calculated using Compustat items "COGS"-("INVT"-INVT"(t-1))-("AP"-"AP"(t-

1))+("AO"-"AO"(t-1))+"XSGA"-("LCO"-"LCO"(t-1))-("LO"-"LO"(t-1))

Est_INTPAID Estimated net interest paid: interest expense ("XINT") – interest income ("IDIT")

Est_TAXPAID Estimated tax paid: tax expense ("TXT")-change in deferred taxes ("TXDB"-("TXDB"(t-

1)) – change in taxes payable ("TXP"-"TXP"(t-1))

Est_CASHOTHER Estimated cash other: difference between total operating cash flows and the sum of other

four estimated components

DIFF Dummy variables set to 1 if the average absolute estimation difference is above the

median, and 0 otherwise.

debtfindum Dummy variables set to 1 if debtfin is above the median, and 0 otherwise.

Receivable Dummy variables set to 1 if dayrect is above the median, and 0 otherwise.

Inventory Dummy variables set to 1 if dayinv is above the median, and 0 otherwise.

Payable Dummy variables set to 1 if dayap is above the median, and 0 otherwise.

37

Appendix 2 Dickinson (2011) Life cycle classification

1 2 3 4 5 6 7 8

Introduction Growth Maturity Shake-Out Shake-Out Shake-Out Decline Decline

Cash flows from

operating activities - + + - + + - -

Cash flows from

investing activities - - - - + + + +

Cash flows from

financing activities + + - - + - + -

Each category of cash flow components: operating, investing and financing activities can take a positive or negative sign. The full factor results in

8 possible combinations.

The 8 possible combinations are then grouped into five distinct life cycle stages based on theories from prior accounting and finance literature.

38

Figure 1 Overall Research Design

39

Figure 2 Summary of Hypotheses Development

Firms’ Choice to

Voluntarily Adopt the

Direct Method

Demand of

Accounting

Information

Supply of

Accounting

Information

Incentives

to Disclose

Costs of

Disclosure

Market Imperfections: Information Asymmetry

and Agency Problems

H1: Reliance on Debt

Financing

H2: Level of Discretionary

Accruals

H3: Operating and Cash

Generating Cycles

H4: Complexity of Firms

(preparation costs)

H5: Market Competitiveness

(proprietary costs)

Are direct method CFO

components incrementally

more useful in these

settings?

H6: Life cycles

H7: Magnitude of

Estimation Differences

H8: Reliance on Debt

Financing

H9: Operating and Cash

Generating Cycles Research Question 1: Determinants

Research Question 2:

Incremental

Usefulness

(Healy and Palepu, 2002; Beyer et al., 2010)

40

Figure 3 Earnings persistence across life cycle stages

This graph depicts the mean of earnings persistence across different life cycle stages. Life

cycle stages are measured following Dickinson (2011). Earnings Persistence is measured as

the coefficient on EARNt from estimating in each stage.

Figure 4 Excess Cash Margin (ECM) across life cycle stages

This graph depicts means and medians of Excess Cash Margin (ECM) across different life

cycle stages. Life cycle stages are measured following Dickinson (2011). The measure of

ECM is adapted from Mulford and Comskey (2005) as [

]

0.682

0.820 0.877

0.842

0.524

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Introduction Growth Maturity Shake-out Decline

Earnings persistence

across stages of firms' life cycle

2013.92

87.13 68.61 142.37

1580.90 9.61 6.75

5.52 6.30

11.03

0

2

4

6

8

10

12

0

500

1000

1500

2000

2500

Introduction Growth Maturity Shake-out Decline

Excess cash margin (ECM)

across firms' life cycle

Mean Median

41

TABLE 1

Sample Selection and Distribution

Panel A: Sampling Process

Number of

Observations

Number of Companies

1. Initial hand collected DM sample

3,076

528 2. After merging with Compustat

2,402

380 3. After removing financial companies

1,965

312 4. After removing mismatched OCF

1,932

309 *5. After removing obs. with missing values from Compustat to calculate needed

variables

1,534

257

42

Panel B: Final Sample Distribution by Year and Industry

Fiscal

Year

Final

DM

Sample

in Full

Sample

**Number

in

Full

Sample

% of Final

DM

sample in

Full

Sample

Agriculture,

Forestry,

Fishing

01-09

Mining

10-14

Construction

15-17

Manufacturing

20-39

Transportation

& Public

Utilities

40-49

Wholesale

Trade

50-51

Retail

Trade

52-59

Services

70-89

Public

Admin.

91-99

DM Full DM Full DM Full DM Full DM Full DM Full DM Full DM Full DM Full

1989 136 4,031 3.37% 1 21 10 204 0 54 66 2,065 12 465 10 206 13 315 23 645 1 56

1990 134 4,231 3.17% 1 24 8 230 0 61 68 2,133 15 495 10 210 11 328 20 688 1 62

1991 125 4,307 2.90% 1 27 9 222 0 60 58 2,168 16 497 10 213 14 345 17 713 0 62

1992 112 4,513 2.48% 1 23 6 211 0 59 53 2,265 18 508 8 212 12 391 14 779 0 65

1993 114 4,831 2.36% 1 24 5 221 1 62 57 2,428 18 538 5 233 12 426 15 840 0 59

1994 110 5,047 2.18% 1 22 7 218 1 67 53 2,523 16 563 4 249 13 444 15 894 0 67

1995 126 5,558 2.27% 1 26 8 228 2 75 60 2,760 16 580 3 271 15 467 21 1,073 0 78

1996 103 6,051 1.70% 1 24 7 244 2 74 48 2,954 14 603 3 284 13 501 15 1,280 0 87

1997 80 6,142 1.30% 1 25 4 244 2 81 39 2,992 11 596 3 273 9 493 11 1,345 0 93

1998 63 5,892 1.07% 2 26 5 216 2 82 29 2,848 5 556 3 269 8 466 9 1,343 0 86

1999 51 5,831 0.87% 2 24 4 217 1 70 21 2,710 3 549 3 250 8 457 9 1,470 0 84

2000 46 5,789 0.79% 2 23 4 227 1 64 20 2,672 1 534 3 228 7 431 8 1,519 0 91

2001 44 5,310 0.83% 2 23 2 201 1 56 21 2,510 1 477 2 200 7 377 8 1,383 0 83

2002 42 4,955 0.85% 2 24 3 187 1 50 22 2,360 2 454 2 192 4 360 6 1,249 0 79

2003 40 4,616 0.87% 2 20 2 176 1 44 21 2,239 3 445 2 180 3 332 6 1,102 0 78

2004 38 4,543 0.84% 2 17 2 191 1 43 21 2,225 3 451 3 173 2 320 4 1,055 0 68

2005 30 4,380 0.68% 2 17 2 200 1 44 15 2,171 3 431 3 155 2 315 2 990 0 57

2006 24 4,221 0.57% 2 15 1 220 1 45 12 2,127 2 402 2 154 2 299 2 911 0 48

2007 22 4,045 0.54% 2 15 1 226 0 45 12 2,053 2 384 2 149 2 283 1 856 0 34

2008 23 3,819 0.60% 2 15 1 222 0 42 13 1,952 2 367 2 140 2 263 1 796 0 22

2009 22 3,644 0.60% 2 18 1 215 0 41 12 1,860 2 352 2 135 2 248 1 762 0 13

2010 19 3,496 0.54% 2 19 0 212 0 41 12 1,790 1 337 1 129 2 250 1 709 0 9

2011 18 3,379 0.53% 2 17 0 218 0 42 12 1,718 1 320 1 134 1 239 1 685 0 6

2012 12 3,276 0.37% 2 17 1 226 0 30 6 1,656 1 314 0 127 1 236 1 666 0 4

Total 1,534 110,201 1.37% 39 506 93 5,176 18 1,332 751 55,179 168 11,218 87 4,766 165 8,586 211 23,753 2 1,391

*This is the number of observations we use to test the determinants model. Our descriptive statistics are also calculated based on this sample. The number of observations in the incremental

usefulness section is lower than this because of the additional requirements to calculate the estimated DM components. We report the number of observation for each incremental usefulness models

in the regression result section.

**The full sample consists of all nonfinancial U.S. incorporated firm-year observations that do not have missing values for variables included in our regressions, exclusive of T=1 observations.

43

TABLE 2

Descriptive Statistics

Panel A: Comparison between DM and indirect

method firms

Variables DM or IM Mean Median Difference

Life Cycle Stages

t-test Wilcoxon

Introduction Growth Mature Shake-Out Decline

leverage DM Firms

0.2087

0.1127

0.0000 0.0002 0.2104 0.2390 0.1858 0.2360 0.1960

IM Firms

0.1867

0.0849

0.1462 0.2129 0.2009 0.1882 0.1384

debtfin

DM Firms

0.5472

0.7974 0.0000 0.0000

0.5486 0.6559 0.4831 0.4711 0.4791

IM Firms

0.4708

0.4211

0.3827 0.5615 0.4988 0.3955 0.3234

disacc

DM Firms

0.3831

0.0808 0.0000 0.0000

0.6189 0.2971 0.3175 0.3275 0.6529

IM Firms

0.5788

0.1127

0.9175 0.4751 0.4508 0.5089 0.7102

dayrect

DM Firms

57.9832

52.6321

0.0140 0.0011

64.8581 59.5147 51.8087 57.1021 74.4321

IM Firms

60.4434

55.5879

70.8113 60.6640 52.5204 60.2230 67.7014

dayinv

DM Firms

69.2761

46.7665

0.1697 0.1477

92.0284 64.1708 69.4310 59.6786 58.3765

IM Firms

66.8269

47.8452

78.7166 60.4257 64.6450 67.9758 67.0622

dayap

DM Firms

32.8383

22.5484

0.0000 0.0000

60.3267 26.7636 22.7667 27.5667 63.1751

IM Firms

43.1328

26.0973

76.6699 32.2195 26.5565 36.4052 74.0303

cycle

DM Firms

94.4210

84.4925 0.0000 0.0006

96.5598 96.9219 98.4730 89.2140 69.6335

IM Firms

84.1374

76.6011

72.8580 88.8702 90.6090 91.7937 60.7333

abncycle

DM Firms

12.1428

3.6387 0.0000 0.0024

5.7140 20.3758 15.3122 6.6157 -10.6356

IM Firms

3.1876

1.1445

-13.9778 13.6671 10.7714 8.4789 -26.8917

logat

DM Firms

4.2753

4.1648 0.0000 0.0000

3.4973 4.9459 4.5432 3.6927 2.9630

IM Firms

4.7873

4.3144

3.2605 5.4822 5.5703 4.4941 3.2751

foreign

DM Firms

0.1076

0.0000 0.0000 0.0000

0.1132 0.1575 0.0941 0.0424 0.1016

IM Firms

0.1583

0.0000

0.1017 0.1654 0.1903 0.1757 0.1197

hhi

DM Firms

0.2617

0.2001

0.0019 0.0099

0.2823 0.2492 0.2515 0.2693 0.2931

IM Firms

0.2475

0.1898

0.2453 0.2343 0.2525 0.2577 0.2425

abnroa

DM Firms

0.4153

0.0676

0.2708 0.1259

0.3025 -0.0259 0.1391 2.0276 1.2351

IM Firms

0.1590

0.0126

-0.3127 -0.0614 0.4772 0.7739 0.0890

No. of obs.

DM Firms

1,534

212 381 648 165 128

IM Firms

108,667

21,869 29,946 37,601 10,050 9,201

44

Panel B Disclosed and estimated DM component

Quantiles

Variables n Mean S.D. Min 0.25 Median 0.75 Max

CASHCOLL 1,714 1.4428 0.9967 0.0000 0.6828 1.2954 1.9606 4.6227

Est_CASHCOLL

IM 1,714 1.4370 0.9978 0.0000 0.6609 1.2926 1.9515 4.8767

BS 1,714 1.4390 0.9977 0.0000 0.6822 1.2865 1.9509 4.8647

CASHPAID 1,144 1.4738 1.0053 0.0579 0.7179 1.3243 1.996246 4.6834

Est_CASHPAID

IM 1,144 1.5064 1.1140 -0.1003 0.7153 1.3216 2.0794 8.3864

BS 1,144 1.0799 0.9461 -1.2380 0.3782 0.8953 1.5169 5.1604

TAXPAID (Compustat) 1,754 0.0174 0.0299 -0.0460 0.0000 0.0042 0.0289 0.1321

TAXPAID (Hand Collected) 1,754 0.0180 0.0294 -0.0254 0.0000 0.0043 0.0289 0.1383

Est_TAXPAID 1,754 0.0204 0.0437 -0.1168 0.0000 0.0086 0.0400 0.1742

INTPAID (Compustat) 1,194 0.0167 0.0330 -0.0622 -0.0011 0.0136 0.0300 0.1440

INTPAID (Hand Collected) 1,194 0.0249 0.0269 0.0000 0.0043 0.0181 0.0342 0.1285

Est_INTPAID 1,194 0.0306 0.1037 -0.0529 -0.0001 0.0164 0.0334 1.0302

CASHOTHER 1,805 -0.0205 0.1180 -0.8057 0.0000 0.0000 0.0000 0.1937

Est_CASHOTHER 1,805 -0.0063 0.1098 -0.9073 -0.0054 0.0000 0.0125 0.5484

45

Table 3

Regression Analysis of the Determinants

Hypothesis Variable

Predicted Sign

Coefficient

P-value

H1 leverage

+

0.24909

0.003

H2 disacc

?

-0.05189

0.007

H3 abncycle

+

0.00032

0.136

H4 logat

-

-0.04803

0.003

foreign

-

-0.13378

0.008

H5 hhi

+

0.19330

0.100

Other

Control

Variables

abnroa

0.00013

0.908

lifecycle

growth

0.16911

0.000

maturity

0.08942

0.005

shake-out

0.13523

0.000

decline

0.12102

0.002

Average of time-variant variables Yes

fyear_dummies

Yes

fyear_dummmies_bar

Yes

Constant

11.15839

0.000

Observations

110,201

(DM observations)

1,534

46

Table 4 Life cycle stages – introduction, growth, maturity, shake-out, and decline

Panel A: Model (2a) - Predicting one-year ahead operating cash flows

(1) (2) (3) (4) (5)

VARIABLES Introduction Growth Maturity Shakeout Decline

Disclosed Cash Flow Components

CASHCOLL 0.0540 0.0999 0.0344 0.0599 1.357***

(0.106) (0.0983) (0.0998) (0.208) (0.266)

CASHSUPP -0.0199 -0.200** -0.191*** -0.574*** -1.150***

(0.0784) (0.0876) (0.0647) (0.0581) (0.184)

TAXPAID 3.059*** -0.661 2.352*** -1.470 0.272

(1.120) (0.687) (0.847) (1.117) (1.191)

INTPAID 0.837 -0.0866 0.401 0.300 0.426

(1.062) (0.499) (0.482) (0.560) (1.160)

Estimated Cash Flow Components

Est_CASHCOLL 0.160 0.0206 0.0843 0.216 -0.146

(0.165) (0.0953) (0.114) (0.207) (0.159)

Est_CASHSUPP -0.181 0.0512 0.0415 0.296*** -0.0451

(0.110) (0.0339) (0.0267) (0.0510) (0.0799)

Est_INTPAID -2.408*** 0.137 -1.454** 0.254 -1.775***

(0.330) (0.605) (0.690) (0.441) (0.473)

Est_TAXPAID 0.211 0.201 -0.0434 0.300 -0.418

(0.872) (0.287) (0.431) (0.282) (0.921)

Est_CASHOTHER 0.339* -0.521*** -0.0272 0.404*** -0.0510

(0.199) (0.140) (0.120) (0.103) (0.293)

Constant -0.0971* 0.0967*** 0.0808*** 0.0490 0.0259

(0.0548) (0.0228) (0.0190) (0.0294) (0.0560)

Observations 116 139 247 73 40

R-squared 0.885 0.208 0.129 0.613 0.691

Test of Coefficient Equality

Coefficients on disclosed cash flow

components are equal

2.86

(p=0.0405)

1.40

(p=0.2450)

3.80

(p=0.0108)

4.63

(p=0.0054)

16.83

(p=0.0000)

Coefficients on estimated cash flow


29.86

(p=0.0000)

4.37

(p=0.0024)

1.26

(p=0.2871)

1.56

(p=0.1968)

8.59

(p=0.0001)

Robust standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1

47

Table 4 (Continued)

Panel B: Model (2b) - Predicting one-year ahead operating cash flows

(1) (2) (3) (4) (5)



CASHCOLL 0.219 0.442*** 0.250*** 0.259 1.298***

(0.187) (0.107) (0.0752) (0.185) (0.241)

CASHSUPP -0.348* -0.467*** -0.234*** -0.663*** -1.158***

(0.194) (0.102) (0.0595) (0.0929) (0.207)

TAXPAID 0.509 -0.174 0.625*** -0.0824 -0.789

(0.965) (0.286) (0.239) (0.431) (0.550)

INTPAID -3.253** -0.617** 0.327 -1.505** -1.344**

(1.542) (0.245) (0.276) (0.723) (0.619)

CASHOTHER 0.504* 0.462*** 0.283*** 0.513** 1.102

(0.296) (0.102) (0.0888) (0.208) (0.786)


Est_CASHCOLL 0.500*** -0.0319 -0.0632 0.148 -0.231*

(0.190) (0.0433) (0.0501) (0.166) (0.131)

Est_CASHSUPP -0.370* 0.0524** 0.0353 0.255*** 0.0618

(0.193) (0.0258) (0.0231) (0.0543) (0.110)

Est_CASHOTHER 0.695 -0.244* 0.0284 0.308*** -0.261

(0.622) (0.146) (0.0853) (0.0941) (0.219)

Constant 0.0816 0.0497** 0.0691*** 0.0566*** 0.0861**

(0.0534) (0.0198) (0.0119) (0.0206) (0.0426)

Observations 159 234 436 107 69

R-squared 0.724 0.202 0.127 0.525 0.428




1.76

(p=0.1757)

11.24

(p=0.0000)

6.94

(p=0.0011)

8.73

(p=0.0003)

17.05

(p=0.0000)



2.99

(p=0.0532)

2.40

(p=0.0935)

1.27

(p=0.2823)

0.35

(p=0.7070)

1.10

(p=0.3387)


*** p<0.01, ** p<0.05, * p<0.1

48

Table 4 (Continued)

Panel B: Model (3a) - Predicting one-year ahead earnings

(1) (2) (3) (4) (5)


ACC 1.130*** 0.186* 0.212** 0.887*** -0.00249

(0.107) (0.109) (0.0929) (0.232) (0.223)


CASHCOLL 0.136 0.0940 -0.0363 0.419 2.639***

(0.137) (0.124) (0.0586) (0.328) (0.711)

CASHSUPP -0.147* -0.106 -0.135** -0.881*** -1.703***

(0.0772) (0.105) (0.0581) (0.173) (0.450)

TAXPAID -2.039** 0.630 0.640 0.717 -0.566

(1.019) (0.491) (0.412) (1.113) (2.785)

INTPAID 1.206 -0.583 0.0339 3.014* 2.101

(1.255) (0.674) (0.749) (1.662) (2.142)


Est_CASHCOLL 0.256*** 0.000819 0.229*** -0.0138 -0.899*

(0.0896) (0.119) (0.0737) (0.271) (0.445)

Est_CASHSUPP -0.235*** 0.0175 -0.0476** 0.454** -0.00128

(0.0425) (0.0238) (0.0200) (0.221) (0.203)

Est_INTPAID -1.181* -0.0409 -0.349 -3.458*** -3.461**

(0.625) (0.541) (0.653) (1.246) (1.572)

Est_TAXPAID 0.247 0.0158 -0.307 -0.858* -1.945

(0.931) (0.253) (0.367) (0.492) (2.406)

Est_CASHOTHER 0.0815 -0.191 0.0907 0.706* 1.466

(0.295) (0.125) (0.138) (0.390) (0.866)

Constant -0.0968 0.0146 0.0134 0.0109 -0.121

(0.0761) (0.0321) (0.0167) (0.0583) (0.122)

Observations 116 139 247 74 40

R-squared 0.975 0.177 0.188 0.863 0.674




3.17

(p=0.0272)

1.63

(p=0.1845)

2.25

(p=0.0831)

6.01

(p=0.0011)

10.60

(p=0.0001)



8.25

(p=0.0000)

0.93

(p=0.4493)

2.92

(p=0.0220)

5.49

(p=0.0007)

3.41

(p=0.0210)


*** p<0.01, ** p<0.05, * p<0.1

49

Table 4 (Continued)

Panel B: Model (3b) - Predicting one-year ahead earnings

(1) (2) (3) (4) (5)


ACC 1.217*** 0.261*** 0.326*** 1.172*** 0.427***

(0.134) (0.0845) (0.0926) (0.291) (0.0954)


CASHCOLL 0.116 0.420*** 0.338*** 0.683 2.505***

(0.125) (0.113) (0.0815) (0.458) (0.708)

CASHSUPP -0.232*

-

0.420***

-

0.296***

-

1.407***

-

1.550***

(0.125) (0.107) (0.0657) (0.283) (0.431)

TAXPAID -2.015** 0.177 0.196 -1.519 -0.200

(0.775) (0.296) (0.208) (0.947) (1.307)

INTPAID -2.135

-

0.872*** -0.238 -0.868 -1.846**

(2.649) (0.262) (0.256) (1.098) (0.754)

CASHOTHER 0.0645 0.457*** 0.413*** 2.110*** 4.053***

(0.184) (0.125) (0.108) (0.581) (1.071)


Est_CASHCOLL 0.408*** -0.0232 0.00223 0.190 -0.987*

(0.0695) (0.0476) (0.0547) (0.389) (0.506)

Est_CASHSUPP -0.303*** 0.0340* -0.0365 0.493** 0.0632

(0.0596) (0.0188) (0.0371) (0.232) (0.144)

Est_CASHOTHER -0.174 -0.173 -0.0617 0.0947 0.436

(0.364) (0.131) (0.102) (0.319) (0.438)

Constant 0.00301 -0.0114 0.00461 0.0981** -0.0156

(0.0648) (0.0218) (0.0117) (0.0451) (0.0745)

Observations 159 234 436 108 69

R-squared 0.924 0.308 0.277 0.772 0.532




1.83

(p=0.1638)

12.86

(p=0.0000)

9.90

(p=0.0001)

9.14

(p=0.0002)

8.46

(p=0.0006)



16.30

(p=0.0000)

1.61

(p=0.0202)

0.26

(p=0.7719)

0.88

(p=0.4176)

2.24

(p=0.1151)


*** p<0.01, ** p<0.05, * p<0.1

50

Table 5 Estimation differences between disclosed and estimated DM components

(1) (2) (3) (4)

VARIABLES Model(2b) CS Model(2b) BS Model(3b) CS Model(3b) BS

ACC

1.192*** 1.174***

(0.119) (0.0972)


CASHCOLL 0.335 0.621*** 0.863* 0.959***

(0.371) (0.119) (0.490) (0.131)

CASHSUPP -0.574** -0.671*** -0.936*** -1.088***

(0.253) (0.0821) (0.297) (0.109)

CASHOTHER 0.121 0.563*** 1.527** 1.330***

(0.521) (0.152) (0.614) (0.235)

TAXPAID -0.123 -0.578** -1.678*** -1.533***

(0.328) (0.265) (0.357) (0.335)

INTPAID -0.355 -0.752*** -1.731** -1.342***

(0.305) (0.239) (0.749) (0.293)

Interactions with DIFF

CASHCOLL 0.187 -0.00725 -0.397 -0.400*

(0.387) (0.160) (0.520) (0.214)

CASHSUPP -0.0486 -0.0151 0.389 0.478***

(0.271) (0.111) (0.344) (0.178)

CASHOTHER 0.674 0.272 -0.841 -0.528*

(0.543) (0.196) (0.670) (0.310)

TAXPAID -0.308 -1.858** 0.735 -0.717

(0.429) (0.884) (0.600) (1.227)

INTPAID -1.907** 0.319 0.975 0.527

(0.804) (0.386) (1.135) (0.512)


Est_CASHCOLL 0.214 0.0678 0.209 0.168

(0.348) (0.110) (0.454) (0.117)

Est_CASHSUPP 0.0104 -0.0301 -0.143 -0.0633

(0.245) (0.0403) (0.347) (0.0491)

Est_CASHOTHER 0.217 -0.0988 -0.134 -1.190***

(0.406) (0.121) (0.387) (0.223)

Interactions with DIFF

Est_CASHCOLL -0.0586 -0.0547 -0.0420 -0.106

(0.362) (0.134) (0.459) (0.160)

Est_CASHSUPP -0.0740 0.109* 0.0594 0.0723

(0.256) (0.0569) (0.349) (0.0683)

Est_CASHOTHER 0.0364 0.381 -0.135 0.807**

(0.533) (0.294) (0.451) (0.316)

Constant 0.0427** 0.0406** 0.0323 0.0313

(0.0184) (0.0160) (0.0223) (0.0224)

Observations 1,009 1,208 1,010 1,209

R-squared 0.605 0.629 0.885 0.877



components plus associated DIFF

interaction coefficients are equal

17.59

(p=0.0000)

35.80

(p=0.0000)

7.58

(p=0.0005)

12.40

(p=0.0000)


components plus associated DIFF


1.16

(p=0.3133)

0.75

(p=0.4740)

2.26

(p=0.1044)

2.02

(p=0.1336)


*** p<0.01, ** p<0.05, * p<0.1

51

Table 6 Percentage of new debt financing

(1) (2) (3) (4)

VARIABLES

Model(2b)

CS

Model(2b)

BS

Model(3b)

CS

Model(3b)

BS

ACC

1.137*** 1.130***

(0.110) (0.0981)


CASHCOLL 0.453*** 0.720*** 0.499* 0.664***

(0.160) (0.126) (0.284) (0.159)

CASHSUPP -0.634*** -0.757*** -0.746*** -0.759***

(0.1000) (0.0658) (0.144) (0.162)

CASHOTHER 1.154*** 1.250*** 1.201*** 1.318***

(0.183) (0.140) (0.259) (0.254)

TAXPAID -0.289 -0.229 -0.854** -0.919**

(0.324) (0.323) (0.337) (0.434)

INTPAID -1.641*** -1.824*** -1.304 -2.270

(0.432) (0.472) (2.299) (1.915)

Interactions with debtfindum

CASHCOLL 0.0863 -0.110 -0.00258 -0.0396

(0.206) (0.163) (0.334) (0.210)

CASHSUPP -0.00441 0.0486 0.169 0.0437

(0.156) (0.0988) (0.202) (0.198)

CASHOTHER -0.570** -0.609*** -0.606** -0.575**

(0.231) (0.178) (0.304) (0.279)

TAXPAID -0.0224 -0.0665 -0.167 -0.0106

(0.449) (0.422) (0.427) (0.499)

INTPAID 0.463 0.502 0.469 1.257

(0.577) (0.586) (2.261) (1.844)


Est_CASHCOLL 0.267* 0.0129 0.273 0.164

(0.157) (0.0844) (0.233) (0.172)

Est_CASHSUPP -0.0852 0.0204 -0.0280 -0.0862

(0.0656) (0.0424) (0.0709) (0.0634)

Est_CASHOTHER -0.0878 0.117 -0.813** -1.085***

(0.139) (0.155) (0.318) (0.285)

Interactions with debtfindum

Est_CASHCOLL -0.118 0.000381 -0.0468 -0.0877

(0.204) (0.115) (0.264) (0.204)

Est_CASHSUPP 0.0172 0.0686 -0.126 0.0971

(0.145) (0.0686) (0.121) (0.106)

Est_CASHOTHER 0.515 0.173 0.869* 0.933**

(0.429) (0.374) (0.450) (0.412)

Constant 0.0351** 0.0482*** 0.0291 0.0359

(0.0158) (0.0149) (0.0253) (0.0251)

Observations 1,009 1,208 1,010 1,209

R-squared 0.611 0.627 0.886 0.874



components plus associated debtfindum


11.84

(p=0.0000)

31.42

(p=0.0000)

8.23

(p=0.0003)

13.64

(p=0.0000)


components plus associated debtfindum


0.64

(p=0.5278)

0.61

(p=0.5457)

1.31

(p=0.2691)

0.41

(p=0.6623)


*** p<0.01, ** p<0.05, * p<0.1

52

Table 7 Operating and cash generating cycles

(1) (2) (3) (4)

VARIABLES Model(2b)

CS

Model(2b)

BS

Model(3b)

CS

Model(3b)

BS

ACC

1.128*** 1.100***

(0.128) (0.106)


CASHCOLL 0.591*** 0.831*** 0.918* 0.992***

(0.116) (0.0990) (0.471) (0.285)

CASHCOLL interactions

Receivables -0.194 -0.385 0.380 0.161

(0.340) (0.247) (0.504) (0.389)

Inventory 0.262 0.174 0.276 0.225

(0.396) (0.271) (0.440) (0.291)

Payables 0.0438 -0.0210 -0.974** -0.758**

(0.328) (0.216) (0.455) (0.322)

CASHSUPP -0.563*** -0.684*** -0.664*** -0.755***

(0.115) (0.0844) (0.169) (0.130)

CASHSUPP interactions

Receivables 0.258* 0.271*** 0.286 0.137

(0.153) (0.0962) (0.218) (0.133)

Inventory -0.00362 -0.0954 -0.0953 -0.281**

(0.271) (0.0887) (0.261) (0.126)

Payables -0.295 -0.171* -0.0907 0.0550

(0.203) (0.0910) (0.236) (0.163)

CASHOTHER 0.773** 0.798*** 0.933*** 1.021***

(0.301) (0.104) (0.263) (0.150)

INTPAID -1.184*** -1.175*** -1.065* -1.287***

(0.452) (0.398) (0.550) (0.497)

TAXPAID -0.177 -0.355 -1.056*** -1.182***

(0.249) (0.228) (0.253) (0.265)


Est_CASHCOLL -0.0527 -0.194** -0.279 -0.248

(0.0953) (0.0823) (0.490) (0.284)

Est_CASHCOLL interactions

Receivables -0.0661 0.211 -0.478 -0.166

(0.329) (0.225) (0.538) (0.385)

Inventory -0.160 -0.178 -0.0721 -0.126

(0.306) (0.252) (0.397) (0.273)

Payables 0.186 0.173 0.985** 0.766***

(0.314) (0.198) (0.485) (0.291)

CASHSUPP 0.0224 0.0514 0.0313 0.0194

(0.0494) (0.0328) (0.0786) (0.0570)

CASHSUPP interactions

Receivables 0.0340 -0.0799 -0.187 -0.164

(0.0879) (0.0561) (0.208) (0.104)

Inventory -0.118 0.115 -0.148 0.188*

(0.152) (0.0786) (0.251) (0.108)

Payables 0.0340 -0.0165 0.0731 -0.0956

(0.0941) (0.0548) (0.228) (0.0887)

Est_CASHOTHER 0.186 0.214 -0.274 -0.391**

53

(0.328) (0.248) (0.218) (0.184)

Constant 0.0450** 0.0492*** 0.0537** 0.0608***

(0.0203) (0.0167) (0.0256) (0.0199)

Observations 1,009 1,208 1,010 1,209

R-squared 0.637 0.660 0.892 0.883


Coefficients on disclosed cash

flow components plus receivables


15.13

(p=0.0.0000)

34.28

(p=0.0000)

9.02

(p=0.0000)

28.12

(p=0.0000)


flow components plus inventory


3.62

(p=0.0272)

36.25

(p=0.0000)

8.40

(p=0.0002)

31.35

(p=0.0000)


flow components plus payables


9.20

(p=0.0001)

50.66

(p=0.0000)

9.59

(p=0.0001)

19.76

(p=0.0000)


*** p<0.01, ** p<0.05, * p<0.1

Voluntary Direct Method Cash Flow Disclosure in the U.S. ...

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