COLLEGE OF BUSINESS ADMINISTRATION

MASTER OF BUSINESS ADMINISTRATION

Why Do Managers Voluntarily Issue Cash Flow Forecasts?

Charlese Wasley Joanna Shuang Wu

Received 9 January 2005; accepted 26 September 2005

Journal of Accounting Research Vol. 44 No. 2 May 2006

SUMMARIZED AND PRESENTED BY

FATIMA QADER - 19922088 MONTHER BUCHEERI 19930211 SUBMITTED TO: DR. BATOOL ASIRI

25 DEC 2011

Objectives of the study: The objectives of this study is find the reason for the recent change in voluntary disclosure practices by management, namely, the issuance of management cash flow forecasts. Prior Research and Hypothesis Development: DeFond and Hung [2003] document the characteristics of firms for which financial analysts issued annual cash flow forecasts over the 19931999 period. They find that analysts are more likely to forecast cash flows for firms with large absolute total accruals, accounting method choices that differ from the industry, higher earnings volatility, higher capital intensity, and a higher risk for bankruptcy. The study also highlighted that Investor demand for cash flow information likely provides incentives for both management and analysts to issue cash flow forecasts. Previous Studies Results from previous studies Current research Hypothesis Result of the Hypot hesis Result Accept

The Nature of Information Conveyed In Management Cash Flow Forecasts Theoretical Literature when there are costs of disclosure or H1: Firms issuing management cash flow forecasts Verrecchia [1983], when investors are uncertain about the have more favorable cash flow information than Dye [1985], information management has, firms those that do not and management cash flow forecasts andVerrecchia [2001] will voluntarily disclose good news are more likely to beat usual cash flow Expectations. and withhold less favorable news Empirical Study Penman [1980] and Lev and Penman [1990] Skinner [1994] and document that management earnings Kasznik and Lev [1995] forecasts are more likely to convey bad news, consistent with managers being concerned with the risk for litigation and issuing preventive earnings forecasts to adjust investor expectations downward Lang and Lundholm find that better performance is [1993] and Miller [2002] associated with higher overall disclosure levels. Management Cash Flow Forecasts and The Nature Of The News In Earnings Hayn [1995] and expect firms with losses forecasted by H2A: The likelihood that a firm issues a management Graham, Harvey, and analysts to have greater incentives to cash flow forecast is higher if the analyst earnings Rajgopal [2005] provide cash flow forecasts because, forecast is negative. in the presence of a loss, earnings have a lower predictive power about a firms future performance Hutton, Miller, and When management earnings news H3A: The likelihood that a firm issues a management Skinner [2003] and guidance is either above or below the cash flow forecast is higher when there is either an Baginski, Hassell, and accepted level, there is likely more unusually positive or unusually negative surprise in Kimbrough [2004] information asymmetry between managements earnings guidance. management and investors and a greater demand by analysts and investors for additional disclosures to help them interpret the news in managements earnings guidance Waymire [1984] When the bad news in earnings is not H2B: For firms with bad news in earnings, those that driven by poor underlying cash flows, issue management cash flow forecasts have more management has an incentive to put favorable cash flow information than those that do the bad news in a more positive light not, and management cash flow forecasts are more and to mitigate its impact by issuing a likely to beat prevailing cash flow expectations. cash flow forecast. Finds that more than 66% of the bad news management earnings guidance in his sample is accompanied by disclosures of other good news.

Accept

Accept

Accept

Hutton, Miller, and Skinner [2003]

document that managers are more likely to supplement good news in their earnings forecasts with verifiable forward-looking disclosures They suggest that management uses additional disclosures to commit to a specific way of reaching an earnings goal and to increase the credibility of good news in their earnings guidance. Management Cash Flow Forecasts And Firm Age Chen, DeFond, and Argue that investor demand for Park [2002] financial information in addition to earnings can be particularly strong for young firms because there is greater uncertainty about these firms earnings and their production activities.

H3B: For firms with positive earnings guidance, those that issue management cash flow forecasts have more favorable cash flow information than those that do not, and management cash flow forecasts are more likely to beat prevailing cash flow expectations.

Accept

H4A: The likelihood that a firm issues a management cash flow forecast is decreasing in the firms age.

Accept

H4B: For young firms, those that issue management cash flow forecasts have more favorable cash flow information than those that do not, and management cash flow forecasts are more likely to beat prevailing cash flow expectations. Management Cash Flow Forecasts and Earnings Management We suggest If managers are managing earnings upward by manipulating discretionary accruals, they are less likely to issue a management cash flow forecast because doing so could draw attention to the upward manipulation in earnings Data and sample H5: The likelihood that a firm issues a management cash flow forecast is lower if the firms discretionary accruals are extremely positive.

Accept

Accept

Analyst cash flow forecasts are obtained from I/B/E/S, and management earnings forecasts are obtained from First Calls Company-Issued Guidance (CIG) file. The sample consists of 2,090 management cash flow forecasts appearing in press releases reported on The Dow Jones News Wires or in The Wall Street Journal. Our search covers the mid-1979 to October 2003 time period. The empirical tests involve comparisons of firms issuing management cash flow forecasts with firms not issuing such forecasts Empirical design and tests Prob [MG_CF = 1] = logit(0 + 1CH_OCF + 2FA_EF_NEG +3MG_EF_BAD + 4MG_EF_GOOD +5FIRM_AGE + 6DACC_HIGH + 7CF_VOL +8ALTMAN + 9E_VOL + 10CAP_INT +11LOG_MV +12FA_CF_DUM + 13MG_EF_DUM +14FA_EF_DUM + 15YEAR_2001 + 16YEAR_2002 +17YEAR_2003 + 18LAG_MF_C F
(Refer to the original Article for the definition)

Concluding remarks It is concluded that management issues cash flow forecasts to 1) signal good news in cash flow, 2) to meet investor demand for cash flow information, and 3) to pre-commit to a certain composition of earnings in terms of cash flow versus accruals, thus reducing the degree of freedom in earnings management. The results also suggest that management discloses good news in cash flow to mitigate the negative impact of bad news in earnings, to lend credibility to good news in earnings, and to signal economic viability when the firm is young. Our finding that management cash flow forecasts primarily convey good news is in contrast to the generally negative nature of management earnings guidance and suggests that different incentives drive firms disclosure of different financial information.