Together with the balance sheet and income statement, the cash flow statement is one of three principal financial statements in a company’s financial report to stockholders. Under classification rules of both the Financial Accounting Standards Board (FASB-95, 1987) and the International Accounting Standards Board (IASB-7, 1992), cash flows are classified as relating to operating, investing, or financing activities, and net cash flow subtotals are presented for each of these three activities (henceforth NCFO, NCFI, and NCFF, respectively). The subtotal of greatest interest to most report users is usually NCFO.

Under FASB-95 and IASB-7, operating cash flows include collections from sales and payments for purchases of goods and services. Investing cash flows include payments to acquire and proceeds from disposals of productive assets, including business acquisitions and dispositions (henceforth acquisitions and dispositions). Financing cash flows include proceeds from issuing debt or equity securities and from other short- or long-term borrowings; and payments to reacquire or retire equity securities, repay amounts borrowed, and dividends.

1. Known classification problems

According to Nurnberg (1993, pp. 61–65), the three-way classification of cash flows is loosely based on the finance literature, but certain modifications result in inconsistent or ambiguous classifications of certain cash flows. As a result, NCFO frequently includes cash flows from investing and financing activities. Similarly, NCFI and NCFF frequently exclude certain cash flows attributable to investing activities and financing activities, respectively.

Many of these classification issues and their distorting effects on NCFO have already been documented in the literature on the cash flow statement. For example, Stewart, Ogorzelec, Baskin, and Duffy (1988, pp. 7–8), Nurnberg and Largay (1998, pp. 411–412) and Vent, Cowling, and Sevalstad (1995, pp. 88–96) note that although they could be treated as elements of NCFO, premiums or discounts on bond investments and bonded debt could be treated as elements of NCFI and NCFF, respectively. Munter (1990, pp. 54–55) notes that two companies with identical interest or lease payments will report different amounts for NCFO if one company capitalizes interest or lease payments and the other company does not. Alderman and Minyard (1991, pp. 20–21) note variations in the cash flow statement classification of bank overdrafts depending on balance sheet treatment; changes in overdrafts are included in NCFO if overdrafts are netted against deposit accounts with positive balances, but are included in NCFF if overdrafts are treated as borrowings. Munter and Moores (1992, pp. 52–55) note several variations in cash flow statement classification of interest payments when total interest cost differs from total interest paid and some interest cost is capitalized. Nurnberg (1993, pp. 67–69) notes that because income tax payments are operating cash flows under FASB-95, NCFO includes the income tax effects of certain gains and losses relating to investing or financing activities; as a consequence, NCFO is contaminated by the tax effects of gains and losses relating to these investing and financing activities.1 Nurnberg and Largay (1996, pp. 123–136) note variations in the cash flow statement classification of hedging activities, sale-leaseback transactions, purchase and sale of rental assets, loan securitizations, and repurchase/reverse repurchase agreements. Finally, Nurnberg (2004, pp. 113, 116) identifies four alternative ways to classify death benefit proceeds from company-owned life insurance (COLI) and three possible ways to classify COLI loan proceeds and repayments under FASB-95 (and presumably IASB-7) rules.

2. Purpose of paper

This paper discusses the importance of NCFO to valuation models of the firm, loan covenants and other contracts, and management compensation plans. It also examines the divergent interests of individual stockholders, institutional stockholders, corporate management, and sell-side analysts of investment banks; and how these divergent interests may motivate corporate management to manage NCFO.

Thereafter, this paper identifies and analyzes another major limitation of the cash flow statement classification and disclosure rules not otherwise identified and analyzed in the accounting literature.2 It shows how NCFO increases by (1) realizing cash on certain net operating assets acquired in acquisitions (as opposed to collections from selling goods and services, etc.); and (2) by transferring rather than paying certain net operating liabilities in dispositions (as opposed to reducing operating payments by better cost control, etc.).

Examples from annual financial reports show that the distorting effects on NCFO of acquisitions and dispositions may be substantial. Disentangling the distorting effects is problematic, however, especially when there are several acquisitions or dispositions during the period, or the disclosures are not provided or are not timely. The paper concludes with suggestions to make the cash flow statement more transparent with respect to these transactions.

3. Importance of NCFO

NCFO is important because it is often held to be a useful measure of corporate performance, often superior to net income. For example, Dechow (1994, pp. 7–8) and Cheng, Liu, and Schaefer (1997, pp. 4–5) note that the flexibility inherent in generally accepted accounting principles (GAAP) enable managers to opportunistically manipulate net income, but suggest that NCFO is not subject to such manipulation and therefore may be a more reliable measure of firm performance.3

NCFO less certain investment outflows is often used in discounted cash flow models to estimate the total value of a corporation (see, e.g., Penman, 2001, pp. 111–114). Dividing this estimated total value by the number of shares outstanding generates an estimate of intrinsic value per share that is used in fundamental investment analysis.

As a measure of corporate performance, NCFO is also used as a numerator in certain financial ratios, such as the cash flow interest coverage ratio, the operating cash flow to total liabilities ratio, the operating cash flow to capital expenditures ratio, the cash flow per share ratio (CEPS), and the cash flow rate of return on investment ratio (CFROI) (see, e.g., Carslaw and Mills, 1991 C.A. Carslaw and J.R. Mills, Developing ratios for effective cash flow statement analysis, The Journal of Accountancy CLXXIV (1991) (5), pp. 63–70.Carslaw & Mills, 1991, pp. 64–69; Stickney, 1993, pp. 387–397). The cash flow interest coverage ratio, the operating cash flow to total liabilities ratio, and the operating cash flow to capital expenditures ratio are often used in contracts with creditors; NCFO, CEPS, and CFROI figure in computing management incentive compensation, such as cash bonuses and long-term bonuses that include issuance of share options. Additionally, when increases in NCFO and CEPS result in higher share prices, stock-based management compensation increases. So does the market value of equity portfolios of hedge funds, mutual funds, and pension funds, resulting in higher fees and profits for fund managers.