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Usefulness of Cash Flow Statements

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Encyclopedia of Finance

Abstract

This paper aims to study the current rules regarding preparation of cash flow statements, as proscribed by Financial Accounting Standards Board (FASB) and pinpoint the problems with the current rules.

The problems with the existing rules under SFAS-95 can be classified into four broad categories: problems arising from the current three-way classification of cash flows, problems due to the method chosen for preparation of cash flow statements, problems due to the ambiguities in the current rules and problems due to the loopholes in the rules that allow manipulation of cash flows. Several examples of each inconsistency and ambiguity are provided using Johnson & Johnson (JNJ) cash flow statements for 2011.

We use an illustrative method to highlight the need for changes in the existing rules regarding cash flow statements. By showing that under the current rules, several cash flows get misclassified, leading to unclear and confusing financial reports, we hope to make the readers of the financial statements aware that the amounts reported as cash flow from operating, investing, and financing activities do not reflect all of the cash consequences of these activities and that the reported amounts should not be used in decision models without adjustment. We also hope that the FASB will be persuaded to amend SFAS-95 to eliminate the ambiguities and conform more closely to the finance literature, so that the information in the cash flow statement becomes more useful to report users.

Since a primary objective of financial reporting is to provide information to help accounting users assess the amount and timing of future cash flow and earnings, removing some of the ambiguities and other improvements suggested in the paper will not only make these statements more useful in credit and investment decisions, it will also lead to an increased usefulness of financial ratios which currently use information from the cash flow statements, such as operating cash flow, in either the numerator or denominator.

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Notes

  1. 1.

    See Finger (1994).

  2. 2.

    See for example, Barth et al(1999 and 2001).

  3. 3.

    See D fisher, “Cash doesn’t lie,” Forbes Magazine (April 12, 2010), pp. 52–55.

  4. 4.

    Ali, A. 1994.

  5. 5.

    See Bowen et al(1986) and Dechow et al (1994,1998).

  6. 6.

    See FASB(1995).

  7. 7.

    “Is the direct method for the statement of cash flow preferable to the indirect method, and if so why?” Joint research initiative by FASB and IASB, 2005.

  8. 8.

    A CFA institute monograph, 2005 on financial reporting lists direct method as one of the 12 significant reforms needed to improve financial reporting.

  9. 9.

    Accounting Trends and Techniques, 2010, reports that out of its 500 surveyed companies, 495(99 %) used the indirect method.

  10. 10.

    See for example, Sender ( 2002).

  11. 11.

    See Solomon, Deborah. (2002).

  12. 12.

    See Maremont (2002).

  13. 13.

    “For example, after WorldCom’s reverse- engineering subterfuge, many have learned to look for excessive capitalization of cash expenditures. Others now scrutinize the cash flow statements for non- recurring sources of cash, such as receipt of an income tax refund and securitization of payables.” Mark A. Siegel, “Accounting shenanigans on the cash flow statement” March 2006.

  14. 14.

    Judith Burns,“ SEC tells Automakers to re-tool cash flow accounting”, Wall street Journal Online (February 28, 2005).

  15. 15.

    “SEC acts to curb cash flow shenanigans” by Darren Dahl, Inc.com, June9, 2005.

  16. 16.

    See for example, Cash flow myths. By: Rosen, Al, Canadian Business, 00083100, 3/12/2007, Vol. 80, Issue 6, “We tell our institutional money-managing clients that all cash flow mistakes result from the arbitrary timing or classification of management actions or inactions. The cash flow statement represents cash amounts. But, they are unevenly categorized, and worst of all, smoothed and shifted from period to period. … Investors tend to forget that accounting cash flows are not “real.” Actual cash flows into a company are first recorded using an accrual (non-cash) income basis, and then translated back into a quasi-cash basis on the cash flow statement. This back-and-forth dance creates what I like to call leakage. Leakage can be caused by pension plans, income taxes, stock options, corporate acquisitions, minority interests, asset securitizations and a host of other factors”.

  17. 17.

    See for example, Livnat and Zarowin ( 1990).

  18. 18.

    Orpurt and Zang (2009) show that direct method leads to a better forecast of future operating performance and cash flows.

  19. 19.

    Accounting Trends and Techniques published by the American Institute of Certified Public Accountants (AICPA, 2005) reports that of 600 U.S. public firms surveyed over 2001–2004, only seven or eight firms disclosed DM statements of cash flows each year. Because few firms were expected to use the DM, FASB requires DM disclosing firms to also provide an IM schedule for comparability (SFAS No. 95, paras. 29–30). However, no separate DM schedule is required with IM statements. Miller and Bahnson (2002) argue that dual reporting required with DM disclosure may cause managers to prefer the IM.

  20. 20.

    See Ross et al. ( 2010).

  21. 21.

    For a detailed analysis of problems with payables, see Nurnberg (2006).

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Authors and Affiliations

  1. Department of Accounting and Information Systems, Rutgers Business School, Rutgers University, Janice Levin Building, Piscataway, NJ, 08854, USA

    Savita A. Sahay

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  1. Savita A. Sahay
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Correspondence to Savita A. Sahay .

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Editors and Affiliations

  1. Dept. Finance, Rutgers University, Rockafeller Road 94, New Brunswick, 08854-8054, New Jersey, USA

    Cheng-Few Lee

  2. College of Business, San Francisco State University, Holloway Ave. 1600, San Fransisco, 94132, California, USA

    Alice C. Lee

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Sahay, S.A. (2013). Usefulness of Cash Flow Statements. In: Lee, CF., Lee, A. (eds) Encyclopedia of Finance. Springer, Boston, MA. https://doi.org/10.1007/978-1-4614-5360-4_72

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  • DOI: https://doi.org/10.1007/978-1-4614-5360-4_72

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