Cash Flow Statement:
Problems with the Current Rules
Neil S. Weiss and James G.S. Yang
2007 - In recent years, the statement of cash flows has received
increasing attention from readers of financial statements.
The cash flow statement gives vital information about a company’s
performance, as well as its major activities during the year;
however, some of the rules for preparation make the cash flow
statement less useful than it should be.
The weaknesses with the
cash flow statement can be divided into five sections:
differences between commercial and industrial companies
versus financial institutions; 2) problems with operating
activities; 3) problems with investing activities; 4) problems
with financing activities; and 5) the role of free cash
flow. The authors offer potential solutions to these problems
that could improve the cash flow statement.
Institutions Versus Commercial and Industrial Companies
the case of financial institutions, the identification of
the core operating activities is important, because they
differ markedly from nonfinancial companies in this respect.
Consider commercial banking institutions, where the core
operations can be divided between on–balance sheet
activities and off–balance sheet activities. The off–balance
sheet activities consist primarily of fee-based activities
for services rendered that do not create an asset or a liability.
These create no problem for the cash flow presentation because
they appear on the income statement and flow directly through
the operating section of the cash flow statement.
major problems are created by activities that have significant
impact on the balance sheet. They are: 1) managing the accounts
of depositors, which appears on the balance sheet as liabilities;
2) lending money to customers, which appears on the balance
sheet as assets; and 3) trading in securities, which appears
on the balance sheet as assets.
these are a bank’s core operations, one would expect
them to be in the operating activities section of the cash
flow statement. Instead, customer deposits are listed as
financing activities, while loans to customers and securities
activities appear in the investing activities section. As
a result, the figure for “cash provided by operations”
is meaningless. In other words, the breakdown of cash flows
into operating, investing, and financing activities—as
presently constituted for financial institutions—is
not useful to readers of the financial statements. A totally
new form of presentation is needed to provide useful cash
is somewhat ironic that FASB, in Statement of Financial
Accounting Standards (SFAS) 102, Statement of Cash Flows—Exemption
of Certain Enterprises and Classification of Cash Flows
from Certain Securities—an amendment of FASB Statement
No. 95—decided to use the fact that financial institutions’
securities trading is an operating activity as the basis
for requiring that commercial and industrial companies treat
securities similarly. This is unfortunate for users of financial
statements, because it makes it easy for a company to manipulate
cash from operations by moving funds between trading securities
and cash equivalents, which are treated as part of cash
rather than as investments.
1 shows the current reporting practice of the cash flow
statement for the banking industry, while Exhibit
2 proposes an alternative format.
of Operating Activities
the accounting profession talks about the importance of
comparability of financial information, the fact that interest
paid is treated as an operating activity while dividends
paid is treated as a financing activity makes it difficult,
if not impossible, to compare the performance of companies
that make different financing choices. Analysts have resorted
to their own measures to make such comparisons. One of the
most common is earnings before interest, taxes, depreciation,
and amortization (EBITDA); however, other means to compare
exist, with no commonly agreed upon measure for all to use.
Up to now, the accounting profession has simply ignored
the issue. The only analytical measure that has been dealt
with by the accounting profession is earnings per share,
because this must be presented on the income statement.
problem affecting the operating activities involves the
financing of receivables. Years ago, receivables were financed
through borrowing, with receivables pledged as collateral.
The monies received were treated as a financing activity,
which was appropriate. In recent years, however, increasing
concern on keeping debt off the balance sheet has led companies
to replace the above treatment with sales of receivables,
with and without recourse. Economically, these activities
still represent a form of financing. The accounting rules,
however, allow these transactions to be treated as operating
activities instead of financing activities. This makes these
transactions doubly attractive to companies: They keep the
borrowing off the balance sheet and inflate cash provided
by operations. Economically, the pledge of accounts receivable
is the same as the sale of accounts receivable, but they
are treated differently in the cash flow statement. This
treatment is inconsistent.
problem that causes distortions in operating cash flows
stems from the treatment of dividends received as an operating
activity rather than as an investing activity. When a company
has significant investments in affiliated companies, it
has the ability to manipulate its own “cash provided
by operations” by increasing the dividends it receives
from such companies. This simple technique has been used
by many companies to inflate operating cash flows. Furthermore,
dividend income comes from investments. If the former is
shown in the section of operating activities, and the latter
placed in investing activities, the financial statement
reader will not be able to visualize the whole picture of
inconsistency involves “capital leases.” It
is true that, on day one, a lease is a noncash transaction.
However, the payment for the lease principal and interest
in later days is undoubtedly a cash flow event in a single
transaction. And yet, the payment for the principal is treated
as a financing activity in one section, while the payment
for the interest is shown as an operating activity in another.
One transaction is broken into two parts; it has lost its
wholeness. It would be more informative if both were brought
together as one transaction under financing activities.
potentially serious distortion to operating cash flows comes
from the rule that requires taxes to be treated as an operating
activity, even when the gain being taxed is included in
investing activities. For example, consider a company that
has low operating profit but has a large gain from the sale
of investments. The bulk of the pretax income is from this
gain, and therefore the bulk of the income tax expense is
related to this gain. On the statement of cash flows, however,
the gain is removed from operating activities and included
under investing activities instead, as part of the proceeds
from the sale of the investments. But the income tax expense
on that gain remains in the operating activities sections,
generating substantial negative cash from operations. This
clearly is misleading, and violates the matching rules required
on the income statement.
serious distortion involves deferred employee compensation.
Many companies pay deferred compensation in the form of
stock options that are off the balance sheet when issued.
When the company later redeems the options by paying cash,
the move is treated as a financing activity—as though
it were a capital allocation, when in reality this payment
is not any different from wages. As such, it should be treated
as an operating activity.
as mentioned earlier, SFAS 102 requires cash flows from
trading securities to be treated as an operating activity,
rather than an investing activity, allowing companies to
easily shift cash flows between years by switching securities
between “trading securities” and “cash
Investing Activities Section
many years, the distinction between cash equivalents (investments
having no principal risk) and other marketable securities
has caused serious confusion for the untrained reader of
financial statements. Cash equivalents are treated as part
of cash, while marketable securities are shown as investing
activities. Where a company’s portfolio manager does
a lot of trading and switching between these two types of
securities, very large numbers will appear in the investing
activities section as “purchases of marketable securities”
and “sales of marketable securities.” It is
not uncommon to see financial statements in which these
numbers represent the largest cash flows. Were one to ask
the untrained reader what the most significant events for
the company were during the year, the answer might be the
purchasing and selling of marketable securities. Yet these
numbers are irrelevant for understanding the company’s
performance. They merely clutter up the statement and cause
confusion. Because SFAS 102 requires the buying and selling
of securities to be treated as operating activities, the
situation will be even worse.
major problem with the investing activities section is that
it is based on the rule that only cash amounts may be shown
in investing and financing activities. Thus, for example,
if one company acquired another at a cost of $10 billion,
but only $1 billion of it was in cash, with the rest paid
in the form of debt and equity instruments, the cash flow
statement would show only the $1 billion cash amount paid
as the cost of the acquisition. The other $9 billion would
be relegated to a footnote. The untrained reader would get
a false picture of the true cost of the acquisition. This
is another example showing the deficiency of the current
rules in preparing the cash flow statement. The rules ignore
the vision of a complete transaction.
major problems in the financing activities section are related
to items discussed above. First is the failure of many companies
to treat receivables financing as a financing activity.
Second is the omission of major noncash financing instruments
from the cash flow statement. Both may conceal the full
extent of new financings engaged in by the company.
3 compares an industrial company’s cash flow statement
prepared according to current rules with a statement incorporating
the changes suggested earlier in Exhibit
3 explains how each of the authors’ proposed changes
to the cash flow statement would make the reporting clearer
and more consistent.
Role of Free Cash Flow
important deficiency in the current cash flow statement
is the absence of the concept of “free cash flow.”
What is free cash flow? Why is it needed? Traditional net
income is a measurement of wealth from the proprietor’s
point of view, but it does not serve managerial purposes.
Earnings are appropriated for dividend payout, plant expansion,
contingencies, and other needs. Earnings after these appropriations
would be more useful for management planning. The cash flow
statement is designed to identify the sources and applications
of cash in line with net income. This does not serve managerial
purposes either. Cash must be reserved for dividend payments
and capital expenditures. The cash balance after these reserves
would be more informative for the management of cash operations.
The concept of free cash flow was born for this reason.
It is defined as cash without any restrictions on its use.
It is available for any purpose at any time. It is similar
to the concept of unappropriated retained earnings. Free
cash flow has become increasingly important in financial
statement analysis, yet the accounting profession has ignored
it. One current problem with free cash flow is that it has
a number of definitions. As a result, different users may
be using different definitions and drawing different conclusions
about a company’s performance.
is a partial list of the definitions of free cash flow currently
Cash provided by operations less capital expenditures
Cash provided by operations less capital expenditures
and dividends paid
Net income plus depreciation less capital expenditures
EBITDA less captial expenditures
Earnings before interest and taxes (EBIT) multiplied by
1 minus the tax rate, plus depreciation and amortization
less changes in operating working capital and less capital
differences in definitions are based on key issues concerning
what should be considered in determining free cash flow:
it be unleveraged (before interest), or leveraged (after
interest)? The advantage of unleveraged free cash
flow is that it provides comparability between companies
that finance with debt and companies that finance with
it be before income taxes? The advantage of using
pretax numbers for cash flow is that it provides comparability
between companies having noticeably different effective
it be after dividends paid? The advantage of subtracting
dividends paid when arriving at free cash flow is that
dividends represent payments that should be provided by
operating cash flows, as opposed to other sources, such
as borrowing, issuance of stock, or sale of assets.
it be before or after the adjustments for changes in operating
assets and liabilities? Using a free cash flow figure
based on funds-flow before adjustments for changes in
operating assets and liabilities takes a long-run view.
In the long run, the changes will vanish. Furthermore,
these funds-flow numbers are not distorted by company
practices such as delaying payment of trade creditors
to inflate cash provided by operations.
The advantage of using a free cash flow figure after adjustments
for changes in operating assets and liabilities is that
it represents a true cash number, whereas the funds flow
number is essentially an adjusted accrual-based number.
Furthermore, any company practices that inflate sales
and net income (such as channel stuffing) will equally
distort the funds flow number. However, the cash provided
by operations number is not distorted, because it is reduced
by the adjustment for the increase in receivables, which
normally accompanies such practices.
it be based on actual capital expenditures or a mandatory
level of capital expenditures necessary to replace fixed
assets used up during the year? The advantage of
using a mandatory level of capital expenditures is that
it levels the playing field between companies that spend
substantial amounts expanding their capacity and companies
that spend little on capital expenditures due to a poor
(For a more complete list of free cash flow definitions,
see John Mills, Lynn Bible, and Richard Mason, “Defining
Free Cash Flow,” The CPA Journal, January
4 illustrates how free cash flow could range from a
low of $21,000 to a high of $85,000, based upon the definition
chosen. If the actual capital expenditures are replaced
by a mandatory level to maintain the existing level of plant
and equipment, an additional eight values for free cash
flow would be generated.
The accounting profession can play an important role in
narrowing the choice of free cash flow computations under
accounting standards. If the traditional cash flow statement
can be extended to include a consistent concept of free
cash flow, it would become far more informative and useful.
the Statement of Cash Flows
response to the issues above, the authors propose a number
of changes that would make the statement of cash flows for
commercial and industrial companies more useful to the readers
of financial statements. For financial institutions, a dramatic
reorganization of the cash flow statement is needed to make
it a useful document, because the current presentation provides
totals that are not useful for evaluating any of the activities
of these institutions.
the concept of free cash flows, two points should be emphasized:
First, increasing reliance is being placed on free cash
flow numbers by a variety of users, including investor analysts,
credit analysts, and finance and economics theoreticians.
Second, as a result of the many users of free cash flow,
a variety of definitions have been introduced for the determination
of free cash flow.
to this point, the accounting profession has ignored the
concept of free cash flow. The authors suggest that the
profession take a serious look at free cash flow, with a
view to narrowing and standardizing the conceptual definitions.
The authors propose that some sort of free cash flow be
disclosed in the financial statements, much as earnings
per share must be included in the income statement.
S. Weiss, PhD, CPA, MBA, is an assistant professor
of accounting, and James G.S. Yang, MPh., CPA, CMA,
is a professor of accounting, both at Montclair State University,