Misclassifying cash ows from

operations: intentional or not?

Karen Lightstone
Accounting Department, Saint Marys University, Halifax, Canada
Karrilyn Wilcox
Toronto, Canada, and
Louis Beaubien
Accounting Department, Saint Marys University, Halifax, Canada
Abstract
Purpose The purpose of this paper is to investigate the accuracy and informational quality of the
cash from operations section of the cash ow statement.
Design/methodology/approach This paper empirically tested the accuracy of the cash from
operations reported by Canadian non-nancial companies. The authors studied 262 companies at three
different time periods providing 786 rm observations. For each observation, the balance sheet was
used to conrm the gures reported in the statement of cash ows. In addition, the authors
investigated managements disclosure of the particular working capital items.
Findings The ndings suggest that in recent years, companies are more likely to overstate their
cash ow from operations, thereby presenting a better nancial picture than is supported by the
balance sheet accounts. This would suggest that the investing or nancing section would be
correspondingly understated. The presence of acquisitions reduces overstatements, which may be the
result of more auditor presence.
Research limitations/implications This paper extends previous research from documented
single, isolated instances of cash from operations being misstated to include a signicant sample with
more generalizable ndings. The data are Canadian which may limit the generalizability to other
countries. Future research should address the extent to which nancial analysts rely on the reported
cash from operations gure.
Practical implications This preliminary study may have implications for nancial analysts and
others relying on the free cash ow gure.
Originality/value This study expands on previous research which has taken place only on a
case-by-case basis.
Keywords Canada, Legitimacy theory, Accounting, Institutional theory, Cash ow from operations,
Statement of cash ows
Paper type Research paper
The great enemy of truth is very often not the lie deliberate, contrived and dishonest but
the myth persistent, persuasive, and unrealistic ( John Kennedy, 1961).
The establishment and acceptance of accounting practice is as much a technical
matter as one governed by the social context in which the practice emerges,
is justied and reviewed, and, ultimately gains acceptance (or not). Mezias (1990;
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1834-7649.htm
JEL classication M
The authors would like to thank the participants at the European Accounting Association
Conference in Rome, Italy for their helpful comments as well as other anonymous reviewers.
Received 16 July 2012
Revised 10 October 2012
15 November 2012
27 November 2012
Accepted 28 November 2012
International Journal of Accounting
and Information Management
Vol. 22 No. 1, 2014
pp. 18-32
qEmerald Group Publishing Limited
1834-7649
DOI 10.1108/IJAIM-07-2012-0039
IJAIM
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Mezias and Scarselletta, 1994) examines the institutional inuences associated
with the development of nancial reporting practices in the Fortune 200 suggesting
these practices are driven by structural inuences that are inscribed with certain goals
and motivations. The potency of institutional forces is such that organizations imitate
procedures adopted by other organizations (mimetic isomorphism) and strive to
conform to perceptions of how things should be done (normative isomorphism)
whether that is advocated deliberately and explicitly, or implicitly (Moll et al. 2006).
Meyer and Rowan (1977) point out that very often the rationale, and the rationalizing,
about a given organizational procedure is subsumed by the myth of correct action,
once the behavior has become institutionalized as the appropriate mode of action
(Lightstone and Driscoll, 2009). In other words, if a given practice is held up as correct
and becomes a normative force, its validity is immaterial, what is material however, is
that the practice is perceived and accepted as correct. As Potter (2005) points out, in the
social and institutional processes that are implicated in the enactment of accounting
practices, there is rarely an unfolding of those practices by organizational
participants. Their actions are shaped by the interpretations and actions that have
come before them, and surround them. This surfaces a question of particular relevance
to accountancy: what if the institutionalized practices we have accepted as being
correct, were in fact different than anticipated, or worse wrong?
Academics have long advocated the importance and usefulness of the statement of
cash ows (Gup and Dugan, 1988; Hodgson and Stevenson-Clark, 2000; Hossain et al.,
2011; Jones, 1998; Purr, 2004; Sharma and Iselin, 2003). The statement of cash ows is
unique from other nancial statements because it is relatively free from bias. Other
studies support this perspective, arguing cash owinformation to be as, or more useful,
than accrual information for decision-making ( Jones and Widyaya, 1998; Sharma and
Iselin, 2003). However, recent examinations question the quality and clarity of
information in the statement of cash ows; arguing it is not clear nor conducive to
providing the information investors require, as classications are poorly dened and not
necessarily consistent (Broome, 2004; Hill et al., 2003). This paper investigates the
accuracy and reliability of the statement of cash ows and demonstrates in the absence
of strict denitions and dened work procedures, poor practices concerning
the reporting of cash ows may emerge from organizational practice.
The denition of operating cash ows is subject to interpretive discretion, and
in the spirit of Potters (2005) assertion of the social construction of accounting policies,
distortions of meaning may emerge. Researchers continue to point out individual
cases containing material misstatements (Broome, 2004; Siegel, 2006; Mulford and
Comiskey, 2005). For instance, Enron Corporation used investing proceeds to increase
operating cash ows ( Jopson, 2006). Consequently, management could misstate
operating activities and external users would be unable to readily discern the fraud.
Hill et al. (2003) suggest cash ow from operations is the hardest component of the
statement of cash ows to understand yet it is one of the most used gures in
determining available cash in the future (Wampler et al., 2009).
Previous research concerning the statement of cash ows of public companies has
been on a case-by-case basis. In this study, we investigate three years of rm-level data
drawn from 262 publicly traded companies, providing 786 observations, to examine
consistency between reported cash ows from operations and the amount calculated
using changes in the balance sheet accounts. Further, we posit an institutional
Misclassifying
cash ows from
operations
19
mechanism for the emergence of cash ow reporting practices found in evidence.
We focus on the operating activities section of the statement of cash ows because it is
the most difcult to reconcile from the other statements and previous research has
indicated a tendency to misclassify elements resulting in more favourable cash ows
from operations than can be supported by the balance sheet and income statement.
Cash ow statement reporting: practices and institutions
The statement of cash ows encompasses changes in all balance sheet items over a
period in terms of cash inows (source) and outows (use). Instances where a change
in a balance sheet account will not be accurately reected on the statement of cash
ows include acquisitions and dispositions of business segments, foreign exchange
translation adjustments, and asset write-offs. However, material adjustments require
disclosure in the notes to the nancial statements and therefore can assist in the
recalculation. The statement of cash ows can be prepared using either the indirect or
the direct method. According to Barsky and Catanach (2007) the use of the indirect
method presents several opportunities for misreporting the cash ow position.
Although the Canadian Institute of Chartered Accountants handbook (CICA, 2006),
recommends the direct method, the indirect method is widely used in practice (CICA,
Section 1540.2). In our study, over 99.9 percent of our observations used the indirect
method for reporting. One company changed from the indirect to the direct method in
one year but subsequently reverted back to the indirect method. Therefore, our
discussion will focus on the indirect method of reporting.
The CICA handbook, which presents the accounting standards in Canada, has
required some formof a cash owstatement since the early 1970s (Matulich et al., 1982).
Initially, the statement followed funds which could be either cash or working capital.
The intent was to supplement inadequate information provided by the balance sheet
and income statement with information deemed essential for decision-making
(Matulich et al., 1982, p. 704). In 1985, the funds ow statement was replaced by the
statement of cash ows, which was intended to be more accurate, informative and
useful to decision makers (Donleavy, 1992). In 1998, the CICA eliminated the need to
include non-cash transactions (CICA, Section 1540.46, 1998). Currently, Canada uses
International Financial Reporting Standards (IFRS, 2008). The accounting standard
addressing the statement of cash ows (IAS 7) contains no changes that are relevant to
our study, and allows the direct or indirect method for reporting cash ows.
Cash ow misstatement
Enron used misstatements of operating cash ows to misappropriate assets and
present fraudulent nancial reports in one of the most famous cases of nancial
reporting deception in recent history (Siegel, 2006; Mulford and Comiskey, 2005).
Fraser and Ormiston (2003) suggest some companies have developed creative
approaches to manipulate operational cash ows to foster the appearance of a more
robust nancial position. Single company studies Mulford and Comiskey
(2005; Hill et al., 2003; Sender, 2002) have demonstrated how oil and gas companies
have attributed nancing and debt repayment as operational cash ows and
Revsine et al. (2005) disclose the manipulation of cash ow gures applied in long-term
contracts related to capital restructuring, foreign currency translation and acquisitions
and divestitures.
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Currently, investors, stakeholders and analysts cannot reproduce the entire
statement of cash ows because of a lack of access to the primary data used to
construct the nancial statements, namely the cost and associated accumulated
amortization for capital asset disposals. However, all other items on the statement of
cash ows can be derived from changes in the balance sheet accounts and adjustments
to the income statement. Current standards do not require disclosure of these capital
asset amounts, nor do they clearly specify what constitutes operating cash ows. By
contrast there is an acceptance in the accounting industry that cash ows may not
always match the balance sheet reconciliation exactly, due to full disclosure of
accruals, acquisitions, and dispositions (Bernard and Stober, 1989).
Given conservatism is a foundational principle of accounting, it might be expected
that under estimating cash ows from operating activities would emerge as the
convention, rather than over estimation (Madsen, 2011; Dechow, 1994). For example,
Gigler et al. (2009) found that organizations frequently adopt projections of cash ows to
cover debt obligations reecting the minimum likely cash ows. This reects a
conservative approach to estimation consistent with general accounting practices
(Watts, 2003a) wherein cautious approaches are adopted in the estimation of benets
and costs to the rm. There is variation in individual interpretation of how a
conservative approach is implemented or interpreted (Madsen, 2011). However, the
general consensus in the market suggests cautious approaches to commentary on the
health of the rm, nancial or otherwise, are deemed more valuable and accurate as
opposed to more aggressive or optimistic assessments (Barton et al., 2010). Thus, as a
generous estimation of cash ows may be interpreted to benet the rm, Watts (2003b)
suggests a conservative approach may lead to a more cautious (and therefore lesser)
estimation of cash ows.
The combination of incomplete information and pervasive vagueness provides
motivated management with a way to misstate operating and investing activities cash
ows: a cash ow statement will balance despite a misclassication between
non-current assets and operating cash ows. The absence of stated denitions and
practices, surfaces questions on the practice of reporting cash ows from operations,
such as: how have practices emerged for cash ows from operations in the absence of
guidance? What are the implications for the quality of information for cash ow
statements? Why does the statement of cash ows continue to be deemed important
given its possibly unreliable character?
Mezias and Scarselletta (1994) argue institutional pressure is implicated in the
establishment of nancial reporting data (Mezias, 1990), suggesting internal and
external pressures result in some perceptions and approaches that may be more highly
valued than others. Managing the reporting of nancial results, particularly using the
income statement is not new. Wang et al. (2010) nd a high percentage of Taiwanese
companies present positive earnings when a small loss should be reported. In the context
of cash ow statements, it might be reasonable to assume in a given industry, when a
critical mass of organizations have adopted particular techniques for reporting cash
ows legitimate or otherwise organizations without established practices
(or with contradictory practices) may follow suit and adopt such reporting practices in
an isomorphic fashion. For instance, if a majority of oil and gas companies report
nancing and repayment as operational cash ows, as noted above, other rms in the
industry may feel pressure to adopt these practices. These rms may even be aware
Misclassifying
cash ows from
operations
21
the reporting technique is incorrect, but must be complicit, otherwise they will appear to
be inconsistent withindustry averages even if those averages create a false impression
of organizational health. This introduces a second form of inuence: the analyst.
Investment analysts assess a corporations health, and thereby its potential as an
investment through a (hopefully) careful examination of its nancial metrics. Billings
and Morton (2002) demonstrate the perceived importance of operating cash ows for
assessing the credit risk of a company and estimating opportunity costs. Cheng et al.
(1996) suggest operating cash ows are deemed to provide a stronger signal for future
performance when the transitory components of earnings are relatively high (for
further examples see: Allen and Cote, 2005; DeFond and Hung, 2003; Barth et al., 2001).
As such, organizations aspire to satisfy the expectations of analysts and follow
prescribed guidance on what nancial performance should be.
Given the demonstrably high misstatement of cash ow reporting noted above,
despite the institutionalized notions that cash ow reporting is a valuable tool in
organizational analysis, the rst proposition is:
P1. Reported cash ows from operating activities cannot be accurately derived
from changes in the balance sheet accounts.
A discrepancy between the reported and calculated numbers does not necessarily mean
users decisions would be affected as differences could be considered immaterial and
therefore inconsequential. To test if the difference affects user decisions, we used the
upper limit for each material criterion dened by Pany et al. (1996), providing the most
liberal denition. This leads us to our second proposition:
P2. The difference between cash ows from operating activities as reported and
cash ows as calculated from the balance sheet is material.
There is one alteration of cash ow reporting standards during the time-span of our
study: the elimination of non-cash transactions (CICA, Section 1540.46, 1998). This
results in a decrease in quantity of information reported on the statement of cash ows,
however it does not directly impact the statement. For instance, the purchase of capital
assets through direct issuance of shares in kind, would result in no acknowledgement
of the transaction on the statement. Given the nature of dealings that could fall into this
transaction category, signicant changes could occur to assets, liabilities and equity
invisibly to the statement of cash ows. Thus, we posit post-1998 cash ow statements
are less connected to the balance sheet and income statement, and therefore the
accuracy of cash ow constructions from these statements will be diminished, leading
to the third and nal proposition:
P3. Reported cash ows from operating activities are less likely to be accurately
derived from changes in the balance sheet accounts post-1998 than pre-1998.
Data and sample description
Our sample period included 1997, 1998, and 2004 providing data from a pre-standard
change year, a straddle change year, and a post-standard change year. Burns (2000)
suggests a reasonable amount of time is needed for the assimilation and adaptation of
new accounting rules. Therefore, we used 2004 as our third data point. To be
considered in our study, we also required the company be:
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.
in existence from 1996 to 2005;
.
a Canadian publicly traded company that used Canadian generally accepted
accounting principles (GAAP); and
.
not acquired during the study period by another company included in our
sample.
We excluded insurance companies and nancial institutions because these companies
produce nancial reports that are closely regulated by the Ofce of the Superintendent
of Financial Institutions. This resulted in a statistical sample of 262 companies
(providing 786 observations). Each rms audited nancial statements were retrieved
from the System for Electronic Document and Analysis Retrieval (SEDAR).
Since the initial portion of the cash ow from operating activities section of the
statement of cash ows commences with net income and adjustments, which can be
traced to the income statement, the main focus of our calculation was the non-cash
working capital amount. For each company the non-cash working capital amount was
calculated from the balance sheet and compared to the amount reported on the
statement of cash ows. If the amount did not agree, the statement was reviewed to
ensure amounts included in the calculation were not reported elsewhere. For instance,
the current portion of long-term debt is commonly reported as part of the change in
total long-term debt and included with nancing activities. Also, if the company
provided notes in the nancial statements disclosing the components of the change in
non-cash working capital, we examined the accounts disclosed and calculate the
changes in those accounts. Another example would be the use of an other account
that might have been listed on the balance sheet as a non-current asset or liability. If the
change in that account accounted for the difference between our calculation and the
reported gure, we considered the non-cash working capital amount to be accurately
reported. We also considered information provided in the statements with respect to
acquisitions and foreign currency transactions as a possible source of reconciling the
calculated and reported differences.
Two researchers collected the data and one senior researcher conrmed the accuracy
of the data on a test basis. To ensure consistency, an initial practice session was
conducted, where all three researchers calculated the cash ow from operations for
several companies. The differences from the reported gure found on the statement of
cash ows and the calculated amount from changes in balance sheet accounts were
investigated and discussed to establish a consistent method for analysis. Any
irreconcilable difference was identied either as an understatement or overstatement.
For example, if the company reported non-cash working capital as a source of cash of
$100 and the calculated amount was a source of $110, the difference would be considered
to be an understatement. The reverse would be an overstatement.
Descriptive statistics
Table I shows descriptive statistics for 2004. The sample included a wide variation in
terms of size and nancial health.
Further, we grouped our rms into industries using ve broad classications.
Table II provides the breakdown of our sample by industry.
The other category represents companies that are diversied and therefore not
tting into another classication.
Misclassifying
cash ows from
operations
23
Empirical results of statement of the operating cash ow position
As discussed earlier, the information contained on the balance sheet can be used to
derive the information reported on the statement of cash ows. In this section, we rst
control for the effects of restructurings, acquisitions, divestitures or translation
changes and examine if the information reported for the cash ow from operating
activities concurs with the balance sheet. Further, we examine if the difference is
signicantly large to affect the decisions of users of nancial statements. Finally, we
examine the agreement between the calculated and reported amounts both pre-1998
and post-1998, before and after the standard change.
Difference in reported and calculated amounts
Table III provides the differences between the calculated and reported gure for each
of the three years. There was a 36 percent decline in the number of companies with
agreement between the calculated and reported gures from 1997 to 2004. The shift
was toward more companies with an overstated position (25 percent increase)
compared to an understated amount (18 percent increase). This means companies in
their 2004 audited annual nancial statements tended to present a stronger cash ow
from non-cash working capital items than could be supported by the balance sheet
position. Only 30 companies (11.5 percent) agreed in all three years. These ndings
Total assets Total revenue Net income
Mean $2,124,020,141 $1,409,647,734 $105,480,784
Median 80,778,000 117,881,566 3,078,838
SD 5,462,530,872 3,532,046,831 347,667,620
Minimum 48,045 0 2307,644,000
Maximum 40,032,538,700 24,885,000,000 3,513,000,000
Note: n 262
Table I.
Descriptive statistics
for sample companies
for 2004
Industry Percentage
Service 13.7
Manufacturing 24.8
Resource 40.5
Technology 5.4
Other 15.6
Total 100.0
Table II.
Industry groupings
1997 (%) 1998 (%) 2004 (%)
No difference 37.4 39.3 24.0
Reported amount is higher than calculation (overstatement) 30.9 28.6 38.5
Reported amount is lower than calculated (understatement) 31.7 32.1 37.4
Note: n 262
Table III.
Results of calculated
vs reported non-cash
working capital
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support Broome (2004) and Hill et al.s (2003) suggestion that the statement is no longer
clear and does not provide the information investors require. It is interesting to note
more companies (74.2 percent) disclosed the components of their non-cash working
capital in 2004 than in previous years (31.7 percent in 1997 and 35.6 percent in 1998).
The ndings from Table III support our P1. In 2004, in only 24 percent of the sample
companies non-cash working capital amounts could be accurately calculated from the
balance sheet accounts. A repeated measures general linear model was signicant and
conrms these results F (2,481) 10.303, p , 0.001, h
2
0.038. In 2004, it is more
likely cash ows from operations will be overstated (M 0.85, SD 0.05) compared to
1998 (M 1.12, SD 0.05) and 1997 (M 1.07, SD 0.05).
Material difference in reported and calculated amounts
Table IV provides results for all three measures of materiality in each of the years
under consideration.
The results in Table IV indicate the number of companies with material differences
grew each year. With respect to net income as a measure of materiality, the percentage
of companies with a material difference between reported and calculated non-cash
working capital gures increased 33.9 percent from 1997 to 2004. Our P3 is supported
by these ndings. Material differences in 1998 are more prevalent than in 1997 before
the standard change. The direction of the difference also changed, again focusing on
net income, from 1997 with 42 percent of the companies materially overstating to
50.5 percent in 2004. For all three measures of materiality, the percentage of companies
overstating increased from year-to-year. This supports P2.
Effect of acquisitions and foreign exchange
Revsine et al. (2005) suggest rms acquiring other companies during the year or
accounting for foreign exchange transactions, might not be able to reconcile the cash
from operating activities with changes in the balance sheet accounts. In our sample, we
identify the number of rms with acquisitions and/or foreign exchange effects disclosed
inthe notes to the nancial statements and investigate whether these disclosures explain
any unresolved differences. Although we found two companies with information
regarding acquisitions that explained any unresolved differences, we wanted to test if
the presence of acquisitions and foreign exchange was a predictor for a reconcilable cash
ow from operating activities. The following table shows the results of a multinominal
logit regression test evaluating the likelihood of agreement between the reported and
calculated gures when there is an acquisition during the reporting year. The dependant
variable is trichotomous with categories representing non-cash working capital
Net income Total assets Total revenue
Year % Over Under % Over Under % Over Under
1997 31.0 42.0 58.6 28.2 35.1 64.9 33.7 38.6 61.4
1998 36.4 44.2 55.8 28.5 41.9 58.1 35.4 40.2 58.7
2004 41.5 50.5 49.5 34.0 54.5 45.5 43.8 49.6 50.4
Note: Materiality is 10 percent of net income, 1 percent of total assets and 1 percent of total revenues
Source: Pany et al. (1996, p. 235)
Table IV.
Percent of companies
with materially
overstated or understated
non-cash working capital
positions for each
materiality measure
Misclassifying
cash ows from
operations
25
differences between reported and calculated amounts that understate the position,
are in agreement, and overstate the position. The control variables are total assets, total
revenue, and net income. The reference category is overstatement of the non-cash
working capital position (Table V).
For all three years the likelihood of agreement between the reported and calculated
non-cash working capital gures increases when there is a disclosed acquisition in the
reporting year. For 2004, total revenue is also a predictor of overstatement, as total
revenue increases the likelihood of disagreement decreases. These ndings are
consistent with results of previous research into earnings management and auditor
decisions (Chong et al., 2012; Nelson et al., 2003; Kinney and Martin, 1994). These
ndings suggest there may be greater auditor inuence in the classication of
operating, investing and nancing activities when there is an acquisition. However,
prior research into cash ow management has not considered the mitigating inuence
of auditors.
Working capital disclosure
Examining working capital disclosures during the sample period reveals 32 percent of
rms disclose the components of working capital used to report the cash ow from
operations gure in 1997. This number grew to 36 percent in 1998 and to 74 percent
in 2004. Overall the data reveal an increase in the number of companies
providing voluntary working capital information. With respect to industry,
Table VI illustrates the percentage of disclosing rms for each of the ve identied
industries.
We observe manufacturing rms, prior to 2004, tend to provide the working capital
component. However, technology companies had the most improvement with only
18 percent disclosing the components in 1997 and over 80 percent in 2004.
Industry 1997 (%) 1998 (%) 2004 (%)
Service 30.0 33.3 67.6
Manufacturing 38.1 50.0 68.4
Resource 30.0 28.6 76.8
Technology 18.2 33.3 80.0
Other 33.3 34.5 80.6
Table VI.
Disclosure of working
capital components
by industry
1997 1998 2004
B Sig. B Sig. B Sig.
Intercept 21.360 0.019 20.634 0.223 21.807 0.002
Total assets 0.000 0.591 0.000 0.402 0.000 0.338
Total revenue 0.000 0.623 0.000 0.392 0.000 0.029
* *
Net income 0.000 0.211 0.000 0.072 0.000 0.311
Acquisitions 2.238 0.000
*
1.604 0.000
*
1.546 0.003
*
Exchange effect 20.077 0.885 20.074 0.884 0.715 0.085
Note: Signicant at:
*
1 and
* *
5 percent levels
Table V.
Multinominal logit
regression analysis
regarding the likelihood
of reconciling given
the presence of
various factors
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Nature of working capital information
The most frequent accounts used in the reported non-cash working capital are: accounts
receivable, inventories, prepaid expenses, accounts payable and accrued liabilities, and
income taxes. However, in total, ndings suggest ve different variants of non-cash
working capital. Variations might include deferred revenue, current portion of
non-current assets or liabilities, and notes receivable. This wide variation suggests that
comparability of non-cash working capital across rms may be difcult. Similarly,
examination of non-cash working capital disclosures demonstrate only 47 (of 262) rms
use the same denition of non-cash working capital across periods. Our results provide
empirical evidence of the lack of consistency and comparability of non-cash working
capital information, suggested byBroome (2004) and Hill et al. (2003). This inconsistency
can lead to misinterpretation of nancial statements when users are relying on differing
denitions of working capital information.
Discussion
The results suggest in the absence of strict denitions and dened work procedures,
practices concerning the reporting of cashows may emerge fromorganizational practice.
Consistent with the theoretical underpinnings of institutional theory, reporting practices
will be reied over time and become the defacto standard, implicitly in the absence of an
explicit standard. These ndings also have implications for the perceived value and
quality of information contained in the statement of cash ows.
Accounting practices are subject to institutional inuences, and are shaped by
internal and external forces. The common assumption is as institutional actors become
entrenched in particular modes of action and, as particular perceptions and procedures
become concretized they become the explicit standard (Mezias, 1990; Mezias and
Scarselletta, 1994). Thus, denitions of what something is, and rules for how
something should be treated are emplaced as the correct mode of action, and deviating
from these perceptions and actions jeopardizes the legitimacy of the entity seeking
an alternate interpretation (Beaubien, 2008; Carpenter and Feroz, 1992, 2001). However,
examination of the data of cash ow reporting suggests the institutionalization of
relevant reporting practices have evolved in a different fashion. Rather than the
emergence of a specic denition of operating cash ows, and an inexible method
of reporting; a non-rigid denition has been institutionalized. In other words,
operating cash ows have become accepted as an amorphous entity with rules which
can be applied with a great degree of variance. Further, the evidence suggests that, in
contrast to a principle of conservatism[1] which Watts (2003a; see also Watts, 2003b;
Gigler et al., 2009; Madsen, 2011) suggest would result in the under-reporting of
cash ows; the majority of organizations adopt practices that over-report cash ows.
Modell (2002) demonstrates institutional forces that impact the development of
practices, and the ways in which those practices are used, are inuenced by
organizations that are industry leaders which are often deemed standard setters.
As such, there are isomorphic tendencies among organizations as they seek to be
deemed legitimate through the adoption of like practices and standards (Carpenter and
Feroz, 2001). This inuence is largely tacit, in that the inuencing entity is not seeking
to exert inuence; but rather is inuential merely by occupying the position held.
Call et al. (2009) argue the inclusion of cash ow analysis with nancial forecasting
improves the quality of the analysis, and the authors posit this is due to anincrease in the
Misclassifying
cash ows from
operations
27
rigor of the analysis. However, LeHavy (2009) takes exception, suggesting that
concordance between cash owanalysis and forecast accuracy diminishes precipitously
after 2004 and further research is required to assess the value of cash ows in
forecasting. This is consistent with Ramnath et al. (2008; see also Demirakos and
Strong, 2004) who nd that cash ows are thought to be an important indicator, but are
becoming less commonly used. This may be in part due to questions regarding the
quality of information and sometimes willful misstatement of material information that
can be found in the statement (Broome, 2004). Thus, despite evidence suggesting the
value (a properly constructed) the statement of cash ows might provide (Purr, 2004),
stakeholders seem to decline to use the resource in recent years (Ramnath et al., 2008).
Conclusion
The institutionalization of the statement of cash ows (particularly the denition of
operating cash ows) appears to be a mutually reinforced construction between
organizations and their various stakeholders. From one position, the reporting of
operating cash ows has attained an unquestioned and reied structure as a exible
repository of transactions. And, given its ill-dened nature, organizations can
incorporate elements into the operating cash ows, which under a stricter regime would
not be allowed. This practice is reinforced as it allows organizations to manage, to some
degree, the image of its nancial health and provides a rhetorical device in the form of a
statement such as, The company is doing well, our operating cash ows showed a
positive trend [. . .]. For these practices to be established, they must have been accepted
by the stakeholders, which must accept the appearance of nancial stability an
organization creates when presenting a statement of cash ows (Burns, 2000; Meyer and
Rowan, 1977). And, most commonly, they do. Rather than challenge the institutional
orthodoxy of how a statement of cash ows might be prepared, stakeholders accept the
presentation of the statement of cash ows, and over time, reify a practice. The
alternative to challenge the statement is made difcult byinstitutional representations
of legitimacy and authority (Carpenter and Feroz, 1992, 2001; Modell, 2002). To
challenge the statement of cash ows is to challenge the professional accountants, the
organization, the auditors, the lawyers that have claried the standards, and so on.
The danger of the unquestioned presentation and acceptance of the statement of
cash ows exists in its reication. If the statement of cash ows remains unreexively
accepted in an incorrect form, then decisions may be made on data that is
demonstrably in error, but assumed, or accepted as accurate. The lesser hazard exists
in that a form of information that has proven value and benets will continue to be
inappropriately used, and provide no true benet the equivalent of a warn-down
speed-bump passed over and barely noticed.
Limitations and future research
Areas of future research may point to a direction as to how the statement of cash ows,
and operating cash ows, might be recaptured as an accurate and valuable tool of
making the operations of an organization transparent. This can be affected through
approaches to practices and standards that seek a useful and productive denition and
set of rules for the reporting of cash ows. Other areas that might prove fruitful for
further inquiry include an examination of how cash ow reporting might change under
international nancial reporting standards and the differences in practice that exist
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within and between industries in the presentation and use of cash ow statements.
Other researchers could conduct the same study in other countries where other
accounting practices occur to determine how widespread the tendency is to overstate
cash from operations. Although auditor presence is suggested as the reason for
improved reporting of cash ows from operations when acquisitions are reported, there
may be alternative explanations. Future research should address the extent to which
nancial analysts rely on the reported cash from operations gure.
Although this research found that the statement of cash ows is more likely to be
reconciled from changes in the balance sheet accounts when the company had an
acquisition, it does not provide alternative explanations that may, in fact, exist. The
companies investigated are all Canadian public companies. Our ndings may not be
generalizable to other companys cash ow statements in other countries. However,
prior research citing individual cases of cash owmisclassication or misrepresentation
indicates this is not the case.
Note
1. Conservatism in an accounting framework suggests that when one is presented with the
choice between two options the one that does not overstate assets or income should be
chosen. By expansion, this would include operating cash ows.
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About the authors
Karen Lightstone is an Associate Professor whose research includes nancial statement
reporting, risk management, and case studies. Karen Lightstone is the corresponding author and
can be contacted at: karen.lightstone@smu.ca
Karrilyn Wilcox has experience in researching and valuating companies, capital stock,
xed income securities and intangible assets. She is also contributing author of IFRS Fair Value
Guide by James P. Catty, has published several research articles, and received several awards in
business, nance and accounting.
Louis Beaubien is an Assistant Professor whose research includes corporate governance,
accounting theory and who teaches management accounting.
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