Flexibility in cash-flow classification under IFRS: determinants and consequences

Flexibility in cash-flow classification under IFRS: determinants and consequences

Abstract

International Financial Reporting Standards (IFRS) allow managers flexibility in classifying interest paid, interest received, and dividends received within operating, investing, or financing activities within the statement of cash flows. In contrast, U.S. Generally Accepted Accounting Principles (GAAP) requires these items to be classified as operating cash flows (OCF). Studying IFRS-reporting firms in 13 European countries, we document firms’ cash-flow classification choices vary, with about 76, 60, and 57% of our sample classifying interest paid, interest received, and dividends received, respectively, in OCF. Reported OCF under IFRS tends to exceed what would be reported under U.S. GAAP. We find the main determinants of OCF-enhancing classification choices are capital market incentives and other https://paydayloanstennessee.com/cities/lavergne/ firm characteristics, including greater likelihood of financial distress, higher leverage, and accessing equity markets more frequently. In analyzing the consequences of reporting flexibility, we find some evidence that the market’s assessment of the persistence of operating cash flows and accruals varies with the firm’s classification choices and the results of certain OCF prediction models are sensitive to classification choices.

Introduction

We examine the determinants and consequences of comparative flexibility in classification choices within the statement of cash flows. International Financial Reporting Standards (IFRS) are perceived to allow managers more flexibility than generally accepted accounting principles in the United States (U.S. GAAP). This increased flexibility is apparent with regard to classifications within the statement of cash flows. U.S. GAAP requires that firms classify interest paid, interest received, and dividends received as operating cash flows. In contrast, IFRS allows firms the flexibility to report these items as operating cash flows (OCF) or as investing or financing. We describe variation in firms’ cash-flow classification choices under IFRS, identify capital market incentives and firm reporting environment characteristics associated with these choices, and document consequences of classification flexibility.

Cash flow, and particularly OCF, is well established as a basis for business valuation (e.g., Damodaran 2006; Imam et al. 2008), Footnote 1 contracting (e.g., Dichev and Skinner 2002; Mulford and Comiskey 2005), and financial analysis (e.g., Estridge and Lougee 2007). Although an extensive literature examines classification shifting within the income statement and the balance sheet (Engel et al. 1999; ; Bartov and Mohanram 2014), less attention has been given to classification variations within the statement of cash flows (Lee 2012) and classification restatements (Hollie et al. 2011). IFRS reporting provides a setting where the accounting standards provide firms flexibility in classification choices within the statement of cash flows.

The effect of flexibility in cash-flow classification and its consequences matter because both the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) share the objective that financial information should enable financial statement users to better predict future cash flows. Footnote 2 Furthermore, both boards articulate the importance of accrual and cash flow information in achieving this objective. The IASB articulates its position as follows.

Information about a reporting entity’s cash flows during a period also helps users to assess the entity’s ability to generate future net cash inflows. It indicates how the reporting entity obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the entity’s liquidity or solvency. Information about cash flows helps users understand a reporting entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance. Footnote 3

Despite identical objectives, standard setters have established different requirements for presentation of certain items-interest paid, interest received, and dividends received-in the statement of cash flows. As a consequence, the amount of OCF reported by a given entity can differ under U.S. GAAP and IFRS. Theoretically, the appropriate classification of these items is open to debate. Even when deliberating on the adoption of the statement of cash flows standard, Statement of Financial Accounting Standards No. 95 (SFAS 95), members of the FASB discussed the classifications of interest paid and interest received, ultimately opting to require these items be reported in the operating section. Footnote 4