The distorting effects of acquisitions and dispositions on net operating cash flow

The cash flow statement is the third principal financial statement in a corporate financial report. It presents the cash inflows and outflows for the period, together with certain net cash flow subtotals, foremost being net cash flow from operating activities (henceforth NCFO). Under the cash flow statement classification rules of both the Financial Accounting Standards Board (FASB Statement No. 95, Statement of Cash Flows, 1987, henceforth FASB-95) and the International Accounting Standards Board (IASB Standard No. 7, Statement of Cash Flows, 1992, henceforth IASB-7), NCFO may increase directly as a result of business acquisitions and dispositions (henceforth acquisitions and dispositions, respectively), although the acquisitions and dispositions themselves are ostensibly reported in the cash flow statement as investing activities. Examples from annual financial reports suggest that this potential distortion of NCFO may be substantial. In general, however, required disclosures do not make transparent these potentially distorting effects on NCFO, especially when there are many acquisitions or dispositions or the disclosures are not timely. These potentially distorting effects are important because they may impair the usefulness of NCFO in valuation models of the firm as well as in loan covenants and management compensation plans; they may also impair the reliability of investment decisions and empirical research findings based on NCFO. There is some anecdotal evidence that management manages NCFO, often with the acquiescence (if not encouragement) of institutional stockholders and sell-side analysts. Acquisition and disposition transactions provide management with another means of managing NCFO. Suggestions are offered to make the cash flow statement more transparent with respect to acquisitions and dispositions. © 2006 Elsevier Ltd. All rights reserved.