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SYNOPSIS: Our anecdotal experience with annual reports unexpectedly showed that many balance sheets and cash flow statements are not articulated in the sense that changes in the current asset and liability account balances presented on the former are often reported on the latter at significantly different amounts. To assess the extent of this phenomenon, we examined a sample of 9,757 sets of public financial statements. This effort revealed many unexplained differences between expected operating cash flow measures and the amounts actually reported in cash flow statements. This finding has important implications for education, research and practice. In particular, it implies that education should be altered to reflect the fact that practice is neither guided nor described by conventional concepts. It also suggests that most previous research about operating cash flows is deficient and unreliable because the calculation of its key variable (operating cash flow) is based on an assumption of articulation. Most significantly, this research implies that the FASB can greatly improve accounting practice by requiring companies to use the direct method for reporting operating cash flows. Our analysis shows that the FASB's conclusions were based on untrue premises about the simplicity of the indirect method and the complexity of the direct method. By requiring the direct method, the FASB will produce benefits for all parties involved with or affected by financial reporting.
Data Availability: The data used in this study were obtained from the Compustat database and selected annual reports.
In preparing to use published annual reports in class, it was puzzling to discover that many cash flow statements presented adjustments to net income in the operating section that did not coincide with expectations. Specifically, we anticipated that the operating cash flow section would generally show changes in current accounts (such as receivables, inventory and payables) that would equal the differences between their beginning and ending balances on successive balance sheets. Although some differences would be expected for nonoperating events, such as reclassifications, acquisitions and currency translations,1 many cash flow statements actually show large but unexplained differences.
The authors thank Loyd Heath, Andrew Rosman, Michael Bradbury, two anonymous reviewers and an associate editor for helpful comments on earlier drafts. Financial support for this project was provided in part by the University of Montana's summer...