Financial Accounting: In an Economic Context

THE STATEMENT OF CASH FLOWS: ECONOMIC CONSEQUENCES

The economic consequences associated with the statement of cash flows result primarily from investors, creditors, and other interested parties using it to assess the investment potential and creditworthiness of companies and the equity and debt securities that they issue. Forbes magazine reported: “a number of stock advisers are basing their work in part on cash flow . . . an investor who ignores cash flow in picking stocks is being deprived of one of the most valuable tools in an arsenal.” Furthermore, many writers have claimed that had investors relied more heavily on cash flow numbers, instead of working capital and the current ratio, famous bankruptcies, like W. T. Grant, Penn Central, Sambo's Restaurants, AM International, and Wickes, might have been foreseen earlier. As one survey found: “The evidence could not be clearer. Investors use the statement of cash flows more, and the income statements less, than previously.”⁵

The increasing importance of cash flow information to investors and creditors creates incentives for management to window dress the statement of cash flows. Such incentives can be troublesome because in the short run it is relatively easy for management to present a favorable cash position. Delaying payments on short-term payables, for example, can significantly boost the amount of cash provided (used) by operating activities. Selling investments, even if it is not in the shareholders' long-term interests, ...