A Longitudinal Perspective of Nonarticulation in the Statement of Cash Flows

ABSTRACT Previous studies have documented numerous occasions of nonarticulation in the statement of cash flows. Nonarticulation occurs when annual changes in the current accounts presented in the balance sheet differ from corresponding changes reported in the statement of cash flow. This paper contributes to our understanding of this issue by studying nonarticulation from 1987 through 2006. We update Bahnson et al. (1996) and further parse their sample, finding that the nonarticulation as reported by them continues. The number of companies that completely articulate has declined over the past 20 years. However, the number of companies with extraordinarily large nonarticulation has also declined. Furthermore, we find that nonarticulation has increased at a fasterrate in inventory and receivables than other areas. Articulation of depreciation, however, has increased during the sample period. These results are relevant to the discussion of transparency in financial statements and the running debate on the preference of the direct or indirect method for presenting the statement of cash flows. INTRODUCTION .. We all knew that transparency is important for the operation of financial markets, but to this time few thought that it could be worth 5 per cent of the U.S. GDP and possibly more. Now that we know this, financial market regulators will have to keep it into account for the future (Pagano, 2008). One of the major reasons for the crisis in the financial markets has been the difficulty in valuing the assets (such as mortgage backed securities and collateralized debt obligations) on the books of banks due to the complexity of the securities and opacity in pricing practices. Problems from opacity are not limited to derivative securities. A review of the popular press indicates that accounting scandals of the Enron era have increased regulating bodies' focus on accurate, informative financial statements. Recent emphasis on proforma results and other GAAP derived performance measures also increases the necessity for transparent and accurate GAAP information. In accounting, articulation has been defined as the manner in which one statement (the statement of cash flow) is mathematically linked to another (the balance sheet). Nonarticulation occurs when annual changes in the current accounts presented in the balance sheet differ from corresponding changes reported in the statement of cash flow (SCF). (Technically nonarticulation also includes non-operating changes in the current accounts and operating changes in the noncurrent accounts. But for ease of comparison, we adopt the definition and estimation of nonarticulation used in previous studies). Could nonarticulation be a possible means of obscuring information content in the cash flow statement? While previous nonarticulation studies have documented its existence, our study provides an understanding of how this phenomenon has changed over time. Articulation has declined during the past 20 years, but the percentage of firms with very large amounts of nonarticulation has also decreased substantially. We add to the body of knowledge by documenting the variation in nonarticulation across accounts types. Receivables and inventory show the largest decline in articulation while articulation of depreciation has actually increased. For pedagogy, our findings can provide better understanding of nonarticulation in the SCF, leading to a deeper discussion of the issue of the direct method versus the indirect method. REVIEW OF RELEVANT LITERATURE One of the first papers to identify the possibility of nonarticulation among the published financial statements is Bahnson et al. (1996). The study examines 9,757 financial statements from 1987 to 1990 and investigates the ability to replicate published net operating cash flow using the information from the balance sheet and income statement. The authors estimate net operating cash flow by starting from the reported income and eliminating all non-cash items. …