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This illustrates the significance of cash-flow classification choices

This illustrates the significance of cash-flow classification choices

For example, Portugal Telecom reported 2006 OCF of €1,788. Interest paid of €569 was classified as financing, and interest received of €239 and dividends received of €36 were classified as investment activities. Overall, OCF would have been 16% lower under U.S. GAAP than as reported under IFRS. An analyst covering Portugal Telecom and U.S. telecommunications companies or even other European telecommunication companies, such as Deutsche Telekom AG (which in 2006 classified dividends received, interest paid, and interest received all in operating), would have had to address noncomparability in financial ratios and in OCF-based valuations.

In their discussion of reasons for flexibility in financial reporting, Fields et al. (2001) note a potential benefit of flexibility is the ability for managers to provide a more informative signal; the authors also describe a pragmatic justification is the cost of eliminating flexibility. Arguably, a pragmatic explanation for flexibility across IFRS is the increased likelihood of widespread adoption.

Additionally, from a practical standpoint, our identification of what appears to be more than incidental noncompliance with classification and disclosure guidance could be relevant to standard setters and regulators.

So income statement classification incentives do not drive cash flow reporting

Because of our cross-country and cross-market setting, we use the Altman model which primarily requires accounting variables. An alternative, the Shumway (2001) distress model, as used by Lee (2012), is developed for a single market and requires market-driven variables. How to extend the market-driven variables to a cross-country and cross-market setting is unclear.

This relates to the work of Khanna et al. (2004) and Bradshaw and Miller (2008), who show that foreign firms are more likely to choose accounting methods closer to U.S. GAAP if they cross-list in the United States or have product ) documents increased cross-country intra-industry information transfers within the EU after IFRS adoption.

Within our sample, operating cash flows for firms reporting negative operating cash flows would become positive from an IFRS-allowed reclassification in about 1% of firm-year observations.

Under IFRS, the choice of classification on the statement of cash flows is not required to be the same as the placement on the firm’s income statement

We select our sample based on data availability in 2008 to maximize coverage of firms with at least 3 years of data following the widespread mandatory adoption of IFRS in Europe starting in 2005. Our focus is on the post-2005 period because that is the timeframe in which firms in our sample largely faced similar classification alternatives. Prior to 2005, some firms had already adopted IFRS or were using a home-country GAAP that permitted IFRS-allowable classifications. Cash flow reporting varied by country in the period before IFRS adoption. According to the Nobes (2001) report, the following countries’ local GAAP had no specific rules requiring a cash flow statement: Austria, Belgium, Finland, Italy, and Spain. For Portugal, Nobes (2001) indicates there were no specific rules except for listed companies; our review of listed companies’ pre-IFRS annual reports in Portugal indicates that the classifications for interest paid, interest received, and dividends received were financing, investing, and investing, respectively. The classification requirements were similar to IFRS in the UK (Davies et al. 1997) and in Germany (Leuz 2000). We were unable to document any local GAAP requirements for Denmark, the Netherlands, Norway, and Sweden, so we reviewed actual annual reports in the pre-IFRS period. In these reports, the classification used for all three items in those countries was operating. Nobes (2011) summarizes classification practices related to interest paid in five countries pre-IFRS as follows: Austria and France-operating; United Kingdom-financing; and Germany and Spain-operating or financing.

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