When valuing companies, cash flows tend to attract the most attention from advisors. But many are surprised to learn how easily management accounting choices can manipulate these figures.

A different philosophy

Accounting rules were not written with investors in mind. Accountants are mostly interested in the big picture. They’re not as concerned with where on the income or cash flow statement companies put certain expenses. For example, they don’t consider the impact that accounting rules have on EBITDA or free cash flow, or how companies might report these amounts inconsistently amongst themselves.

Management, however, has been given different choices on whether certain expenses get reported above or below the EBITDA line on the income statement, as well as the free cash flow line on the cash flow statement.

And the accounting rules governing the cash flow statement for most Canadian companies are vague. International Accounting Standard (IAS) 7 states a company should “present its cash flows from operating, investing and financing activities in a manner which is most appropriate to its business.”

This suggests the most useful financial reporting comes from allowing management to craft financial statements in ways they think best represent their companies. The rationale is: management knows the company and should pick the rules that seem most suitable. Interesting in theory, but it falls apart under application, especially when it becomes more difficult to compare financial information between companies.

Cash flow statements are divided into three categories of inflows and outflows: operating, investing and financing. Free cash flow, often used as a basis for valuing stocks, is frequently calculated by deducting investments in capital expenditures from operating cash flows. Unfortunately, this only accounts for about one-third of the information on the cash flow statement. Worse, cash flows can be miscategorized by management, or misinterpreted by investors.

Investors and analysts don’t usually adjust cash flows because they don’t realize companies have leeway to categorize cash differently. Again, this makes free cash flow figures incomparable.

One area with significant impact on free cash flow comparability is the allocation of interest expenses. Under U.S. accounting rules, and previously under Canadian requirements, interest expenses were deducted from operating cash flows (and free cash flow). But new IFRS rules allow companies to allocate interest expenses as part of financing or investing cash flows.

Most companies choose to count interest paid as an operating expense because it helps determine profit. But some opt to deduct interest expenses from investing or financing cash flows because the interest is a cost of obtaining financing resources or assets that produce a return on investment.

A sampling of Canadian companies that choose to exclude interest expenses from operating cash flows include: Northland Power, Bonavista, Talisman and Pengrowth. In recent annual results, excluding interest expenses helped boost the operating cash flows of these companies by 10% to 60%.

Problems arise when analysts don’t adjust their free cash flow figures, or when investors rely on quantitative models or screening techniques that aren’t sophisticated enough to catch these types of inconsistencies between companies.

Active manipulation?

A recent study by U.S. academics at Fordham University, Temple University, University of Colorado (Boulder), and University of Texas (San Antonio) looked at the flexibility of cash flow reporting under IFRS. It found roughly 77% of companies using IFRS across 13 European countries chose to allocate interest expense as cash from operations. Given 23% chose to include it elsewhere on the cash flow statement meant that, on average, operating cash flows under IFRS tended to be higher than under U.S. accounting rules.And the choices weren’t random. The study found that, when given the option, management was not neutral to capital market considerations, and actively chose the accounting treatment that painted the company in a better light.

Companies chosing to enhance their cash flow from operations (by excluding interest expenses) were more likely to be in financial distress, have a greater probability of default, and access equity markets more frequently than companies using more conservative approaches. So, the best solution for advisors is to ignore the alternative accounting choice introduced under IFRS. Instead, be conservative in equity analysis, consider interest expense as an operating cash flow, and include it when calculating free cash flow.

On a larger scale, remember IFRS was not designed for investing purposes. Accounting needs to be constantly adjusted in large cap companies to correct for inconsistencies that can negatively impact valuations.

Operating Activities
Net income

Add: Interest expense

Add: Non-cash items









Changes in non-cash working capital($125)($125)
Cash from operating activities$2,716$2,440
Investing Activities
Capital expenditures($1,466)($1,466)
Cash from investing activities($1,466)($1,466)
Financing Activities
Debt repayment($471)($471)
Dividends paid($285)($285)
Interest expenses($276)
Cash from financing activities($1,032)($756)
Net Increase in Cash$218$218