The Classification of Cash Flows Related to Taxes Paid on Non-Operating Items

Abstract

The ability of a company to generate sustainable operating cash flow and free cash flow is an important indicator of the company's financial health.

Current treatment of income taxes paid calls for their inclusion in operating cash flow. However, some of these taxes are related to gains on investing or financing items. Their inclusion in operations can cause operating cash flow to be understated.

In this study, we examine 2004 and 2005 financial statements to identify a sample of companies where the effects of taxes on non-operating gains have a material effect on operating cash flow. We found cases where operating cash flow was understated by a significant amount. In one case, the removal of the taxes paid on non-operating gains caused an increase of operating cash flow by nearly forty-five percent. A supplemental table looks at the effects of such taxes on free cash flow with similar findings.