The operating‐financing distinction in financial reporting

This paper addresses an important issue of presentation in the financial statements, namely the distinction between, on the one hand, the obligations and associated flows arising from the provision of finance to an entity ('financing') and, on the other hand, all other activities of the entity ('operating'). This operating‐financing distinction has been wellestablished in the finance literature since the work of Miller and Modigliani (1958, 1961) and is ubiquitous and of considerable importance in practice in financial markets (e.g. Koller et al., 2005; CFA Institute, 2005; Penman, 2006). Yet accounting standards are underdeveloped in this area, and there are gaps and inconsistencies in both IFRS and US GAAP. Drawing upon the distinction between nature and function in the presentation of financial statement information, the paper contributes, first, to enhance our theoretical understanding of the operating‐financing distinction, which is currently defined in different and unreconciled ways in the literature and, second, to propose a practical basis for accounting standard‐setters to determine requirements for the reporting of financing activity in the financial statements.