Magazine article Strategic Finance

Making Stronger Statements: Cash Flow and Income

Magazine article Strategic Finance

Making Stronger Statements: Cash Flow and Income

Article excerpt

Statement of Financial Accounting Concepts (SFAC) No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises," states that a full set of financial statements should include, among other things, information about an entity's cash flows and net income. The interrelationship between them is obvious: Cash flow information is necessary to both substantiate and complement reported income. Furthermore, cash flow information is an important factor in investment decisions, firm valuation, and performance appraisal. Consequently, in 1987 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 95, "Statement of Cash Flows," which requires that an SCF be included for each period for which the results of operations are provided. This Standard has since been incorporated into the FASB's 2009 Accounting Standards Codification[TM].

SFAS No. 95 requires that cash flows be shown in one of three categories: operating, investing, and financing. Although there was broad support for the use of these three categories, there was significant disagreement concerning how to classify certain cash flows within them. For example, many respondents to the Exposure Draft (and three of the seven FASB members) believed that cash flows for interest should not be classified as operating activities. There was also disagreement regarding the presentation method (direct or indirect) for operating cash flows. Although SFAS No. 95 permits the use of either method, two FASB members felt that the indirect method should be prohibited. Thus, despite the widespread support for an SCF, disagreements over format, presentation, and classification were so significant that the final Statement was adopted by a slim margin of 4 to 3.

To help sort through these issues, the FASB is currently engaged in a joint project with the International Accounting Standards Board (IASB). Phase B of this project specifically mentions consideration of SFAS No. 95 and International Accounting Standard (IAS) No. 7, "Cash Flow Statements," including whether to require the use of the direct or indirect method. The Boards also have agreed to take a fresh look at the presentation of information in the financial statements, which implies that more fundamental changes to both the SCF and the income statement might be considered.

Because it has been more than 20 years since SFAS No. 95 was issued, it's time to revisit the design of the SCF and the manner in which cash flows are classified. Our approach addresses several classification issues associated with the current format and provides cash flow information that more closely correlates with what is (or should be) provided on the income statement, especially with regard to operating income. We believe it results in a more useful financial statement.

A Consistent Approach

SFAS No. 95 lists several specific objectives that an SCF (along with related disclosures and information in other financial statements) should satisfy if it's to be as beneficial as possible. One of these objectives is to provide information to help management accountants and other users "assess the reasons for the differences between net income and associated cash receipts and payments." Our approach makes it easier to evaluate the reasons for these differences, especially differences between operating income and cash flows from operating activities.

The fundamental conflict between cash-basis and accrual-basis accounting arises because of the need for periodic financial statements (i.e., the time-period assumption), which tie revenues and expenses with specific accounting periods. For accrual-basis accounting, the resulting recognition issues are sometimes subjective, whereas these issues never arise under cash-basis accounting since cash receipts and payments are simply recognized in the period in which they occur. In the long run, total income must be equal under both bases of accounting: In other words, if financial statements were prepared only at the end of an entity's life, the choice of accounting method would be irrelevant. …

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