Magazine article The CPA Journal

Examining Preferences in Cash Flow Statement Format

Magazine article The CPA Journal

Examining Preferences in Cash Flow Statement Format

Article excerpt

In November 1987, FASB issued SFAS 95, Statement of Cash Flows, which required businesses to issue a statement of cash flows rather than a statement of changes in financial position, effective July 15, 1988. FASB made the decision to encourage, but not require, the use of the direct method for reporting. Both the direct and indirect methods (illustrated in Exhibit 1) require cash flows to be classified according to operating, investing, and financing activities. The different presentation affects the operating section only. The investing and financing sections do not differ between the two presentations.

The direct method, also referred to as the income statement method, reports major classes of operating cash receipts and payments. In this respect, it is more consistent with the objective of SFAS 95. Supporters of the direct method contend that it is more revealing of a company's ability to generate sufficient cash from operations to pay debts, reinvest in operations, and make distributions to owners. Detractors point out that many corporate providers of financial statements do not currently collect information that would allow them to determine the information necessary to prepare the direct method. More important, the direct method effectively presents income statement information on a cash rather than an accrual basis and may erroneously suggest that net cash flow from operations is as good as, or better than, net income as a measure of performance (Mahoney, Sever and Theis, 1988).

The indirect, or reconciliation, method focuses on the difference between net income and net cash flow from operations. Advocates of the indirect method note that it provides a useful link among the statement of cash flows, the income statement, and the balance sheet. Critics point out that the direct method requires a supplemental disclosure to present a reconciliation of net income and net cash. The incremental cost of providing the additional information disclosed in the direct method is, however, not significant.

The first column of Exhibit 1 illustrates the format of the indirect cash flow statement. The operating section starts with net income for the current period. Then, all noncash transactions are negated. Finally, the changes in the balance sheet accounts that relate to operations are reconciled. For example, when accounts receivable increases, sales included in net income must be reconciled for the additional uncollected amounts. Ultimately, the operating section reconciles net income with net cash provided by operations. The second column of Exhibit 1 displays the direct cash flow statement format. Operating cash receipts and payments and their sources are presented. The format is similar to a cash-basis income statement for operations.

Cash Flow Format and Decision Making

Research has shown that a relationship exists between the presentation of financial information and users' decisions. A study conducted by Stock and Watson (1984) concluded that judgment can be influenced by the accounting report format used. Hard and Vanecek (1991) concluded that different formats are appropriate depending on the user's task.

Cash flow information is integral to investment and credit decisions. With SFAS 95, FASB has provided better access to cash flow information. While earnings information is extremely important, balance sheet and cash flow items have value to financial analysts as well. A survey of investors revealed that investors' appreciation for the value of the cash flow information has increased significantly and is useful in the assessment of investment decisions (Epstein and Pava, 1992).

Since the issuance of SFAS 95, the debate has continued over the virtues of the direct versus the indirect format. Advocates for the direct format claim it better fulfills clients' information needs because of the breakdown of major classes of cash inflows and outflows (Collins, 1990). In addition, the format is simpler to understand and provides performance evaluation via the expected and actual cash flows (Bohannon and Edwards, 1993). …

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