The IASB has proposed amendments to cashflow reporting, but the need for the change has been questioned, finds Graham Holt
This article was first published in the June 2015 international edition of Accounting and Business magazine.
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IAS 7, Statement of Cashflows, was first published in 1992 and has barely changed since that date. It allows users of financial statements to assess how different types of activity affect a company’s financial position by classifying cashflows as operating, investing and financing activities.
By requiring companies to consider transactions this way, the cashflow statement is thought to support various methods of analysing the present value of future cashflows and of making company comparisons. However, there are issues with the current standard. For example, cashflows from the same transaction may be classified differently. A loan repayment would see the interest classified as operating or financing activities, whereas the principal will be classified as a financing activity.
The operating activities in the cashflow statement can be presented in one of two ways: the direct method or the indirect method. The direct method is seldom used, as it displays major classes of gross cash receipts and payments.
Companies’ systems often do not collect this type of data in an easily accessible form. Basically, the direct method of accounting tracks cash changes from the bottom up to arrive at net income, rather than starting with net income and making adjustments.
The indirect method is more commonly used to present operating activities. Under this method, a statement reconciling profit or loss with operating cashflows is shown, instead of a statement of cash inflows and outflows. This reconciliation allows users to determine the effect of accruals of profit or loss items and to obtain an indication of ‘earnings quality’.
For example, if an entity’s net income is higher than its operating cashflow, a user would seek further explanations as to the reasons for this occurrence. A reason could be an accounting policy choice, for example. The presentation of operating profit under the indirect method of the cashflow statement can start with either profit or loss before
or after tax. A user’s ability to make comparisons may be affected if different starting points are presented in the reconciliation by entities.
Free cashflow is used by analysts in various valuation models and is thought to be a better measure than using the figure for operating cashflow. Free cashflow is often taken as the excess of a company’s operating cashflows over its capital expenditure, which essentially reflects the cashflows available to owners. Entities have been encouraged to disclose cashflows that increase operating capacity and the cashflows required to maintain it. This information can be used as an indicator of the financial strength of an entity.
There are concerns over the current classification of items in the statement of cashflows. For example, dividends and interest paid can be classified as either operating or financing activities. As a result, users have to make appropriate adjustments when comparing different entities, particularly when calculating free cashflow for valuation purposes. Additionally, when a user is assessing an entity’s ability to service debt, interest paid would be reclassified from operating activities to financing activities.
Research and development expenditure is classified as cash from operating activities, but is often considered to be a long-term investment. Some argue that such cash outflows should be included within investing activities, because they relate to items that are intended to generate future income and cashflows. IAS 7 takes the view that to be classified as an investing cash outflow, the expenditure must result in an asset being recognised in the statement of financial position.
Some items of property, plant and equipment are purchased from suppliers on similar credit terms to those for inventory and for amounts payable to other creditors. As a result, transactions for property, plant and equipment may be incorrectly included within changes in accounts payable for operating items.
Consequently, unless payments for property, plant and equipment are separated from other payments relating to operating activities, they can be allocated incorrectly to operating activities.
There are currently different views as to how to show lessee cashflows in the statement of cashflows. Some users would like the statement of cashflows to reflect lessee cash outflows in a way that is comparable to those of a financed purchase where the entity buys an asset and separately finances the purchase. Other users take the view that lease cash payments are similar in nature to capital expenditure and should be classified within investing activities in the statement of cashflows. Some users would like all lease cash outflows to be included within the free cashflow measure, which would require lease cashflows to be classified within either operating or investing activities.
Finally, there is concern about the current lack of comparability under International Financial Reporting Standards (IFRS) because of the choice of treatment currently allowed. A lessee can classify interest payments within operating activities or within financing activities.
Many issuers recognise that current cashflow disclosures are inadequate, as they give an incomplete picture. Investors and analysts need a better understanding of the economics of their business and so voluntarily supplement the cashflow information required by IAS 7. In addition, some issuers provide a reconciliation of net debt from the end of one accounting period to the end of the subsequent period. The net debt reconciliation discloses information such as acquired debt and the inception of finance leases, as well as any fair value adjustments made to debt and the impact of foreign exchange movements.
Partly as a result of the above practices, the International Accounting Standards Board (IASB) published an exposure draft (ED) in December 2014 that proposes amendments to IAS 7. The main objective of the ED is to improve information about changes in an entity’s liabilities that relate to financing activities and the availability of cash and cash equivalents, including any restrictions on their use.
This latter situation could arise from existing economic restrictions where, for example, the cash and debt are in different jurisdictions and using the cash to settle debt would trigger a tax payment, or from legal restrictions on the ability of the entity to freely use the cash.
IAS 7 already requires the disclosure of significant cash and cash equivalent balances that are not available for use. However, this requirement does not address the situation where cash and cash equivalents are available but, because of restrictions, the entity would find it more economical to use other sources of finance.
The ED results from the IASB’s Disclosure Initiative, which comprises smaller projects to improve presentation and disclosure requirements in existing IFRSs. As part of the initiative, the IASB has already issued proposed amendments to IAS 1, Presentation of Financial Statements. The initiative also complements the current review of the Conceptual Framework. The proposed amendments require an entity to provide a reconciliation of the opening and closing amounts in the statement of financial position for each liability for which cashflows are classified as financing activities.
The ED would not prohibit disclosures on a net basis – that is, liabilities relating to finance activities less cash and cash equivalents. The reason behind this view is that some entities manage debt on a net basis and there was no intention on the part of the IASB to limit management’s ability to explain its financial and risk management strategies. IFRS 12, Disclosure of Interests in Other Entities, already requires disclosure of significant restrictions on the access and use of assets and settlement of liabilities. However, the IASB felt that current disclosure does not address economic restrictions.
For a number of years, users have been requesting the IASB to require companies to provide a net debt reconciliation. Although the proposed amendment to IAS 7 does not include net debt reconciliation, it will help users by providing them with sufficient information to prepare net debt reconciliation themselves. The problem facing the IASB is that there is no definition of net debt in IFRS. The proposed changes will require companies to reconcile the movement in debt from one period to another and, together with the existing information from the statement of cashflows, this will facilitate a net debt reconciliation.
Because many entities already voluntarily provide a net debt reconciliation, the proposed changes should theoretically not impose any additional burden on issuers. The proposals also require issuers to provide information to help users better understand any liquidity issues. The understanding of limitations on the use of liquid resource is important, and some users would like additional disclosures to better understand the different types of debt financing by the entity. The changes should help users in making investment decisions.
Where’s the need?
However, there is currently no general agreement about the need for the ED. Although a reconciliation of ‘debt’ or ‘net debt’ is a common feature of reporting, some feel it is not appropriate to make such disclosure compulsory prior to establishing a conceptual basis for requiring reconciliations in general. Also, there has been comment that the practicality of implementing such a requirement has not been sufficiently analysed to merit an amendment to IAS 7.
Finally, it is thought by some that additional disclosure requirements of this type should not be added in advance of the IASB’s conclusions on relevant elements of its Principles of Disclosure project.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School
CPD technical article
"If an entity’s net income is higher than its operating cashflow, a user would seek further explanations as to the reasons for this occurrence"