Graham Holt examines how preparers of accounts must state a business’s cashflows and explains the pros and cons of the two methods for doing so
This article was first published in the February 2010 edition of Accounting and Business magazine.
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IAS 7, Statement of Cash Flows, is the standard that prescribes the presentation of a statement of cashflow disclosing information about the historical changes in cash and cash equivalents of an entity over the reporting period.
The cashflow statement is an integral part of an entity's financial report for each period for which a financial report is presented. Cashflow information provides an insight into an entity's ability to generate cash and its needs to utilise these cashflows.
Cashflows are classified as relating to operating, investing and financing activities in a manner that is most suited to the nature of the business.
Cashflows from operating activities are primarily derived from the main revenue activities of the entity and generally result from the transactions and other events that determine profit or loss. They are a key indicator of the extent to which the entity's operations have generated sufficient cashflows to repay loans, maintain operating capability, pay dividends and make new investments without recourse to external sources of financing. Cashflows from investing activities are important because they represent the extent to which expenditures are made to generate future income and cashflows. Examples include cash payments to acquire investments and property, plant and equipment.
Cashflows from financing activities help to predict the claims on future cashflows by providers of capital to the entity. Examples include cash proceeds from share issues, and cash payments to owners to acquire and/or redeem the entity's shares.
Some cashflow items may differ in classification as a result of specific industry and entity practices, so IAS 7 permits some flexibility here. For example, cashflows from interest and dividends received and paid can be classified as operating or investing activities, as long as the classification is consistent. IAS 7 permits entities to show dividends paid in operating activities as this lets users determine the entity's ability to pay dividends out of operating cashflows.
IAS 7 requires cashflows from operating activities to be reported using either the direct or the indirect method. With the direct method, major classes of gross cash receipts and gross cash payments from operating activities are disclosed. Information about major classes of gross cash receipts and payments may be obtained from the accounting records of the entity or by adjusting sales, cost of sales, expenses and other items reported in the income statement, as appropriate. Entities are encouraged to report cashflows from operating activities using the direct method.
In the indirect method, profit or loss is adjusted to take account of the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cashflows.
A statement of cashflow is required as part of a complete set of financial statements prepared in conformity with International Financial Reporting Standards (IFRS). IAS 7 lays down a formal structure for the statement of cashflow. The classification of cashflows from operating, investing and financing activities is essential to the analysis of cashflow data. Net cashflow (the change in cash and equivalents during the period) has little informational content in itself; it is the classification and individual components that are informative.
Although the classification of cashflows into the three main categories is important, classification guidelines are arbitrary. Additionally, issues arise because there is no standard definition of operating activities. The International Accounting Standards Board (IASB) has taken the position that operating activities are not investing or financing activities. At the same time the opinion that the association of a cashflow with profit is the primary criterion for classifying the flow as operating is expressed.
Both the direct and indirect methods require cashflows 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 reports major classes of operating cash receipts and payments. Proponents of the direct method argue 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.
The indirect method focuses on the difference between net income and net cashflow from operations. Advocates of the indirect method say it provides a useful link between the statement of cashflows, the income statement, and the statement of financial position.
Research has shown that a relationship exists between the presentation of financial information and users' decisions. Cashflow information is integral to investment and credit decisions. With IAS 7, IASB has provided better access to cashflow information. While earnings information is extremely important, cashflow items have value to financial analysts as well. Investors' appreciation of the value of the cashflow information has increased significantly and it is useful in the assessment of investment decisions.
Direct versus indirect
There is debate over the respective virtues of the direct and indirect format. Advocates for the direct format claim it better fulfils clients' information needs because of the breakdown of major classes of cash inflows and outflows. In addition, the format is simpler to understand and provides performance evaluation via the expected and actual cashflows.
Those in favour of the indirect method say it helps users determine the reasons for the difference between net income and associated cash receipts and payments to provide a basis for evaluating the quality of income. However, only the direct method reports actual sources and amounts of cash inflows and outflows which are needed to understand the liquidity, solvency and the long-term viability of a company.
The indirect method is derived from reprocessing and reclassifying data from the income statement and statement of financial position to filter out non-cash items and other adjustments. It is thought that the direct method offers analysts better insights into the current cash position by specifically recording operating cash inflow and outflow items, which allows for realistic projections of future operating cashflow. Another perceived benefit is greater transparency and the resulting market confidence based on the cashflow position.
Users relying on the direct method to project future operating cashflow are in a better position to balance the timing of payments and allocating upcoming earnings because they possess specific information on the current cash position. The way in which components of the direct method are recorded suits cashflow projections better, whereas indirect method disclosures are derived from the mathematical conversion of adjusted data. Thus, there are further issues about the margin of error with the indirect method.
The vast majority of companies use the indirect method for the preparation of statements of cashflow even though it provides the least useful information for investment decisions. Most companies justify this on the grounds that the direct method is too costly.
The complicated adjustments required by the indirect method are difficult to understand and provide entities with more leeway for manipulation of cashflows. The adjustments made to reconcile net profit before tax to cash from operations are confusing to users. In many cases these cannot be reconciled to observed changes in the statement of financial position. Thus users will only be able to understand the size of the difference between net profit before tax and cash from operations.
An issue for users is the abuse of the classifications of specific cashflows. Misclassification can occur within the sections of the statement. Cash outflows that should have been reported in the operating section may be classified as investing cash outflows to enhance operating cashflows.
The complexity of the adjustments to net profit before tax can lead to the manipulation of cashflow reporting. Cashflow information should help users understand the operations of the entity, evaluate its financing activities, assess its liquidity or solvency and interpret earnings information. A problem for users is that entities can choose the method and there is not enough guidance on the classification of cashflows in the operating, investing and financing sections of the indirect method used in IAS 7.
Graham Holt, ACCA examiner and principal lecturer in accounting and finance, Manchester Metropolitan University Business School.