Every year I attend Financial Executives International’s annual Current Financial Reporting conference. The 2009 conference, held in November, was its usual excellent event, addressing everything from new accounting rules for mergers to new guidance on fair value to the future of financial statement presentation.
And one specific point about the future of financial statements ended up dominating discussion: the “direct method” of compiling the cash-flow statement.
When the Financial Accounting Standards Board issued Financial Accounting Standard No. 95, Statement of Cash Flows, back in 1987, it made the decision only to encourage, not require, the direct method for reporting cash flows. In the 21 years since, however, very few companies have chosen to use the direct method. The large majority instead has used the indirect method, no matter what FASB might be encouraging.
Both methods require cash flows to be grouped into operating, investing, and financing activities; the key difference is how the operating section is presented. The direct method reports major classes of operating cash receipts and payments on a gross basis. Supporters say that reveals more of a company’s ability to generate cash from operations, so it can pay debts, reinvest, and pay dividends to shareholders. It effectively presents income statement information on a cash basis rather than an accrual basis.
The indirect method focuses on the difference between net income and net cash flow from operations. Therefore, it provides a useful link among the statement of cash flows, the income statement, and the statement of financial condition. And one reason FAS 95 was originally issued was to assist users in understanding the difference between net income and cash receipts and payments to give investors a basis for evaluating the quality of income.
To apply the direct method, companies are required to create the statement of cash flows from transactional data. In other words, each transaction would need to be tracked on both a cash basis and an accrual basis—which isn’t easy. Many accounting systems aren’t designed to capture this and would need to be overhauled. This is especially true of companies with many subsidiaries operating in multiple currencies.
FASB and the International Accounting Standards Board also conducted a field test of their Discussion Proposal for financial statements earlier this year. The purpose was to determine whether the proposed model provides more useful information to readers of financial statements, to understand the costs of implementing the proposed presentation model, and to identify any unintended consequences in applying that model.
Thirty-one companies volunteered to recast their financial statements for two consecutive years using the principles and guidance provided in the DP. After the exercise, the participants completed a survey about their experience. One telling fact: None of them could prepare a direct-method cash flow statement without significant costs to change existing systems. In fact, one participant told me he believed the changes needed to track all necessary information would exceed the costs of Sarbanes-Oxley compliance and adopting International Financial Reporting Standards combined.
When you read comment letters about the DP, you find that nobody is arguing that cash-flow information isn’t important to investment decisions. But a sharp divide exists over the direct and indirect methods of calculating cash flow. Most preparers believe that the costs to implement the direct method would far outweigh the benefits that would be derived. After all, if that data really were useful to manage the business, wouldn’t companies have put the systems and processes in place to capture this information?
Several groups that represent investors noted in their comments that they strongly support the proposal to require the direct method. But almost universally, they also don’t want to lose the information they receive from the indirect method. Therefore, they want to retain that information as a schedule in the footnotes. Some went so far as to say that the costs outweigh the benefits. None, however, provided any empirical evidence to the cost-benefit analysis or any research they performed to reach their conclusions.
I’m sure the companies that participated in the field test could provide an estimate of costs to implement the direct method, if they haven’t provided that already to FASB and IASB. I’ll only note that if we look at the estimated costs to implement SOX Section 404, preparers generally underestimate the true cost of compliance.
Despite many comments that companies can’t obtain the information necessary for the direct method without incurring significant costs, FASB and IASB tentatively concluded in an October 2009 meeting that the direct method of stating cash flows should be included anyway. Additionally, in a change from the discussion proposal, the boards decided to require the presentation of an indirect reconciliation of operating income to operating cash flows in the notes to the financial statements.
There’s always a challenge in reconciling divergent points of view, certainly, but giving certain user groups greater control may work against the interests of most individual shareholders.
In other words, essentially, both the direct and the indirect method would be required.
FASB, IASB, and the Securities and Exchange Commission have all tried to reach out to users of financial statements as much as possible to hear much- needed feedback on this topic. Usually, however, only the well-funded “users” are providing that input. Individual shareholders, employees, creditors, and the like are generally silent.
Don’t get me wrong. I think obtaining varied points of view on accounting standards is absolutely essential. I do worry, however, when the standard setters and regulators appear to rely on certain sets of users too much, who all happen to be the most vocal and most funded. The SEC should not forget that “users” also include individual investors.
As we grapple with the direct vs. indirect method question (and others), we need to remember that a diverse group can gain efficiency and effectiveness in obtaining a holistic view. There’s always a challenge in reconciling divergent points of view, certainly, but giving certain user groups greater control may work against the interests of most individual shareholders.
The SEC Committee on Improvements in Financial Reporting (CIFR) has an excellent suggestion on this point: to create a Financial Reporting Forum that could provide input to all of the standard setters and regulators, and be comprised of all appropriate constituents in the financial reporting supply chain. I think we should act on this as soon as is practicable. Otherwise, we will continue to make decisions—such as requiring a direct method for the cash flow statement—without appropriate discussion.
FASB and IASB should consider the issues identified by companies participating in the direct method field test more fully, and pay close heed to the comment letters from preparers regarding the difficulty in preparing a direct-method cash flow statement. The companies participating in the field test in particular spent a significant amount of time and effort to provide FASB and IASB with important information. One suggestion would be to bring together the “users” that those boards are relying on for input with the participants of the field test. Perhaps a deeper understanding by both groups of the other’s point of view would provide an appropriate compromise solution.
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