George Hamelos 12/10/13
Prof. Friday-Davis Accounting Blog ACC 9110
“Examining Preferences in Cash Flow Statement Format”
Article Link: http://www.nysscpa.org/cpajournal/2004/1004/essentials/p58.htm
An article written by Tantatape Brahmasrene, C. David Strupeck, and Donna Whittena, which was published in the Online CPA Journal in October of 2004 examines user preferences in determining Cash Flow Statement Format. As indicated in the article, the FASB mandated that businesses issue a statement of cash flows as opposed to a statement of changes in financial position. In issuing a statement of cash flows companies can decide between two methods, the indirect method and the direct method. The direct method is called as such because in calculating the cash associated with operating activities, inflows and outflows of cash can be directly linked to a company’s cash T-account. The indirect method calculates cash provided by operating activities by starting with net income and adjusting this amount for differences between the cash basis and accrual basis methods of accounting (Pratt, 2011). While the FASB has encouraged companies to use the direct method of cash flows, it has not made this a requirement and as such, users have the option to choose which method they prefer. The decision to choose between the indirect and the direct method has led to much disagreement and controversy. While support exists for both sides of the spectrum, the debate still continues today.
Supporters of the direct method of the statement of cash flows, reports all of the major classes of operating cash inflows and outflows. This method is more in line with the FASB’s initial purpose in mandating that a statement of cash flows be prepared as opposed to a statement of change in financial position, which was cited in the FASB’s issuance of SFAS 95 in November, 1987. Those who support the direct method of cash flow reporting argue that it is exactly as it sounds, more direct. It is clearer and does a better job of showing how a company is able to maintain and operate its company and tells if the company is doing so efficiently. Complaints do exist with regard to the viability of the direct method of cash flows. Some users feel that the direct method presents cash flow information from the net income statement on a cash basis as opposed to an accrual basis of accounting. This they deem as misleading because it shows that net cash flow from operations is as indicative of a company’s performance as is net income. This can lead to discrepancies because of the key differences between the accrual and cash basis methods of accounting. For example a sale can be made as a receivable and under the accrual basis of accounting will be counted in net income but under the cash basis it will not be recognized until the cash is collected. Those who support the indirect method of cash flows maintain that the method synchronizes the income statement with the statement of cash flows and the balance sheet. They are also cite that an additional disclosure is needed to reconcile net cash with net income, but the necessity for providing this additional information is not a large burden as critics will make it out to be.
A study by Stock and Watson (1984) indicates that users’ decisions are influenced by which reporting method for cash flows is used. Given that users make different determinations on financial positions based on the method a company is using in preparing its financial statements and the fact that this is an ongoing topic of debate within the realm of accounting, tons of research has been done regarding the implications of using either of these two methods over the other. According to Hard and Vanecek (1991), the decision of which method to use should be specific to the individual user’s task.
The use of the statement of cash flows has proven critical for investors, creditors and financial analysts in their detailed reviews of the financial standing of various companies. A survey of user preferences, categorized by business sector and respondent perspective (manager and investor) showed that more manager level personalities preferred the indirect method than did investors and analysts. The majority of users preferred the indirect method, a total of 78.9% to be exact.
Managers and investors were polled to determine the reasons they preferred either of the two methods over the other. More managers than investors who preferred the indirect method cited familiarity with format and the ability to determine the difference between net income and cash flow from operations as the main reason for their decision. For proponents of the direct method, the opposite was true in both categories, as a higher percentage of investors reported preferring the direct method for its familiarity and ability to differentiate between net income and cash flow from operations. Proponents of the indirect method did not cite being able to determine cash paid/received as a reason for their choice, while this was largely the cash for advocates of the direct method. Consistency in comparisons from year to year was not significant for advocates of the direct method, while it was highly significant for those in favor of the indirect method. As a result of the poll, for both the direct and indirect method, investors seemed to be more concerned than did managers in determining the change in accounts payable and accounts receivable.
In looking at respondents categorized by different business sectors, users placed more importance on familiarity, consistency, seeing change in accounts payable and receivable and understanding the difference between net income and cash flow from operations, as reasons they prefer the indirect method to the direct method. The manufacturing sector reported preferring the indirect method more than the direct method and cited familiarity as the main reason in its thinking. The merchandising sector cited knowing the change in accounts receivable and payable as the most important reason for choosing the indirect method. The services sector also reported preferring the indirect method over the direct method. Financial companies remained divided when deciding between the direct and indirect methods. The utilities sector, which is actually required to use the direct method, reported preferring the indirect method. While the majority of business segment users prefer the indirect method, those that do prefer the direct method cite being able to see cash being paid as the most important reason in their line of thinking.
It is apparent that there are many advocates for both methods so it is hard to say definitively that one is better than the other. Every user has his or her own distinct reason for choosing the direct method over the indirect method and vice versa. According to Brahmasrene, Strupeck and Whitten, financial statement users should base their usage on market needs and the evolution of financial models. The incidents of citing familiarity as a preference for the indirect method is something that will fade over time as users become more familiar with the SFAS 95. Users who are concerned with consistency can just take prior year cash flow statements and reorganize them to be in line with the new methods. With the advent of computer software and technology, the direct method is more commonly being preferred and used today. As this article is dated around 9 years ago, it gives a sense of why users had difficulty in adjusting from the statement of change in financial position to the direct method of cash flows. As we continue to age and progress we will inevitably see more and more users prefer the direct method to the point where the indirect method will eventually be phased out. Until then though, there will still be a heavy segment of advocates who might be a little bit older fashioned, that defend to the death their preference of the indirect method of cash flow reporting.
References:
1. Pratt, Jamie, “Financial Accounting in an Economic Text”, Eighth Edition, John Wiley & Sons, Inc, 2011