Improving the Statement of Cash Flows, Lecture notes of Accounting

Download Improving the Statement of Cash Flows and more Lecture notes Accounting in PDF only on Docsity!

Improving the Statement of Cash Flows

Draft of a Discussion Paper prepared by staff of the UK

Financial Reporting Council

May 2016

Contents

• Overview of the suggestions made in this paper Page
• Invitation to comment
• 1 Introduction
• 2 The usefulness of information about cash flow
• 3 The classification of cash flows
• 4 Cash equivalents and the management of liquid resources
• 5 Reconciliation of operating activities
• 6 Direct or indirect method?
• Appendix: Illustration of the suggestions made in this paper

Requirements of current IAS 7 Suggestions made in this paper

The classification of cash flows

(Discussion Paper, Section 3 )

‘Operating activities’ include all activities that do not meet the definition of investing or financing activities. (paragraph 6)

Operating activities should be positively defined or described (perhaps as including transactions with customers, employees and suppliers) and that items that do not relate to operating activities (or another defined section of the cash flow statement) should be reported separately. It should also be clear that items should not be excluded from operating activities merely because they are unusual or non- recurring.

Cash payments to acquire property, plant and equipment, intangibles and other long-term assets are reported within cash flows from investing activities. (paragraph 16(a))

Entities are encouraged to disclose the aggregate cash flows that represent increases in operating capacity separately from those that are required to maintain operating capacity. (paragraph 50(c)

Cash outflows to acquire property, plant and equipment should be reported as a cash outflow from operating activities. As such outflows are likely to be volatile, a sub-total of cash generated from operating activities before capital expenditure should be disclosed.

Entities should be encouraged to disclose the extent to which expenditure on property, plant and equipment represents ‘replacement’ or ‘expansion’.

Requirements of current IAS 7 Suggestions made in this paper

Cash flows from interest and dividends received and paid shall be classified consistently as either operating, investing or financing activities. (paragraph 31)

Cash flows on financing liabilities (including the payment of interest) should be reported in the financing category of the cash flow statement. Cash received from customers (including any amount treated as interest income in the statement of profit or loss) should be reported within cash flow from operating activities.

Cash flows arising from taxes on income shall be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. (paragraph 35)

Cash flows relating to tax should be reported in a separate section of the statement of cash flows.

Cash equivalents and the management of liquid resources

(Discussion Paper, Section 4)

Cash flows are defined as inflows and outflows of cash and cash equivalents (paragraph 6)

The statement of cash flows should report inflows and outflows of cash, rather than cash and cash equivalents. A separate section of the statement of cash flows should report cash flows relating to the management of liquid resources. Liquid resources should be limited to assets that are readily convertible into cash, but should otherwise not be restrictively defined. Entities should be required to disclose their policy for the management of liquid resources, and the classes of instruments that are treated as such.

Reconciliation of operating activities

(Discussion Paper, Section 5)

Invitation to comment

[To be completed.]

1 Introduction

The aims of this paper

1.1 The statement of cash flows is a well-established part of financial reporting, which complements the statement of financial position and statement(s) of financial performance. It is clear that the information provided by the statement of cash flows is valuable to investors and other users of financial statements.

1.2 Entities that prepare their financial statements in accordance with IFRS Standards are required to follow the requirements of IAS 7 ‘Statement of Cash Flows’. IAS 7 is an old standard—it was originally issued in 1992 —and it would be surprising if improvements cannot be identified from the perspective of 2016. And a fundamental review may be in sight: the IASB’s project on ‘Primary Financial Statements’ is examining the purpose, structure and content of the primary financial statements, including the statement of cash flows.

1.3 This paper presents some ideas to improve the usefulness of the statement of cash flows, which might be considered in the course of the IASB’s project. These suggestions, which are not official positions of the FRC, are intended to stimulate debate by providing an opportunity for those interested in financial reporting to comment on them: this feedback is likely to be of interest to the IASB.

1.4 A more ambitious approach could have been adopted, which would attempt to determine the additional statements or disclosures that would be the ideal supplement for the statement of financial position and the statement(s) of financial performance if a cash flow statement were not required. However, this might result in proposals that would require a radical change in practice—with unwelcome implications for both preparers and users of financial statements. Therefore, this paper adopts the more modest aim of attempting to identify possible improvements to the statement of cash flows as required by IAS 7.

1.5 This paper does not aim to provide a comprehensive discussion of all the issues that should be considered in improving the statement of cash flows. In particular, it does not address issues that arise in the context of financial institutions.^1 Views on other issues that respondents believe should be addressed are welcome.

(^1) The European Financial Reporting Advisory Group (EFRAG) has an active project on The Statement of Cash Flows: Issues for Financial Institutions, details of which may be accessed on www.efrag.org

2 The usefulness of information about cash flow

Main suggestions made in this section

The principal purpose of the statement of cash flows is to assist an

assessment of the entity’s liquidity and changes in that liquidity. This requires

that the statement of cash flows reports inflows and outflows of cash. This is

a departure from the approach adopted in IAS 7, which can be viewed as an

attempt to restate information in the statement of profit or loss (and

particularly earnings) on a cash basis rather than an accruals basis.

2.1 IAS 7 notes: “The economic decisions that are taken by users require an evaluation of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation”. It is to assist in this evaluation that it requires information about “the historical changes in cash and cash equivalents” —in other words an account of where the cash has come from and where it has gone.

2.2 The IASB’s Conceptual Framework notes (in paragraph OB20):

Information about a reporting entity’s cash flows during a period also helps users to assess the entity’s ability to generate future net cash inflows. It indicates how the reporting entity obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the entity’s liquidity or solvency. Information about cash flows helps users understand a reporting entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance.

2.3 The following more specific uses for information about cash are discussed in the following paragraphs: (i) To assess liquidity—that is to assess whether the entity is likely to generate sufficient cash to meet its liabilities as they fall due. This is more important than merely assessing the risk that the entity is likely to face bankruptcy, for if the entity can generate more cash than is required to meet its commitments, the excess can be used to provide further value for shareholders, either by new investments or by dividends. (ii) An assessment of the management of working capital. This is one aspect of an assessment of how efficiently the resources of

the entity have been managed, which responds to the need for financial statements to assist an assessment of stewardship. (iii) To derive a measure of performance, such as ‘free cash flow’. A performance measure may be useful as an input to valuation (enterprise value can be estimated as the present value of future free cash flow). Such performance measures are also useful to users in filtering a population: for example, an investor may wish to identify the companies within a sector that have the most significant growth in a performance measure in order to concentrate further analysis on those companies.

Liquidity

2.4 The US Securities and Exchange Commission has helpfully pointed out:

Cash flow statements report a company’s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.^2

2.5 Differences between profitability and liquidity may arise because:

(i) Profits are not represented by cash. This may happen, for example, where profits include the upward revaluation of assets, or where revenue is recognised before the customer pays, for example on a long-term contract. (ii) Profits are struck after deducting non-cash expenses, for example depreciation, share-based remuneration and provisions for future expenses. (ii) Cash generated from profitable trading is reinvested in assets other than cash, perhaps including highly illiquid assets.

2.6 Information on liquidity is reported in the balance sheet (statement of financial position). Because that statement reports the amount of cash and other assets and liabilities, it should assist an evaluation of whether the entity is able to meet its liabilities when they fall due. As comparative amounts are provided it is also possible to assess the extent to which that position has changed in the reporting period.

(^2) Beginners' Guide to Financial Statements http://www.sec.gov/investor/pubs/begfinstmtguide.htm (accessed 22 April

Accruals have long been used to measure the ultimate cash consequences of business activities, and allocations have been used to assign resource costs to periods of resource use. The objective of departing from cash-basis accounting is, paradoxically, to improve the measurement of a firm’s cash generating ability. Accruals measure cash consequences, and allocations even out lumpy cash expenditure or commitments.^3

2.14 The IASB’s Conceptual Framework makes a slightly lengthier case for the superiority of accruals information (paragraph OB17):

Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.

2.15 Some discussions of the use of free cash flow (FCF) suggest that it should be derived from accruals information. James A Ohlson, for example, says:^4

Many analysts think that if they want to estimate a company’s FCF, they need to look at the cash flow statements; however, the cash flow statements are not needed. The best answer to the problem of how to estimate the current FCF is to define FCF as NOPAT [net operating profit after taxes] minus the change in the book value of invested capital.

Stephen H Penman advocates a similar approach.^5

2.16 This suggests that the cash flow statement is not required to provide a performance measure, such as free cash flow. However, it is clear that cash flow information is valuable by providing an alternative

(^3) Thomas H Beechy (1983) Accounting for Corporate Income Taxes: Conceptual Considerations and Empirical Analysis Canadian Institute of Chartered Accountants, page 128.

(^4) Cash Flow Analysis and Equity Valuation , reprinted as Chapter 16 of Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options, edited by David T Larrabee and Jason A Voss. Wiley,

2013. Page 354.

(^5) Financial Statement Analysis and Security Valuation , Fifth Edition 2012, Chapter

perspective on performance, and in particular by relating the results of operations to cash flow.

2.17 The FASB, in the development of FAS 95 ‘Statement of Cash Flows’ concluded that ‘reporting cash flow per share would falsely imply that cash flow, or some component of it, is a possible alternative to earnings per share as a measure of performance’ (paragraph 122). It noted that ‘ net cash flow from operating activities is not comparable to net income because recovery of capital is not a factor in its calculation, and net cash flow from operating activities includes both returns on and returns of investment’. FAS 95 therefore prohibits the reporting of an amount of cash flow per share.

2.18 One of the dissenting FASB members (Raymond C Lauver) suggested that, in spite of statements to the contrary, FAS 95 attempts to establish cash flow from operating activities as an alternative performance indicator. He objected in particular to FAS 95’s observation that ‘Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income’. Some of the consequences of that statement are: (i) Cash flows from operating activities are after interest and tax; and (ii) Non-operating items that are included in net income are also included in cash flow from operating activities. These issues are considered later in this paper.

2.19 In summary:

• accruals information provides superior information on performance than information about cash flows;
• at least in the opinion of some, the best measure of free cash flow can be derived from accruals information;
• cash flow information cannot be considered as a measure of performance as it includes both returns on and returns of investment.

2.20 It is therefore reasonable to be wary of the idea that a main focus of improvements to information about cash flow is to provide a measure of performance. The cash flow statement should not be simply a restatement of the statement(s) of financial performance on a cash basis rather than an accruals basis.

2.21 However, information about cash flow can assist users in their understanding of performance as it provides a different perspective on an entity’s operating activities. By explaining the relationship between accruals-based performance measures and the entity’s cash generation cash flow information provides an insight into the quality

3 The classification of cash flows

Main suggestions made in this section

Operating activities should be positively defined or described (perhaps as

including transactions with customers, employees and suppliers) and that

items that do not relate to operating activities (or another defined section of

the cash flow statement) should be reported separately. It should also be

clear that items should not be excluded from operating activities merely

because they are unusual or non-recurring.

Cash outflows to acquire property, plant and equipment should be reported as

a cash outflow from operating activities. As such outflows are likely to be

volatile, a sub-total of cash generated from operating activities before capital

expenditure should be disclosed.

Entities should be encouraged to disclose the extent to which expenditure on

property, plant and equipment represents ‘replacement’ or ‘expansion’.

Cash flows on financing liabilities (including the payment of interest) should be

reported in the financing category of the cash flow statement. Cash received

from customers (including any amount treated as interest income in the

statement of profit or loss) should be reported within cash flow from operating

activities.

Cash flows relating to tax should be reported in a separate section of the

statement of cash flows.

3.1 IAS 7 requires that the cash flows are classified into operating, investing and financing activities. This classification has strong intuitive appeal, and seems to work reasonably well in practice. This section discusses some of the ways in which the classification could be improved. The specific areas that are discussed are:

• The definition of cash flow from operating activities (paragraphs 3.2–3.4);
• Property, plant and equipment (paragraphs 3.5–3.16);
• Interest and dividends (paragraphs 3.17–3.30); and
• Taxation (paragraphs 3.31–3.33).

The definition of cash flow from operating activities

3.2 The importance of information on cash flow from operating activities is clear. Operating activities are generally more persistent than other

activities and are therefore central to an assessment of the entity’s liquidity.

3.3 IAS 7 defines operating activities as ‘the principal revenue-producing activities of the entity and other activities that are not investing or financing activities’ (paragraph 6; emphasis added). One of the consequences of that definition is that ‘operating activities’ becomes the default category, i.e. it includes anything, irrespective of its nature, that does not meet the definition of the other categories. If operating activities are important, it is possible to feel some discomfort with this. It would seem preferable for only items that are operating to be reported as such—not operating + hard to classify items. A superior approach would be to require items that are non- operating (and do not fall within one of the other defined categories) to be reported in an additional, separate, section of the statement of cash flows. One might expect, for example, that many would find it useful to distinguish cash outflows relating to the defence of a hostile takeover approach from operating cash flows.

3.4 To meet this aspiration it would be necessary to delete the reference in IAS 7’s definition to ‘and other activities that are not investing of financing activities’ and expand on ‘the principal revenue-producing activities’ of the entities. It might be explained that ‘operating activities’ would typically include transactions with customers, employees and suppliers. This would be consistent with the IASB’s observation in its Exposure Draft Conceptual Framework for Financial Reporting (ED/2015/3) that, in classifying items in the financial statements, their role or function within an entity’s business activities is a relevant consideration. It should be clear that items should not be excluded from ‘operating activities’ simply because they are unusual or non-recurring.

Property, plant and equipment

3.5 Under IAS 7, the purchase of property, plant and equipment is reported as an investing activity. However, because such purchases are required to support operating activities, this requirement appears anomalous. It gives the impression that an entity’s operating activities can be carried out without requiring cash outflows to acquire fixed assets, which is not usually the case if such assets are significant.

3.6 It would be more logical for the purchase of property, plant and equipment to be reported as an operating cash flow, as proposed in the 2010 staff draft ‘Financial Statement Presentation’. This would accord with the practice of some users who subtract investing cash flows from cash generated from operations to derive a measure of ‘free cash flow’.

classifying expenditure as expansion in order to counter this temptation. It might be specified, for example, that: (i) expenditure should be classified wholly as replacement even if the replacement asset is economically superior to that which it replaces—for example, by providing lower operating costs, or greater capacity. (ii) expenditure on property, plant and equipment should be classified as investing only if it relates to the expansion of the entity’s activities to a new line of business. (iii) the basis for classifying expenditure as investing should be disclosed.

3.12 But it is questionable how effective such an approach would be. It would add complexity, and the requirements for the distinction might prompt debate and demands for interpretation. On balance, the better approach is to require all capital expenditure to be reported as a cash outflow from operating activities, with encouragement of separate disclosure of the two classes of capital expenditure.

3.13 Operating activities are often more persistent than other activities. However, expenditure on property, plant and equipment will often be lumpier than other components of operating activities. For this reason it should be separately disclosed.

3.14 If expenditure on property, plant and equipment is separately disclosed as a component of cash generated from operating activities, it would be natural to disclose an amount of ‘cash generated from operating activities before capital expenditure’. In any case, users will be able to derive such a measure. As is discussed below, the suggestions in this paper are that interest on financing liabilities and tax should both be excluded from cash flow from operating activities. It would seem that a consequence of these would be that ‘cash generated from operating activities before capital expenditure’ would resemble EBITDA, with cash substituted for earnings.^6

3.15 An issue related to the reporting of cash flows for the acquisition of property, plant and equipment, arises in the presentation of business combinations. The cash consideration for the acquisition of a business would presumably be reported as a cash outflow from investing activities. However, sometimes there may be little substantive difference between buying a business and purchasing assets. IFRS 3 ‘Business Combinations’ addresses whether a transaction is a business combination or the acquisition of assets and

(^6) This assumes that ‘earnings’ includes only operating items, interest and tax. Also, non-cash operating items (eg share-based compensation expense would be excluded) from cash generated from operating activities before capital expenditure.

liabilities.^7 It would seem confusing and unnecessary to use a different distinction for the purposes of cash flow information.

3.16 While the above discussion has focussed on the reporting of cash flows to purchase property, plant and equipment, the requirements of IAS 7 to report such flows within investing activities also apply to the purchase of intangibles and other long-term assets. Cash receipts from the sale of such assets are also included in investing activities. The considerations set out above would apply equally to such cash flows.

Interest and dividends

3.17 IAS 7 requires an entity to disclose separately cash flows from interest and dividends received and paid and classify them consistently within the categories of operating, investing or financing. The flexibility this allows can be expected to lead diversity in practice and hence a loss of comparability.

3.18 Interestingly, the Illustrative Examples that accompany IAS 7 include an amount captioned ‘Cash generated from operations’ that excludes interest and tax paid: these items are then deducted to arrive at a total for ‘Net cash from operating activities’.

3.19 FAS 95 ‘Statement of Cash Flows’ requires all cash flows of interest received and paid and dividends received to be reported within operating activities—a treatment to which three (of the then seven) FASB members dissented. The options allowed by IAS 7 and the divergence of views among FASB members shows that the classification of such cash flows is a difficult issue.

3.20 The difficulties may be illustrated by considering the example of zero coupon debt. This requires only one cash flow, which is paid on maturity. Therefore, in accounting periods while the debt is in issue no cash flows are reported. In the period in which it matures a single cash flow may be split into an amount representing interest, reported as a cash outflow from operating activities, and an amount representing repayment of principal, reported as a cash flow relating to financing activities.^8 At least one writer^9 has commended this

(^7) The IASB has a current project that may clarify the distinction between an acquisition of an business and an acquisition of a group of assets.

(^8) The FASB has recently proposed that this is the approach to be adopted under US GAAP: (Proposed Accounting Standards Update: Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. January 29, 2016.

(^9) Standard & Poor’s Rating Services Ratings Direct: The Statement of Cash Flows— Comparing the Incomparable February 2014