Cash is cash, isn’t it?

In times of economic distress, there is greater focus on cash. This seems rather obvious. So it should be no surprise that I am returning to the subject of cash flow after my previous posting on net debt.

One of the higher profile proposals in the IASB and FASB discussion paper on financial statement presentation concerns the cash flow statement. IFRS reporters may currently present a cash flow statement on either a direct or an indirect basis, but the Boards are proposing only to permit the former in the future. That is, all cash flow statements should be presented on a direct basis.

But what do ‘direct’ and ‘indirect’ mean? Consider a simple company that buys goods from suppliers on credit, sells them to customers on credit and has PP&E that it depreciates. Under current practice, that company will probably use the indirect method, which results in a presentation like this:

 Profit 1,000
 Add: depreciation 300
 Less: increase in receivables (400)
 Add: increase in payables 500

 Operating cash flow 1,400

In other words, operating cash is derived by adjusting profit to take account of changes in working capital (such as receivables and payables) and non-cash items (such as depreciation).

A direct cash flow, on the other hand, might look something like this:

 Receipts from customers 4,600
 Payments to suppliers (3,200)

 Operating cash flow 1,400

Operating cash flow is therefore a ‘derived’ number under the indirect method, but it more closely represents actual cash flow under the direct method. The subtotals are the same, but they provide information about a company’s economic activity from different perspectives. For example, the reconciliation of profit to operating cash flow gives an insight into how working capital is managed. The total of receipts from customers, on the other hand, provides information that might contribute towards an assessment of the quality of earnings. Both provide users with important information.

So why is there so much debate about the merits or otherwise of the direct method? Companies are seldom as simple as in my example, so their accounting systems may not generate the required information to produce a cash flow statement ‘directly’ from the primary ledgers. But as an alternative they could derive, for example, the cash received from customers by adjusting revenue for movements in receivables and sales taxes – the so-called indirect-direct or derived-direct method.

 This sounds complicated, especially where revenues and costs attract indirect taxes at differential rates or are, in some cases, partially exempt, but it is actually nothing new. It is described in IAS 7, ‘Cash flow statements’, and is commonly used by companies that already prepare a cash flow statement under the direct method. In effect, it is a development of the reconciliation of operating cash flow prepared under the indirect method. Items such as sales taxes may make the calculation more complicated, but the principle is similar. For many companies, this ability to derive the ‘actual’ cash flows will be a pre-requisite for adoption of the direct method.

This means that both the indirect and direct methods of producing cash flow statements involve a degree of estimation based on amounts presented elsewhere in the financial statements. Neither is a cash flow statement in the truest sense. Indeed, to produce a truly direct cash flow statement may require a significant systems investment for many companies. But as I mentioned above, both the direct and indirect methods provide information that is regarded as useful. So one thing is clear: if the Boards continue down their current path and require cash flow statements by the direct method, this alone will not provide the information required by users. I have already talked about the importance of net debt in my previous posting. To that I would add the reconciliation of operating net income to operating cash flow as a vital piece in the jigsaw.

I would be interested in your thoughts, either by commenting here or by email.

Comments

[D.V. Ramana]

You are right both methods will give the same result ie. Cash from operation.

As a teacher of accounting, I always find it useful to explain the concept of CFO using both direct and indirect methods. I say the following:
Direct method: will show the actual flows of cash. Direct method fail to show the reasons for the difference between CFO and profit.

Indirect method: Will answer the question why is the profit not same as CFO? One cannot observe the actual receipts from the debtors or payments to the creditors from the CFS.

So I find strengths in both methods. It will be useful if the companies are asked to show CFO using both methods.

I have a doubt based on your write-up. You mentioned that the both methods involve some degree of estimation. Will be glad if you can further elaborate on that.

Regards,

D.V.Ramana
Professor, Accounting Area
Xavier Institute of Management

[MIchele Webster]

Applying the direct method to a large international company would be very challenging and seems impractical. We must strip out currency effect and it is unclear how that system logic would be accurately structured when the direct method is employed. Aside from sales / VAT taxes that affect receivables (and do not run through our p&l) there is consideration paid to customers and other items not at invoice level....the "derived direct" method it seems would have higher risk of errors. We believe that significant system changes would be necessary to comply with a mandate to use the direct method.

[Richard Keys]

Many thanks for your comments. Although it might be assumed that a 'direct' cash flow draws its information straight from a company's primary ledgers or cash book, this is rarely the case. The current standard, IAS 7, permits a company to derive its operating cash flows by adjusting sales and costs for changes in inventories, receivables and payables, as well as other non-cash or non-operating items. To do this will require some degree of estimation. Hence, in most cases a 'direct' cash flow statement may not be exactly as it seems.

[ENRIQUE ROSADO PACHECO]

Well, there is a way for companies, regardless of their size, to manage cash flow components or group types in their accounting records for the cash flow statement preparation.

For each bank account, let us say Bank of Verne we asign a code 101.

For:
A/R related transactions we asign a code 101001

A/P related transactions we asign a code 101002

Financial investments, if many, can have their own cash sub-divisionary; if not too many, then under a miscellaneous investment bank-cash divisionary, etc., etc., etc.

Each cash flow transaction component type should only be linked to the account assigned for that purpose, so as to avoid mistakes of posting, for example, an A/P transaction using a divisionary that belongs to A/R or to another type of cash flow account.

This way we can have totals by type of components for the cash flow statements,for any period.

The software programs needed would therefore be less costly and the usage and management of accounts is less labour intensive this way.

Then after all what is left to do is just a work sheet to summarized the cash and bank accounts by component taking the totals from the accounting divisionaries and entering them in a work sheet.

Enrique Rosado Pacheco, CPA
Lima, Peru

[Shafi]

Concerning the isue of estimation, the other way to look at it is that however accurate the accountants and auditors may be, errors will always find their way in accounts since they can not be all removed (cost-benefit analysis). so derivation of true cash will not be possible because of these errors.