PwC IFRS blog

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.

Revenue recognition – let the discussion commence!

In a previous posting last May, we took a quick look at how the global revenue project was shaping up. I also boldly predicted that there would be a discussion paper issued on the topic ‘within the next few weeks’.

Well, so much for that prediction, but we did get a delightful, festive present on 19 December: a revenue discussion paper issued jointly by the IASB and the FASB. The discussion paper explains the preliminary views of both standard setters and proposes a single contract-based revenue recognition model that would replace the current revenue guidance.

So what are the proposals? The key change from the current model is that revenue will be based on the changes in contract assets and liabilities. What does this mean? Well, all contracts (with the possible exception of contracts for financial instruments, insurance and leasing) would be analysed into contract assets (the right to receive payment) and contract liabilities (the obligation to perform under the contract). Revenue would only be recognised when either the net contract liability is reduced or the net contract asset has increased, both as a result of the entity discharging its contract liabilities by performing.

All this seems relatively straightforward, although rather conceptual, and, of course, follows the IASB’s framework balance sheet approach. However, let’s examine it some more. Entities are going to have to identify what performance obligations have to be satisfied (the delivery of either a good or a service) and allocate a value to each. Also, remember that construction contracts, which are currently covered by IAS 11,’Construction contracts’, are within the scope of this project. It will be important to identify when performance has been satisfied, as it could take place over a period of time or at the very end of a project.

That is the current proposal in a nut shell; however, the standard setters acknowledge that there are several areas where a preliminary view has not yet been considered. These include the measurement of contract assets, how much someone is going to pay the entity to satisfy the obligations, the impact of any changes to contractual terms, how revenue will be presented and a decision on whether and how the fair value of certain performance obligations should be measured. 

The standard setters have stated that they believe the proposed model will not change the accounting for many transactions. In some cases that will clearly be true, but, as they also acknowledge, there are some significant changes in the proposals.  For example,

• What is the impact for a construction company if it can’t recognise revenue until construction is complete?
• How will revenue recognition patterns change for a consumer products company if its warranty obligations are contract liabilities?
• Will changes from detailed and sometimes industry-specific revenue guidance under US GAAP to a single principle-based model change business practices?

This is one of the most important convergence projects for both the IASB and FASB, and we are expecting a standard by 2011. It is important to determine how the proposals will impact your business. I therefore encourage you to respond to the IASB with any comments you have. I would also be very interested in your views on the proposals, either by commenting here or by email.