Statement of Cash Flows: Time for Change!

The statement of cash flows is one of the three basic financial statements required under generally accepted accounting principles (GAAP). Recent financial reporting scandals have shown that this basic financial statement is in need of reform. The presentation of operating cash flow using the indirect method is confusing to many readers, including financial analysts. The terminology used in the statement is unclear and unhelpful. The misclassification of specific cash flows in the operating, financing, or investing sections can result in overstatement of operating cash flow. The direct method for reporting cash flow from operations is recommended, together with an improved reconciliation of operating cash flow to net income. Moreover, companies need better guidance on classifying individual cash flows; the statement itself needs improved descriptions and straightforward terminology. The statement of cash flows is a key financial statement used by analysts and other readers to assess the financial performance of publicly held corporations, but this statement has serious deficiencies. In Statement of Financial Accounting Standards (SFAS) No. 95, issued in 1987, the Financial Accounting Standards Board (FASB) recommended that the direct method be used to report operating cash flows. An AIMR white paper of 1993 also expressed a strong preference for the direct method. Yet, more than 90 percent of corporate statements of cash flow use the permissible indirect method. Equally troubling is that the cash flows are sometimes misclassified among the operating, investing, and financing sections. Moreover, the terminology used in the statement of cash flows is often unclear and unhelpful.Analysts have commonly believed that, unlike the income statement and balance sheet, the statement of cash flows cannot be manipulated by company managers if it is prepared in accordance with generally accepted accounting principles. Recent financial reporting scandals have shown, however, that the statement of cash flows can be subject to management manipulation. Therefore, now is the time to make improvements in this important statement.After a review of the requirements of SFAS No. 95 and illustration of typical statements of cash flows, this article presents a comparison of the alternative methods for reporting operating cash flow—the direct and indirect methods. Because the direct method reports operating cash flow in more understandable categories than the indirect method, the direct method allows analysts to identify trends in the major causes of cash inflows and outflows, which raises the question of why corporations predominantly use the indirect method. Although cost considerations are often cited, the short answer is that the indirect method can provide a kind of “cover” for potential manipulation of the statement. In addition to using the more confusing indirect method, corporations can misclassify transactions to overstate operating cash inflows and use unclear terminology in the statement of cash flows. Several high-profile financial reporting failures—Tyco, Dynegy, Qwest, Adelphia, and WorldCom—show how the statement of cash flows can be manipulated in the company's favor.Financial reporting should provide information to help investors, creditors, and other users assess the amounts, timing, and uncertainty of prospective cash flows. The manipulation of the statement indicates that this important report does not meet those criteria. Therefore, now that confidence in financial statements is at low ebb, the time has come for the FASB to tighten standards for the statement of cash flows. The FASB should require use of the direct method and provide additional guidance on the proper classification of cash flows in the operating, investing, and financing sections.In addition to use of the direct method, the FASB should require an understandable reconciliation of operating cash flow to net income. This reconciliation should report adjustments in four distinct categories: (1) operating cash inflows not recognized as revenues during the current year, (2) operating cash outflows not recognized as expenses during the current year, (3) current revenues for which there were no current cash inflows, and (4) current expenses for which there were no current cash outflows. The article includes a representative list of adjustments classified into these categories and provides a model statement of cash flows to illustrate the recommended format and terminology.