The Cash Flow Statement: Problems with the Current Rules

Transcription

1 A C C O U N T I N G & A U D I T I N G accounting The Cah Flow Statement: Problem with the Current Rule By Neii S. Wei and Jame G.S. Yang In recent year, the tatement of cah flow ha received increaing attention from reader of financial tatement. The cah flow tatement give vital information about a company' performance, a well a it major activitie during the year; however, ome of the rule for preparation make the cah flow tatement le ueful than it hould be. The weaknee with the cah flow tatement can be divided into five ection: 1) difference between commercial and indutrial companie veru financial intitution; 2) problem with operating activitie; 3) problem with inveting activitie; 4) problem with financing activitie; and 5) the role of free cah flow. The author offer potential olution to thee problem that could improve the cah flow tatement. Financial Intitution Veru Commercial and Indutrial Companie In the cae of financial intitution, the identification of the core operating activitie i important, becaue they differ markedly fi-om nonfinancial companie in thi repect. Conider commercial banking intitution, where the core operation can be divided between on-balance heet activitie and off-balance heet activitie. The off-balance heet activitie conit primarily of fee-baed activitie for ervice rendered that do not create an aet or a liability. Thee create no problem for the cah flow preentation becaue they appear on the income tatement and flow directly through the operating ection of the cah fiow tatement. The major problem are created by activitie that have ignificant impact on the balance heet. They are: 1) managing the account of depoitor, which appear on the balance heet a liabilitie; 2) lending money to cutomer, which appear on the EXHIBIT 1 Current Reporting XYZ Commercial Bank Statement of Cah Flow for the Year Ended December 31, 2003 (Amotmt in million) OPERATING ACTIVITIES Net income Proviion for loe Depreciation and amortization Proviion for deferred taxe Lo on ale of ecuritie Net change in accrual and other Net decreae in loan held-for-ale Net increae in trading account aet Net increae in trading account liabilitie Cah provided by operation INVESTING ACTIVITIES Purchae of invetment Proceed from ale and maturitie of invetment Net increae in depoit at interet with bank Increae in federal fund old under reale agreement Net increae in loan Proceed from ale of loan Capital expenditure Sale of property, plant, and equipment Buine acquiition FINANCING ACTIVITIES Net increae in depoit Reported (87) 66 (366) (1,819) 1,771 (33) (5) (316) 186 (16) ( 215) ( 564) 408 Net deceae in federal fund purchaed under repurchae agreement (62) Net increae in commercial paper and fund borrowed Proceed from iuance of long-term debt Repayment of long-term debt Dividend paid Net change in cah and equivalent (266) (42) MARCH 2007 / THE CPA JOURNAL

2 balance heet a aet; and 3) trading in ecuritie, which appear on the balance heet a aet. If thee are a bank' core operation, one would expect them to be in the operating activitie ection of the cah flow tatement. Intead, cutomer depoit are lited a financing activitie, while loan to cutomer and ecuritie activitie appear in the inveting activitie ection. A a reult, the figure for "cah provided by operation" i meaningle. In other word, the breakdown of cah flow into operating, inveting, and financing activitie a preently contituted for financial intitution i not ueful to reader of the financial tatement. A totally new form of preentation i needed to provide ueful cah flow infonnation. It i omewhat ironic that FASB, in Statement of Financial Accounting Standard (SFAS) 102, Statement of Cah Flow Exemption of Certain Enterprie and Claification of Cah Flow from Certain Securitie an amendment of FASB Statement No. 95 decided to ue the fact that financial intitution' ecuritie trading i an operating activity a the bai for requiring that commercial and indutrial companie treat ecuritie imilarly. Thi i unfortunate for uer of financial tatement, becaue it make it eay for a company to manipulate cah from operation by moving fund between trading ecuritie and cah equivalent, which are treated a part of cah rather than a invetment. Exhibit 1 how the current reporting practice of the cah flow tatement for the banking indutry, while Exhibit 2 propoe an alternative format. Reporting of Operating Activitie Although the accounting profeion talk about the importance of comparability of financial information, the fact that interet paid i treated a an operating activity whme dividend paid i treated a a financing activity make it difficult, if not impoible, to compare the performance of companie that make different financing choice. Analyt have reorted to their own meaure to make uch comparion. One of the mot common i earning before interet, taxe, depreciation, and amortization (EBITDA); however, other mean to compare exit, with no commonly agreed upon meaure for all to ue. Up to now. EXHIBIT 2 Propoed Alternative XYZ Commercial Bank Statement of Cah Flow for the Year Ended December 31, 2003 (Amount in million) CORE ACTIVITIES INCOME STATEMENT ACTIVITIES Net Income Proviion for credit loe Depreciation and amortization Proviion for deferred taxe Lo on ale of ecuritie Change in accrual and other, net Cah provided by income tatement activitie LENDING ACTIVITIES Net increae in loan Proceed from ale of loan Net decreae in loan held-for-ale Cah ued in lending activitie DEPOSITOR ACTIVITIES Net increae in depoit TRADING ACTIVITIES Net increae in trading account aet Net increae in trading account liabilitie Purchae of invetment Proceed from ale and maturitie of invetment Increae in federal fund old under reale agreement Net deer, in federal fund purchaed under repurchae agreement Net increae in depoit at interet with bank Cah ued in trading activitie Cah provided by core activitie INVESTING ACTIVITIES Capital expenditure Sale of property, plant, and equipment Buine acquiition FINANCING ACTIVITIES Net increae in commercial paper and fund borrowed Proceed from iuance of long-term debt Repayment of long-term debt Dividend paid Net change in cah and equivalent Propoed (87) ( 316) ( ) 408 ( 366) 271 (1,819) ( i ( 1,771 (5) (62) (33) 373) ) (215) ( 218) i (266) (42) MARCH 2007 / THE CPA JOURNAL 27

3 the accounting profeion ha imply ignored the iue. The only analytical meaure that ha been dealt with by the accounting profeion i eaming per hare, becaue thi mut be preented on the income tatement. A econd problem affecting the operating activitie involve the financing of receivable. Year ago, receivable were financed through borrowing, with receivable pledged a collateral. The monie received were treated a a financing activity, which wa appropriate. In recent year, however, increaing concern on keeping debt off the balance heet ha led companie to replace the above treatment with ale of receivable, with and without recoure. Economically, thee activitie till repreent a form of fmancing. The accounting rule, however, allow thee tranaction to be treated a operating activitie intead of fmancing activitie. Thi make thee tranaction doubly attractive to companie: They keep the borrowing off the balance heet and inflate cah provided by operation. Economically, the pledge of account receivable i the ame a the ale of account receivable, but they are treated differently in the cah flow tatement. Thi treatment i inconitent. Another problem that caue ditortion in operating cah flow tem from the treatment of dividend received a an operating activity rather than a an inveting activity. When a company ha ignificant invetment in affiliated companie, it ha the ability to manipulate it own "cah provided by operation" by increaing the dividend it receive from uch companie. Thi imple technique ha been ued by many companie to inflate operating cah flow. Eurthermore, dividend income come from invetment. If the former i hown in the ection of operating activitie, and the latter placed in inveting activitie, the financial tatement reader will not be able to viualize the whole picture of invetment trategy. Another inconitency involve "capital leae." It i true that, on day one, a leae i a noncah tranaction. However, the payment for the leae principal and interet in later day i undoubtedly a cah flow event in a ingle tranaction. And yet, the payment for the principal i treated a a financing activity in one ection, while the payment for the interet i hown a an operating activity in another. One tranaction i broken into two part; it ha lot it wholene. It would be more informative if both were brought together a one tranaction under financing activitie. Another potentially eriou ditortion to operating cah flow come from the rule that require taxe to be treated a an operating activity, even when the gain being taxed i included in inveting activitie. For example, conider a company that ha low operating profit but ha a large gain from the ale of invetment. The bulk of the pretax income i from thi gain, and therefore the bulk of the income tax expene i related to thi gain. On the tatement of cah flow, however, the gain i removed from operating activitie and included under inveting activitie intead, a part of the proceed from the ale of the invetment. But the income tax expene on that gain remain in the operating activitie ection, generating ubtantial negative cah from operation. Thi clearly i mileading, and violate the matching rule required on the income tatement. Another eriou ditortion involve deferred employee compenation. Many companie pay deferred compenation in the form of tock option that are off the balance heet when iued. When the company later redeem the option by paying cah, the move i treated a a financing activity a though it were a capital allocation, when in reality thi payment i not any different from wage. A uch, it hould be treated a an operating activity. Finally, a mentioned earlier, SFAS 102 require cah flow from trading ecuritie to be treated a an operating activity, rather than an inveting activity, allowing companie to eaily hift cah flow between year by witching ecuritie between "trading ecuritie" and "cah equivalent." The Inveting Activitie Section For many year, the ditinction between cah equivalent (invetment having no principal rik) and other marketable ecuritie ha caued eriou confuion for the untrained reader of financial tatement. Cah equivalent are treated a part of cah, while marketable ecuritie are hown a inveting activitie. Where a company' portfolio manager doe a lot of trading and witching between thee two type of ecuritie, very large number will appear in the inveting activitie ection a "purchae of marketable ecuritie" and "ale of marketable ecuritie." It i not uncommon to ee financial tatement in which thee number repreent the larget cah fiow. Were one to ak the untrained reader what the mot ignificant event for the company were during the year, the anwer might be the purchaing and elling of marketable ecuritie. Yet thee number are irrelevant for undertanding the company' performance. They merely clutter up the tatement and caue confuion. Becaue SFAS 102 require the buying and elling of ecuritie to be treated a operating activitie, the ituation will be even wore. Another major problem with the inveting activitie ection i that it i baed on the rule that only cah amount may be hown in inveting and fmancing activitie. Thu, for example, if one company acquired another at a cot of 10 billion, but only 1 billion of it wa in cah, with the ret paid in the form of debt and equity intrument, the cah flow tatement would how only the 1 biuion cah amount paid a the cot of the acquiition. The other 9 biluon would be relegated to a footnote. The untrained reader would get a fale picture of the true cot of the acquiition. Thi i another example howing the deficiency of the current rule in preparing the cah flow tatement. The rule ignore the viion of a complete tranaction. Financing Activitie The major problem in the financing activitie ection are related to item dicued above. Firt i the failure of many companie to treat receivable financing a a financing activity. Second i the omiion of major noncah financing intrument from the cah fiow tatement. Both may conceal the full extent of new financing engaged in by the company. Exhibit 3 compare an indutrial company' cah flow tatement prepared according to current rule with a tatement incorporating the change uggeted earli- 28 MARCH 2007 / THE CPA JOURNAL

4 EXHIBIT 3 Comparative Effect of Propoed Change to the Cah Flow Statement XYZ Company Statement of Cah Flow for the Year Ended December 31, 2003 (Amount in million) OPERATING ACTIVITIES Adjut. Reported Revied Adjutment made a follow: Net Income Depreciation and amortization Gain on ale of invetment Unditributed equity in earning of affiliate Account receivable. Inventorie Prepaid expene Account payable Accrued liabilitie Redemption of employee coupon Income taxe payable [1] [2] [3] [7] (30) (60) 40 (24) (5) (20) (net of tax) (100) (85) (24) (5) (10) 12 [1] A the gain on ale of invetment i tranferred to inveting activitie, the tax effect of the gain hould alo be tranferred to inveting activitie. (See Hugo Nurnberg, "Income Taxe in the Cah Row Statement," Tiie CPA Journai, June 2003.) [2] Dividend from affiliate hould be hown a an inveting activity, rather than an operating activity. Thi adjutment tranfer the 40 million dividend received from operating to inveting activitie. [3] The receivable old with recoure of 125 million are tranferred from operating activitie to financing activitie. Interet paid Net purchae of trading ecuritie Cah provided by operation INVESTING AaiVITIES Capital expenditure Proceed from ale of invetment Dividend received from equity affiliate Acquiition of ABC Company FINANCING ACTIVITIES Sale of receivable with recoure Reduction in hort-term borrowing Long-term debt paid Long-term debt iued to ABC hareholder Redemption of employee coupon Common tock iued Interet paid Dividend paid Net chanqe in cah and equivalent [4] [5] [1] [2] [6] [3] [6] [7] [41 (50) 81 (55) 80 JlOO) (J5) (74) (20) - (10) 20 (22) (106) (100) 30 (net of tax) - (_4) (55) 70 (net of tax) 40 (600) (545) 125 (74) (20) (30) (net of tax) _(22) 499 (50) [4] Like dividend payment, interet payment hould be treated afinancingactivitie in order to provide an unleveraged definition of "cah provided by operation." Thi adjutment tranfer the interet paid from operating to financing activitie. (See Hugo Nurnberg and Jame A. Largay III, "Interet Payment in the Cah Row Statement," Accounting Horizon, December 1998.) [5] Trading ecuritie, being highly liquid, hould be part of the bottond-line cah number, rather than treated a an operating or inveting activity. Thi adjutment remove the net purchae of trading ecuritie from operating activitie to the bottom-line change in cah. [6] Thi adjutment how the total cot of a major acquiition in the cah flow tatement, not jut the cah component Both the acquiition in the inveting activitie ection and the debt iued for the acquiition in the financing activitie ection are increaed by 500 million. [7] Thi treat deferred compenation a an operating activity. The company iued 10 coupon to employee a a deferred con^penation. Later the company redeemed the coupon by paying cah and treated the tranaction a a financing activity. MARCH 2007 / THE CPA JOURNAL 29

5 > o er in Exhibit 2. Exhibit 3 explain how each of the author' propoed change to the cah flow tatement would make the reporting clearer and more conitent. ie IU CU g S 5 CU CU O CU C^ U 4= CO 0} ^ c 3 I = 2 CU a _ o I x: 0} The Role of Free Cah Flow Another important deficiency in the current cah fiow tatement i the abence of the concept of "iiee cah flow." What i free cah flow? Why i it needed? Traditional net income i a meaurement of wealth from the proprietor' point of view, but it doe not erve managerial purpoe. Eaming are appropriated for dividend payout, plant expanion, contingencie, and other need. Eaming after thee appropriation would be more ueful for management planning. The cah flow tatement i deigned to identify the ource and application of cah in line with net income. Thi doe not erve managerial purpoe either. Cah mut be reerved for dividend payment and capital expenditure. The cah balance after thee reerve would be more informative for the management of cah operation. The concept of free cah flow wa bom for thi reaon. It i defined a cah without any retriction on it ue. It i available for any purpoe at any time. It i imilar to the concept of unappropriated retained eaming. Free cah fiow ha become increaingly important in financial tatement analyi, yet the accounting profeion ha ignored it. One current problem with free cah fiow i that it ha a number of definition. A a reult, different uer may be uing different definition and drawing different concluion about a company' performance. Following i a partial lit of the definition of free cah fiow currently in ue: Cah provided by operation le capital expenditure Cah provided by operation le capital expenditure and dividend paid Net income plu depreciation le capital expenditure EBITDA le captial expenditure Earning before interet and taxe (EBIT) multiplied by 1 minu the tax rate, plu depreciation and amortization le change in operating working capital and le capital pending. The difference in definition are baed on key iue concerning what hould be conidered in determining free cah fiow: 30 MARCH 2007 / THE CPA JOURNAL

6 Shouid it be unieveraged {before interet), or leveraged (after interet)? The advantage of unieveraged free cah flow i that it provide comparability between companie that finance with debt and companie that finance with equity. Shouid it be before income taxe? The advantage of uing pretax number for cah flow i that it provide comparability between companie having noticeably different effective tax rate. Shouid it be afier dividend paid? The advantage of ubtracting dividend paid when arriving at free cah flow i that dividend repreent payment that hould be provided by operating cah flow, a oppoed to other ource, uch a borrowing, iuance of tock, or ale of aet. Should it be before or afier the adjutment for change in operating aet and liabilitie? Uing a free cah flow figure baed on fund-flow before adjutment for change in operating aet and liabilitie take a long-run view. In the long run, the change will vanih. Furthermore, thee fund-flow number are not ditorted by company practice uch a delaying payment of trade creditor to inflate cah provided by operation. The advantage of uing a free cah flow figure after adjutment for change in operating aet and liabilitie i that it repreent a true cah number, wherea the fund flow number i eentially an adjuted accrual-baed number. Furthermore, any company practice that inflate ale and net income (uch a channel tuffing) will equally ditort the fund flow number. However, the cah provided by operation number i not ditorted, becaue it i reduced by the adjutment for the increae in receivable, which normally accompanie uch practice. Should it be baed on actual capital expenditure or a mandatory level of capital expenditure neceary to replace fixed aet ued up during the year? The advantage of uing a mandatory level of capital expenditure i that it level the playing field between companie that pend ubtantial amount expanding their capacity and companie that pend Uttle on capital expenditure due to a poor financial condition. (For a more complete lit of free cah flow definition, ee John Mill, Lynn Bible, and Richard Maon, "Defining Free Cah Flow," The CPA Journal, January 2002.) Exhibit 4 illutrate how free cah flow could range from a low of 21,000 to a high of 85,000, baed upon the definition choen. If the actual capital expenditure are replaced by a mandatory level to maintain the exiting level of plant and equipment, an additional eight value for free cah flow would be generated. The accounting profeion can play an important role in narrowing the choice of free cah flow computation under accounting tandard. If the traditional cah flow tatement can be extended to include a conitent concept of free cah flow, it would become far more infonnative and ueful. Improving the Statement of Cah Flow In repone to the iue above, the author propoe a number of change that would make the tatement of cah flow for commercial and indutrial companie more ueful to the reader of financial tatement. For financial intitution, a dramatic reorganization of the cah flow tatement i needed to make it a ueful document, becaue the current preentation provide total that are not ueful for evaluating any of the activitie of thee intitution. Conceming the concept of free cah flow, two point hould be emphaized: Firt, increaing reliance i being placed on free cah flow number by a variety of uer, including invetor analyt, credit analyt, and finance and economic theoretician. Second, a a reult of the many uer of free cah flow, a variety of definition have been introduced for the determination of free cah flow. Up to thi point, the accounting profeion ha ignored the concept of free cah flow. The author ugget that the profeion take a eriou look at free cah flow, with a view to narrowing and tandardizing the conceptual definition. The author propoe that ome ort of free cah flow be dicloed in the financial tatement, much a eaming per hare mut be included in the income tatement. Neil S. Wei, PhD, CPA, MBA, i an aitant profeor of accounting, and Jame G.S. Yang, MPh., CPA, CMA, i a profeor of accounting, both at Montclair State Univerity, Montclair, N.J. Employee Benefit Conference Thurday, Maly^l 0,2007 Topic include: Audit Review, Health Inurance Update ^ Ditribution Planning Defined Benefit Plan IRS and DOL Update \nd inure! \ FAE Conference Center 3 t»ark Ave., at 34th Street \M9tH\Flopr: i -,~. NewYork,NYl001.6\M Coure Code: "; ' Member Fee: 300 -j Nonmember Fee: 400 ' CPE Credit: 8 hour ' MARCH 2007 / THE CPA JOURNAL 31

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