Peeling away financial reporting issues one layer at a time

Financial Statement Presentation: Will Issuers or Investors Prevail?

The comment period has ended on the IASB and FASB's joint discussion paper (DP), Preliminary Views on Financial Statement Presentation, and it looks like there's going to be a rumble between investor advocates and issuer special interests. I have written three posts in the last few months on this topic (one, two, three), and I am drawing on two additional sources for this post: the CFA Institute's comment letter, and Tim Reason's piece headlined "Critics Pan New Financial Statements."

The Statement of Cash Flows: Direct v. Indirect Method

The most basic of all proposals in the DP was to fix the loophole in SFAS 95 allowing the indirect method and mandating the direct method for the statement of cash flows. Among those who issuers claim to serve, however, it's a must have; according to the CFA Institute:

"We strongly support the adoption of the direct method cash flow statement as it would be a significant step towards improving financial reporting. The DM [direct method] offers insights into the quality of revenues, earnings and the characteristics of the cash conversion cycle, which are not available from an indirect method of reporting cash flows from operating activities. The DM is also consistent with and achieves greater relevance of disclosure of gross rather than net amounts. We strongly believe that the benefits outweigh the cost of adopting this method. In addition, we believe that the information provided by DM cash flows would be beneficial to management as well as investors. [Bolding in original]

But, according to, issuers appear to sing a different tune in their comment letters. Here's quoting from IBM's comment letter:

"IBM 'is aware that limited academic research supports the hypothesis that the direct method of cash flow provides better predictive value to future operating cash flows than either the indirect method or the income statement,' wrote Gregg L. Nelson, the company's vice president of accounting policy in financial reporting. But if that were true, he argued, companies themselves would use that information for internal reporting, something IBM and many other companies insist they do not do. 'To state the obvious,' added Nelson, 'future cash flow is largely driven by future transactions. Historical data is of limited predictive value.' IBM, he wrote, believes that revenue, days sales outstanding, changes in accrual balances and company information should be sufficient for investors to make their decisions." [Italics supplied.]

I love that part about 'if the direct method were useful, we'd be using it.'  It makes me feel like Voltaire's Candide, smugly assured by Pangloss, the pseudo-intellectual, that all is for the best; if there had been a better way, management would be all over it.

Right.  Are you really saying, Mr. Nelson, that IBM doesn't actually care to know where its precious cash came from, and where it went? How about cash planning?  If Nelson is actually saying that IBM management cannot answer those questions for itself, then I say "SELL!" Just to ratchet things up a little, ask yourself how credible Nelson's statements would be if they emanated from the ruby lips of his counterparts at GM, Ford, Chrysler or some other company flirting with bankruptcy. 

Implementation costs of switching to the direct method are also a factor noted by issuers. cites Intel's letter, which claims that it will cost them $5 million in the first year to convert their accounting systems over to the direct method, plus $2 million every year thereafter. I'm not a software guru, but I have trouble taking such dire warnings at their face value. It can't be too hard to pull out each cash receipt and disbursement, sort them into about fifty different buckets, and add up the totals in each bucket; probably 99.9% of that be done automatically. 

On the other side of the cost equation, I'm guessing that the thousands of investors who actually want to understand Intel's financial statements spend a lot more than $5 million worth of time each year attempting to reverse engineer Intel's indirect method statements, along with trying to make heads or tails of the gobbledygook, boilerplate explanations of liquidity trends in their MD&A (I haven't actually read Intel's). For those of you accounting educators who I am fortunate to have as a reader, you will especially appreciate the millions of hours we spend trying to get students to think while they are standing on their head, as it were, in order to get their brains around preparing a cash flow statement; or just being able to read and understand the indirect format.

The Reconciliation of Cash Flows to the Comprehensive Income

The CFA Institute's comment:

"The requirement to present the schedule in the notes to financial statements that reconciles cash flows to comprehensive income and disaggregates comprehensive income into four components: (a) cash received or paid other than in transactions with owners, (b) accruals other then read measurements, (c) remeasurements that are recurring fair value changes or valuation adjustments, and (d) remeasurements that are not recurring fair value changes or valuation adjustments. We would not get information on operating changes versus investing decisions versus foreign exchange rate effects – currently provided (albeit poorly and/or incompletely) in the indirect cash flow statement reconciliation. We recommend and strongly prefer the statement of financial position reconciliation as it provides more comprehensive information and includes the statement of financial position and direct cash flow statement."

Just like one of my earlier posts, the CFA Institutes wants a line-by-line reconciliation of each balance sheet category. That's essentially what I have been pushing for (see this post), but the CFA is asking for comparative balance sheets in full reconciliation format. I imagine that the CFA Institute is working on the entirely valid assumption that disclosures are not taken as seriously by auditors and issuers as amounts on the financial statements. That's a great point, but I'm concerned that important information can become overly aggregated. For that reason, I had envisioned highly detailed reconciliations presented as tabular disclosures — like what the IASB requires for some, but not all, accounts.  It's critical that it be required for all accounts. did not report that issuers squawked much about the cash flow reconciliation. Execs, no doubt, are aware that the Boards considered balance sheet reconciliations in their deliberations, but ultimately got enough pushback to contract a case of cold feet. So, issuers probably want to let sleeping dogs lie at this juncture. That's one reason why I would be willing to, albeit reluctantly at this point, settle for note disclosure, as a sort of compromise.

Classification According to Operations, Investing and Financing

CFA Institute supports the Boards' preliminary views to carry the same classification scheme (i.e., operations, investing and financing) across the three main financial statements, but issuers are objecting. Banks, in particular, are not sure how to reasonably go about separating their operating activities from their investing activities. There may also be a difference in preferences between the IASB and the FASB here; the former might be more comfortable with classification decisions made by management subject to some general 'principles' (a view I absolutely abhor), but U.S. issuers may prefer more FASB-like rules to back them up.

I am actually in the issuer camp on this one. I don't think it is possible to make a principled distinction between operations and investing for any industry. Try these:  Is the acquisition of inventory investing or operations? Is purchasing new equipment to replace old equipment an investing or an operating decision? Are planned expenditures on a 20-year-old oil field to extend proved reserves a part of normal operations, or are those expenditures an investment?

However, as I have stated here, I am very much for a principled distinction between financing transactions and everything else. I see no useful purpose in allowing management the discretion to fiddle with what goes where; but, it should be a straightforward exercise to write rules for classifying financing transactions apart from everything else.

Overall, though, I think organizations like the CFA Institute treat the FASB much too gently. They should be telling them also that, even though there are some satisfactory portions of the DP on financial statement presentation, it doesn't come close to going far enough. They should be telling them that convergence is not near as important as getting it right for U.S. investors. They should be SCREAMING that irrespective of the rules we have for recognition and measurement or the reporting of other comprehensive income,  financial reporting will never be what should be without a full balance sheet reconciliation and a direct method statement of cash flows.

No Comments

Leave a Comment