Hey Friends,

Today, we consider the Operating Section of the Statement of Cash Flows in a bit more detail. You’ll read about the behind-the-scenes politics of how we got to the current presentation of operating cash flow on the Statement of Cash Flows (SCF).

Generally Accepted Accounting Principles (GAAP) are codified in the private sector albeit the overseer is in the public sector, namely the Securities and Exchange Commission (SEC). As you might guess, special interests of business and public interest often conflict and the politics of self-interest can therefore come into play with establishment of accounting rules. Until the late 1980s, there was no cash flow report. Instead, there was an activity report called the Statement of Changes in Financial Position. It explained how the balance sheet changed from the beginning of an accounting period to the end of that period by reporting on increases and decreases to a company’s working capital across the accounting period. This report was helpful but simply didn’t provide statement users, like us stock investors, with any kind of clear picture of what was going on with “cash.” Yes, reporting on changes in net working capital (current assets less current liabilities) may arguably serve as a proxy for operating liquidity but nonetheless is a poor substitute for an outright explanation of cash activity. The politics of accounting, if you will, for many years may have effectively concealed cash activity from the face of any report and left creditors and investors a rather daunting task of analyzing the balance sheet deeper to get at what happened with the cash account over the accounting period.

In 1988, the Statement of Changes in Financial Position was replaced with another Statement — namely the SCF. This was a major change in GAAP and one needed by creditors and investors. Banks, especially, need to know clearly about cash from operations since they get paid back in cash, not working capital. Go here to read about this transition to the SCF back in 1988. If you are interested in this subject of the SCF, I recommend a careful read of the linked page.

I’m even going to extract a paragraph from the Financial Accounting Standards Board archived page I linked (just above). Don’t be confused by the “This Statement” at the start of the quoted paragraph below. “This Statement” refers to the FASB’s Statement of Financial Accounting Standard number 95 from 1988 that requires the SCF. So, in the paragraph below the FASB is discussing its own Statement (Standard) with regard to the standard’s intended presentation of operating cash flow on the newly ordained SCF:

“This Statement encourages enterprises to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method). Enterprises that choose not to show operating cash receipts and payments are required to report the same amount of net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities (the indirect or reconciliation method) by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. If the direct method is used, a reconciliation of net income and net cash flow from operating activities is required to be provided in a separate schedule.”

If this quoted section above sounds a bit convoluted, it surely is. In fact, the politics are pretty apparent given a close read. The FASB states that a company can follow either something called the direct method or the indirect method with regard to reporting operating cash flow activity on the SCF. However, the FASB encourages the use of the direct method. But the bottom line from a full reading of the above quoted paragraph is that no company is required to either report on the SCF itself or disclose in a separate schedule the direct layout of operating cash flows but every company must either report or disclose the indirect method. Say what?? On the one hand, every company is encouraged by FASB to follow the direct approach but only the indirect approach is effectively required. And guess what? You’ll be hard pressed to find a SCF with the operating cash flow presented per the direct approach. I believe the FASB encouraged it because it makes operating cash flows straightforward and easy to understand. But it seems businesses found a way to avoid being required to reveal cash flow so directly.

My years of teaching GAAP at the university level and of performing research in this field has left me painfully aware of the politics behind many accounting rules that, at times, make accounting information harder to understand (in financial reports) and often hard to even find without pouring over pages of footnotes in financial filings.

I’ll have to leave you with this today and wait till next post to continue. The SCF includes a section on Cash Flows from Operating Activities. But because companies don’t present operating cash flows directly but rather use an indirect presentation that adjusts net income, you don’t actually see the cash flows from operations presented. Yes, you see additions and subtractions to net income, and you’ll end up in the same place after all is said and done, but you don’t actually see the cash inflows and outflows from operations.

I hate to leave you on this note but we’ll pick it up next time. See you then.

Paul