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The ongoing financial crisis has given more urgency to long-running efforts to reshape the corporate reporting model—efforts that so far have borne little fruit. A key aspect of that debate focuses on improved disclosures and understanding of cash flow statements.
The need for improved cash flow statements features prominently in a broader report by the Financial Reporting Council, the United Kingdom’s independent regulator of corporate reporting, on ways to make financial reports more transparent and useful. The June 4 report, Louder Than Words: Principles and Actions for Making Corporate Reports Less Complex and More Relevant, found that users "are more worried that reports no longer reflect the reality of the underlying businesses, with key messages lost in the clutter of lengthy disclosures and regulatory jargon."
As for the cash flows, one major problem "is that users cannot reconcile the movement in net debt," the report said. "Users like to reconcile opening and closing net debt rather than opening and closing cash because a company can borrow money at year end to increase cash balances—a reconciliation of net debt makes these transactions transparent."
Many professionals are turning their focus to better reconciliation of cash flows with net debt—which is roughly total liabilities and capital obligations minus cash, cash equivalents and liquid investments—to better understand how an entity is actually performing.
Current Statements Fail. "Our face-to-face interviews confirmed that users are a diverse group with very diverse needs," the report said about its discussion with FRC members that it contacted in conducting research for the report. "They did agree, though, that understanding the cash flows of the business is vital and that the cash flow statement in its current form is failing them in this regard. Preparers agree that this statement is not useful for internal management purposes, either. As a consequence, many companies are voluntarily providing significant additional detail in their reports."
Besides face to face interviews with representatives of publicly traded U.K. companies under its jurisdiction, the FRC research for the report also investigated the current literature on complexity in financial reporting and examined surveys conducted by other accounting and professional organizations.
The FRC had hoped that the debt-reconciliation issue would be addressed in the Financial Accounting Standard Board and International Accounting Standard Board joint project on financial statement presentation. But so far, that apparently has not happened to the satisfaction of professionals the FRC polled for its report.
"During our research, users were hopeful that the IASB’s joint project with the FASB on Financial Statement Presentation would address some of their cash flow reporting concerns," FRC said. "However, the discussion paper for this project was issued in October 2008 (4 APPR 949, 10/31/08), and feedback from users has since revealed that the proposals do not yet address the main user concerns" in this area.
Beside the financial statement presentation project not addressing the issue of reconciling net debt and cash flows, the FRC said its research also found concerns that the project might fail in eliminating "vague and ambiguous descriptions in the cash flow statement" and in easing the "difficulty in recalculating the amounts based on balance sheet and profit and loss movements."
Clearer Cash Flows Not a Panacea. While clearer and more detailed depictions of cash flows might have helped detect the current financial crisis and warn of a future one, they are not silver bullets capable of preventing the next one, professionals say.
"The crisis was a combination of many things," Charles Mulford, accounting professor at the Georgia Institute of Technology told BNA July 6. "It is hard to point a finger at one thing that might have changed it. But that said, if investors would have had more forewarning on debt and borrowing in cash flows, it may have helped. But it’s too much to say that this one thing would have forestalled or prevented the problem from developing."
Bob Laux, director of technical accounting and reporting at Microsoft Corp. told BNA July 6 that he thought that reconciliation of net debt and cash flows would bring "a slight improvement, but not a wholesale improvement" to cash flow transparency. "I agree you need greater transparency. And if users believe that this will provide them with that, it will be a slight improvement, but not a panacea" for being able to detect an impending financial crisis, he said.
The FRC in conducting its research and preparing its report was mindful of complexity’s possible role in helping foment the credit crisis.
"During the research phase, it became clear that the credit crisis would have a significant impact on the wider economy," the FRC discussion paper said. "We reviewed our research to make sure that we understood the effects of the crisis on those preparing and using corporate reports. This convinced us that the need for high quality corporate reporting is greater than ever and that we must deliver on our efforts to help make corporate reports more understandable and relevant."
Recommendations for reconciling cash flows and net debt "I think are on the right track," said Mulford, who also directs the school’s continuing project analyzing cash-flow trends. "What bothers me about cash flow are [that] non-cash transactions don’t appear. For instance, if I borrow money, and it is wired to the bank directly, that transaction won’t appear on my cash flow."
"I could borrow money and buy equipment and it doesn’t show up in my operating cash flow, my investment cash flow, or financing cash flow, but it will show up in debt and assets," Mulford adds. He said he thinks that reconciling net debt to cash flows would uncover non-cash transactions.
Direct Flow Model Too Costly. Laux said that while many users might favor a direct cash flow model with data taken directly from sales, investing and financing operations, "there’s been a lot of feedback from preparers that it’s cost-prohibitive."
The FASB-IASB financial statement presentation discussion paper proposed to require direct cash flow reporting, which has elicited objections from the preparer community (5 APPR 388, 5/1/09), much of it concerning costs (please see related article in this issue).
For instance, Arnold Hanish, the chief accounting officer at Eli Lillly and commenting as the chairman of Finance Executive International’s Committee on Corporate Reporting, noted in an April 14 letter to the FASB on the presentation project that "we strongly believe that the costs to implement a direct method cash flow statement far outweigh the benefits to be derived."
"We question how critical this information is to financial statement users and how specifically it will be used in practice, particularly as the information provided through the direct method is generally not compiled or prepared, and rarely if ever used by management to make business decisions," Hanish continued.
Laux posited that it might be possible to derive the cash flows indirectly from the income statement to hold down preparation costs, but present it in a direct way that would still reflect cash flows from operations, financing and investment. "You could calculate it somewhat indirectly, but present it directly," he said.
Laux said he had seen proposals that would reconcile net debt, and "I think it would a slight improvement" from the current way of presenting the cash-flow statement. It could "give some important information," especially "given the current financial situation," he said
Nonetheless, "I still think that cash flows from operations, financing and investment really gives the information that should be looked at," Laux said.
Look to the Order Book. Steve Priddy, director of technical policy and research, for the Association of Chartered Certified Accountants (ACCA) in London, told BNA that cash flow reporting needs upgrading, but he approached it from a different angle than Mulford or Laux. Financial report users "are too focused on profitability rather than cash flow," he said. Cash flow statements in turn need to be "more accurately and easily depicted," he said.
"It always fascinates me that accountants and the accounting profession do not spend enough time on cash flow instead of profitability," Priddy said. To better understand the origin of cash flows, "they need to understand the strength of [a company’s] order book—how good it is, does it match a firm’s staffing and other requirements, the amount of financing available to support the activity needed to fill those orders. We need better reporting in that area. We need to have better indicators for that.
However, Priddy also cautioned that building an accounting model that reflects the demands of an order book "can be difficult because the components of cash flow can be so industry-sector specific." The FRC report said that those it interviewed for its report urged it to launch "a project to further investigate users’ needs for cash flow and net debt reporting with a view to better aligning reporting with these needs, possibly through producing best practice guidance."
Greater Simplicity Is the Overall Goal. The focus on cash flows is one major component of the FRC report’s overall mission: seeking ways to identify and eliminate complexity in financial reporting.
"We use the term ‘complexity’ throughout this paper," the FRC said. "One thing we have learned is that it means different things to different people. So in this paper, we define it as anything that makes regulations or the reports themselves unnecessarily difficult to understand, implement or analyze."
"Reports can be difficult to understand and/or analyze if they contain information that lacks relevance, and so provides clutter—or, equally, if relevant parts of the picture are missing, the FRC said. "We consider that relevance is an aspect of complexity because missing information and irrelevant detail can obscure the overall message of a report and so add to complexity."
"One of the questions we asked was whether these or any other areas of corporate reporting are so complex that we cannot make improvements," the FRC report said. "The response was nearly unanimous: complex transactions can be explained more clearly than they are at present. We cannot make all transactions or an international business with multiple products and services simple, but we can communicate them more simply."
Focus on Investors. However, the report also cautioned that the goals of financial reports should not be overly ambitious.
"One widely acknowledged problem is that reports currently aim to please too many types of user" the FRC report said. "There is a need to refocus them on their primary purpose: providing investors with information that is useful for making their resource allocation decisions and assessing management’s stewardship. We suggest that regulators and companies should reconsider how they address the needs of other stakeholders—for example, those with specialist interests in environmental and employee diversity issues."
"There is a need to reestablish the principle that corporate reports should be designed for their primary purpose—providing investors with information that is useful for making their resource allocation decisions and assessing management’s stewardship," the FRC report also said. "This is consistent with the IASB’s latest thinking on the conceptual framework for financial reporting, which identified the primary users of corporate reports as ’present and potential equity investors, lenders, and other creditors.’ For the purposes of this paper, we consider users to be capital providers and their advisers."
Other Areas for Improvement. The FRC report also highlighted several areas where financial reporting could be improved:
- end acquisition accounting because the valuation of intangibles in transactions is unnecessarily complex, time consuming and adds no useful information;
- clarify and make consistent among companies accounting for the capitalization of research and development costs, which now lacks comparability and breeds confusion;
- avoid overloading financial reports with corporate social responsibility items, which can make them cluttered and divert attention from information more useful to making investment decisions;
- reduce the complexity that surrounds valuation of pension plans and disclose future cash flows related to funding the plans;
- end restatement of financials each time an operation within an entity is discontinued and rely instead on disclosure of the discontinued operation;
- general simplification of accounting for financial instruments;
- compensation information that is more relevant to how performance ties to compensation, a reduction in "boilerplate text," and greater use of graphical displays of information; and
- better business segment reporting, including "greater granularity" and more cash flow detail.
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