2006 Reports

Perspectives on the Cash Flow Statement Under FASB Statement No. 95

Nurnberg, Hugo

This paper demonstrates that current cash flow statement classification rules under Statement No. 95, Statement of Cash Flows (SFAS-95, 1987), are simplistic and wrought with internal contradictions. As a result, net cash flow from operating activities (NCFO) is often contaminated by the cash flow effects of certain investing and financing transactions, including the income tax effects of those transactions; and a similar contamination often results in net cash flow from investing activities (NCFI), and net cash flow from financing activities (NCFF). It also demonstrates a priori that reporting gross operating inflows and outflows under the direct method with a supplemental reconciliation of net income and NCFO is more informative than reporting NCFO under the indirect method. A three-part solution to these problems is proposed. First, SFAS-95 should be amended to prescribe the direct method together with a supplemental reconciliation of net income and NCFO. To apply the direct method, accounting systems should be modified to routinely record gross operating inflows and outflows in nominal cash accounts; the patchwork after-the-fact analysis of deriving gross inflows and outflows indirectly is too complicated and prone to error. Second, the SFAS-95 classification rules should be amended to distinguish where necessary between non-financial and financial companies, and to conform to the underlying economics of the business. In particular, for non-financial companies, SFAS-95 should be amended to classify all interest payments as financing outflows, because they arise from borrowing, a financing activity; and to classify purchases and sales of most short-term non-trading debt securities as financing flows, together with interest collections thereon, because they arise from parking excess cash balances, the opposite of borrowing, another financing activity. For financial companies, SFAS-95 should be amended to classify cash flows from taking deposits and honoring withdrawals as investing flows, because they are the opposite of making and collecting loans, another investing activity; and to classify all interest payments on bonded debt as financing outflows. Other ambiguous and/or inconsistent classification rules under SFAS-95 should also be amended or eliminated. Free cash flow (FCF) should also be defined unambiguously for non-financial and financial companies. Third, income taxes should be allocated among operating, investing, and financing activities so that (1) actual NCFO is uncontaminated by the income tax effects of investing and financing activities; actual FCF (if reported) is uncontaminated by the income tax effects of financing activities; and (3) actual NCFO, NCFI, and NCFF subtotals are reported on an after-tax basis. Additionally, the income tax effects of individual investing and financing transactions should be disclosed, whether of the current, past, or future period, so that users can more accurately estimate prospective after-tax NCFO (and after-tax FCF) for analytical purposes. Finally, report users should remember that, except for certain income tax flows, the cash flow statement is a historical report of actual cash flows. For analytical purposes, especially for valuation purposes, the cash flow statement should be adjusted to a prospective basis; it should be adjusted to exclude cash flows that are not representative of past performance and/or not expected to recur in the future, and to include cash flows that are expected to occur in the future that did not occur in the past.