Producing accurate financial statements is a crucial part of conducting business. Financial reports such as cash flows, income statements, and balance sheets are very useful to different parties with interest in the firm’s performance. Business managers require accurate reports on which to base their decisions. The owners of the businesses on the other hand need to understand the health and growth prospects of their investments. The government is keen to obtain accurate tax assessments while the financiers require accurate historical records to assess the viability of advancing credit to the business.
The complexity of preparing accurate and comparable financial reports has over the years been a subject of debate. Many contributions have been made regarding the treatment of various items in the preparation of financial statements. Major disagreements mainly based on the differences in understanding the rationale for preparing the reports have emerged. This paper evaluates the contribution of Bruce Wampler, Harold C., and Timothy Vines towards the possibility of strengthening the cash flows and income statements.
The scholars have put up a case concerning the comparability of income statements to cash flows. They argue that preparing cash flows in three categories namely operating, investing and financing had introduced some major disagreements in terms of how to classify some of the items among the three categories. The Statement of Financial Accounting Standard (SFAS No.95) introduced the three categories but raised major divisions within the Financial Accounting Statements Board (FASB) on some items categorization. Also, disagreements in whether to use the direct or the indirect method in preparing cash flows were significant.
The adoption of the regulation was thus based on a very weak win in votes by the FASB members. Indeed the SFAS No. 95 specifies the need to make certain disclosures while preparing the Statement of Cash Flows (SCFs) which assist the users in identifying reasons for the variances in incomes and the corresponding cash flows regarding receipts and payments. These differences emerge due to the use of cash basis in preparing cash flows while the accrual basis is applied in reporting incomes (Bruce Harold Carl & Timothy 2009 p1).
Though the accrual basis appears more accurate by matching incomes and expenditures to the periods in which they were earned as opposed to the period of receipt, questions emerge about the accuracy of the many estimates made in determining the accrual-based income. Therefore, though the income statement is central to the evaluation of performance, the SCF offers very useful information about the business’s ability to generate revenues for use in repaying debts, expanding capacity, and paying dividends.
The scholars argue that fundamentally, cash flows should reflect the current period’s effects of cash on all the items used in establishing the operating incomes for the period. The SCF should offer a cash-based measure of the firm’s performance on the operating section the same way as the income statement offers an accrual-based measure of the firm’s performance for there to be more sensible comparisons. This presents the basis on which to assess the income statement and address some presentation and classification problems of SCFs’ operating section (Bruce Harold Carl & Timothy 2009 p2).
The first issue is establishing the effectiveness and applicability of the direct or indirect approaches in preparing SCFs. The scholars argue that the option for use of an indirect approach in preparing the SCFs operating section is not viable. The direct approach is more meaningful. This is because the section should exhibit information on an equal level as the income statement. If revenue or an expense is shown separately in the income statement due to its significance, then the corresponding cash flows should also be displayed separately in the SCF. This implies that the operating section of the SCF should not follow a predetermined syntax but should be shaped and by the specific business’s income statement. Regulation on a fixed method is thus not meaningful.
The strict requirement for a subtotal of operating cash flows in comparison to the flexibility in the income statement is also surprising. Net income is recognized as the single best yardstick to enterprise performance. This being the case, it is not clear why the FASB is flexible towards the income statement than the cash flows. Businesses are allowed to prepare income statements using either the single-step or the multiple-step.
The multiple-step format displays more details of the components of income including gross profit, the various revenues, and gains as well as a breakdown of expenses and costs as opposed to the single-step format. It is thus reasonable to adopt the multi-step format for all businesses due to the sub-total for operating income to strengthen the financial reporting (Bruce Harold Carl & Timothy 2009 p4).
In following these principles, cash interest received should not be included in the operating cash flows as is the case with the current standards since interest revenue is not part of the operating income in the income statement. It should be displayed in the investment section as it results from investment activities. These alterations would bring meaningful changes in depicting the performance of the firm.
While calculating operating income, interest expense should not be deducted. This detaches the operating performance of the business from the resultant effects of its capital portfolio. The business performance can thus be analyzed and accurately compared to other companies with different capital structures. On the same note cash interest paid should not be part of operations cash flow but should be categorized together with other financing activities as a financing outflow.
In accounting for depreciation, the cash-based equivalent of depreciation should appear as a cash outflow in the operating section of the SCF and not in the investment section. This is not only consistent with the income statement but also recognizes the effect of new assets in improving cash flows. Also, cash flows for all operating expenses should be displayed in the operations section as they are operating assets. However, in implementing this, three years should be used to determine a typical year for a company’s cash flow. Any significant non-cash acquisitions should then be disclosed separately.
The treatment of income taxes is generally consistent between SCF and income statements. Logically, income taxes should thus not be attributed to any section as is currently the case where income taxes are shown just before net income. The current system requires that all taxes paid to be part of operating cash outflows. Matching this to the income statement would require that all taxes be charged against operating incomes. This is undoubtedly a misleading approach. Since allocating the cash paid for income taxes may not be feasible, the best practice would be to list the income taxes paid as a separate item of the cash flow just before calculating the net increase or decrease in cash which is the ultimate result of the cash flow.
The arguments put across are very legit. The requirement for the preparation of SCFs in addition to income statements implies that the two reports should be read together. This brings out the need for harmony between the two reports for an accurate reading. Bringing out the true picture of the operating cash flows by classifying cash paid for operating assets is a very authentic way of bringing out the true picture of the operating cash flows for the business. Also, interest truly depicts the return to investments. As such, whether it is paid or received, it should be categorized under-investing section of the cash flow and not the operating section.
A requirement that all businesses show a sub-total for the operating income would indeed go a long way in enhancing the use of the income statement especially by financiers. There would be no requirement for any further assessments in terms of the viability of a firm for short-term financing.
All the proposals above are well thought out and highly likely focused on strengthening the preparation of income statements and cash flows. The FASB should indeed consider and further examine the applicability of the proposals to introduce them as rules to guide accounting. Indeed if adopted they would very significantly strengthen the reporting standards.
Bruce, W., Harold, C., Carl, S., & Timothy V., 2009. Making Stronger Statements: Cash Flow And Income.