Various observations on limitations of the cash flow statement

A former IASB board member, Steven Cooper, is among those behind the recently established blog The Footnotes Analyst. A recent entry focused on the significance of investing and financing transactions not involving the movement of cash, and therefore excluded from the cash flow statement: the new leasing standard, IFRS 16, may increase the incidence of these for many entities. As the blog explains:

• When a company enters into a new lease there is generally no initial cash flow and hence nothing appears in the cash flow statement. Of course, there are the subsequent lease payments which, for a capitalized lease, would be split between the interest and principal repayment components. Under IFRS the interest flow is included in operating or financing according to the accounting policy selected by the company and the capital element in financing. The problem is that we do not consider this to be enough to easily obtain relevant cash flow subtotals.
• When a new lease is capitalized, a company reports an increase in fixed assets (specifically a right of use asset) and an increase in lease obligations. The two offset and there is no cash movement. However, suppose that the company had purchased the asset with the transaction financed by debt. In that case there would have been an investing outflow for capital expenditure and a financing inflow representing the increase in borrowings. Free cash flow would therefore be reduced by the additional capital expenditure. But purchasing an asset financed by debt is economically the same (or at least very close to being the same) as a new capitalized lease and it would seem odd to report a different free cash flow metric.

As the article notes, IAS 7 requires that such non-cash transactions be disclosed “elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.” But this isn’t sufficiently specific to provide consistency in the location, format and detail of what’s disclosed. More recently, an additional requirement has been provided, to provide a more informative breakdown of financing-related liabilities: this might help with some of the issues the authors have in mind, but not all of them (for example, it wouldn’t capture a non-cash transaction in which an entity disposed of an asset and accepted another as consideration).

Coincidentally, a current IASB member, Nick Anderson, has also been musing about the importance of cash flows, in a slightly different context. He notes that “the extent of reinvestment opportunities and cash flow generation will be important considerations in determining the most appropriate dividend policy for a company” – for example, “a mature business generating steady returns with few opportunities for growth” may be expected to pay out a high proportion of profits in dividends, relative to a growing business with ample reinvestment opportunities. However, compliance with national legislation or regulation also plays a key part in determining the level of dividend payments. This leads to the following conclusion:

• Directors are required to comply with their legal obligations. The responsibility to determine whether dividend payments are appropriate is beyond the remit of the IASB. However, there is no impediment to complementing high quality financial statements prepared in accordance with IFRS Standards by providing additional disclosures about dividend policies and dividend payments, including any disclosures needed to meet jurisdiction requirements.

The observation seems obvious, and yet one might reflect on how seldom financial statements go clearly beyond what IFRS requires. Of course, in a jurisdiction like Canada, such additional information may often be provided in the MD&A, or somewhere else altogether, but that takes us to the perpetual issue that the regulatory insistence on preparing and filing separate linear documents, with little or no active linking between the two, hardly assists a reader in finding all the relevant disclosure on a given topic.

Anyway, it seems there’s never a shortage of ideas on how the cash flow statement might be enhanced (I covered some others here for instance). In the past, I cited yet another IASB member’s comments, made as part of a dissent at the time those IAS 7 amendments were proposed:

• … the cash flow statement’s usefulness “is significantly impaired when it is presented as part of consolidated financial statements…because consolidated financial statements do not provide information about the location and the availability of assets and liabilities. For example, if a parent company has debt of CU100 and a 51 per cent controlled subsidiary has cash of CU100, it could be interpreted in the consolidated statement of financial position that the group has sufficient cash and cash equivalent balances to meet the debt. However, this may not be true.”

Of course, this is just one example of the inherent limitations of a summarized presentation. Again, the “other disclosures” section of IAS 7 makes the broad point that additional information may be relevant to users, and provides some examples. But to some extent this additional information is only “encouraged” by IAS 7, and again the standard doesn’t address the appropriate format, location in the statements, or degree of detail. Perhaps IAS 7 will be overhauled one day to address all these problems (and, who knows, to require the use of the direct method?) Until then, as the man said, there is no impediment to complementing IFRS standards by providing additional disclosures about, well, almost anything…

The opinions expressed are solely those of the author