The Statement of Cash Flows – What a Long Strange Trip It’s Been

Grab a cup of copy – this should be fun !

HISTORY

Fifty-years ago the Statement of Cash Flows was called the Statement of Changes in Financial Position, or “funds statement”. The Accounting Principles Board, in 1971, made the funds statement a requirement in financial statements issued to shareholders and subject to annual audits. This requirement was made official in Opinion 19, issued by the APB, however the opinion did not specify a format for the funds statement.

The funds statement, at the core, was much like today’s cash flow statement, in that activity is comprised of three sections ie, operations, investing and financing. However, the definition of “funds” varied, and the actual format of the funds statement was inconsistent throughout the accounting industry.

Users of financial statements tended to rely on EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) as a measure of cash flow. The Financial Executives Institute (FEI), in the early 80’s, promoted a policy of cash emphasis for the funds statement. As a result of this movement towards a Cash Flow Statement, by the mid 1980’s, 70% of Fortune 500 companies were using a “cash” approach on their funds statements.

In 1987 the Financial Accounting Standards Board (FASB) eliminated the various definitions of funds, such as working capital and provided formatting for the new Cash Flow Statement. FASB Statement No. 95 superseded APB Opinion No. 19 and marked a new era with the renaming of the old funds statement. In the future, the Statement of Cash Flows will reconcile beginning and ending cash and cash equivalent balances. But the story ends not there, or not yet to be precise.

Statement No. 95 offers credence to the notion that accounting is an art and not a science, even though the “books balance”. For instance, the FASB members wrestled with classifying cash flows between the surviving three major sections of the original funds statement. Classification of Interest Expense, Dividends Paid, Interest Income and Dividend Income were rather intensely debated prior to the issuance of FASB 95. The result was interest income, interest expense and dividends received would be reported in the operating activities section. Dividend payments are included in the financing activities section.

One significant issue remains to this day. Prior to FASB 95, the direct method of reporting was widely used, which led to the disparity in reporting formats. The direct method summarizes financial data by type of disbursement or receipt – a “to-whom/from-whom” scenario.  “Receipts received from Customers”, “Payments paid to Suppliers”, “Payments paid to Employees”, “Interest Payments”, “Income Tax Payments” are all lines you might see on a direct method Cash Flow Statement. In contrast the indirect method summarizes data using traditional accounting balances.

Support for the direct method came from the Financial Sector ie, Wall Street, Banks, Investors, Lenders etc. as these groups found the direct method more informative for their purposes. Support for the indirect method came from the Accounting industry arguing the direct method imposes additional costs, especially for large firms with a wide range of clients. Both methods survive to this day. As a practical matter, the indirect method is the default format for today’s cash flow statement.

REQUIREMENTS

FASB 95 states, subject to exceptions below, a Statement of Cash Flows is required whenever a set of financial statements includes an Income Statement and a Balance Sheet. Furthermore, the cash flow statement must include the same financial statement reporting periods.

EXCEPTIONS

• Compiled financial statements, if the absence of the cash flow statement is disclosed in the compilation report.
• Income Tax-basis financial statements, with compilation/review/audit report disclosure.

DEFINITION OF CASH

FASB 95 calls for the reconciliation of beginning and ending balances for Cash and Cash Equivalents. Cash equivalents are defined by FASB as highly liquid investments meeting maturity, risk and convertibility criteria. In my experience the type of accounts included in Cash Equivalents include money markets, CD’s, brokerage cash balances, savings accounts and conversely, overdraft protection balances.

Entities with restricted cash and equivalents, such as non-profit organizations, are subject to additional reporting requirements. Specifically, FASB 95 prescribes 2-options for disclosing restricted cash and equivalents.

OF NOTE

The restricted cash and equivalents rules became effective for years beginning on or after December 15, 2017 for public entities and other entities are phased in over 2018 and 2019.

FASB has proposed eliminating equivalents and adopting a pure Statement of Cash Flows.

NET VS GROSS CASH FLOWS

In Statement of Financial Accounting Standards (SFAS) No. 95, FASB states “Generally, information about the gross amounts of cash receipts and cash payments during a period is more relevant than information about the net amounts of cash receipts and payments”.  There are obvious and some subtle exceptions to this gross reporting recommendation. Entities who regularly acquire, inventory and subsequently sell real estate would report in the operating activities section of the cash flows statement. Other entanglements in the gross vs net decision include questions surrounding the reporting of refi’s and loan/lease conversions, for example.

PIONEERS

The Romans in 70 AD first described a double entry system, from Plinius the Elder; “On one page all the disbursements are entered, on the other page all the receipts; both pages constitute a whole for each operation of every man”. The first record of the Messari system we still use today is from 1340 Genoa, Italy.

The Statement of Cash Flows has a short history compared to the almost 700-years of debiting and crediting. So, fundamentally what is a cash flow statement? How does one go about constructing a cash flow statement? Since cash flows are not inherently unmasked by the traditional accounting structure, a logical starting point is the difference between the opening entries and adjusted ending trial balances for a given period.

In the early 1980’s I was given the task of programming a computer to produce Statement of Changes in Financial Position. The computer was a Litton 1251 with punch-paper tape storage and a typewriter style terminal. In other words, the printer was also the input device, or the equivalent of a CRT/LCD screen today. The program would stop on certain lines while printing the report for operator input. It was impossible fully automate a cash flow statement back then. The 128-bytes of memory and 128-program registers which could each contain four lines of assembler code were not up to the task.

Litton ABS 1251 (1970’s)

Computing has evolved exponentially since then, but the classic Italian bookkeeping system perseveres. Accounting, as we know it, escaped the computer revolution unscathed and computers produce the same information accountants produced by hand 700-years ago.

TRADITIONAL CASH FLOW AUTOMATION

All the software platforms that produce a cash flow statement that I have seen, do so with journal entries. This seems slightly counter-intuitive initially. Why would I want to make a journal entry? Or worse yet, change my books just for a cash flow statement. However, cash flow journal entries only affect the cash flow statement. In my opinion this approach results in a mostly manual system. It leaves the entire process of producing, correcting, balancing and reconciling up to the preparer, via journal entries. The workflow is generally:

1. Make a journal entry
2. Review the report
3. Use your calculator or Excel sheet
4. Return to Step 1

You might wonder how this absurd methodology was developed. I mentioned earlier that accounting was an art. Accounting is also a science with a universe of strict rules and is inherently fail-safe from a debits and credits perspective. From a programmer’s perspective, accounting systems are easy to design and implement. Standards have been developed over the years and if a programmer wants to integrate accounting into his favorite software application, it can be as easy as adding a template database to an existing application. Debits/Credits = On/Off and they must balance – simple as that…unless you want to do cash flows!

Programmers took the fail-safe tools at-hand, primarily the digital journal entry, and adapted it to direct certain flagged entries toward the cash flow statement only. A simple solution and cash flows have been programmed using this technique ever since.

BalanceWare’s Cash Flow Dashboard is designed to guide the preparer through the process of developing a cash flow statement. The first time you open the dashboard, cash flow lines and account assignments are established. Thereafter, in following years, the Statement of Cash Flows will be automatic, apart from adjustments which we will speak of shortly.

The cash flows dashboard displaying the Cash and Equivalents Tab.

The last of 5-tabs is the Diagnostic tab which will expose many common reconciling discrepancies. As a matter of fact, the diagnostics tab will isolate all reconciling discrepancies, except adjustments.

Cash and cash equivalent accounts are selected from the Chart of Accounts on the Cash and Cash Equivalents Tab.

The cashflow lines are maintained and account assignments for those lines are made on the Operating Activities Tab and likewise on the remaining two tabs, Investing and Financing Activities Tabs.

The dashboard calculates the differences between the Opening Entries and the Ending Adjusted Balances for the accounts assigned to each cash flow line. Simple as that. (Income Statement accounts, of course, always have an Opening Entry of -0-.) The opening entries for balance sheet accounts are obtained from the History table.

On all the tabs, the cash flow line balances are displayed for easy reference while the dashboard provides real-time reconciliation status and totals in the upper right-hand corner.

BalanceWare’s Statement of Cash Flows Dashboard

Every line on the cash flow statement can be adjusted from the dashboard. It is this adjustment field that provides the ability to divide the current year activity for balance sheet accounts into multiple lines on the cash flow statement. For example, a fixed asset account might have both newly purchased and retired assets, perhaps sold at a gain or loss, triggering the need for multiple cash flow line adjustments.

BalanceWare produces both Current Year and 2-Year Comparative cash flow statements. I have found that the Statement of Cash Flows enhances an engagement, and although you may not be using the direct method, lending institutions seem to respect the effort.

I am always interested in hearing your thoughts, questions and ideas. Contact support@balware.com – I look forward to a virtual meet-and-greet! Stay safe!

Jeff