Financial Reporting

The Cash-Flow Clash

After years of neglect, cash-flow statements get FASB’s attention.
David KatzSeptember 7, 2016

Pity the poor cash-flow statement. The youngest of the three major corporate financial reports, it’s gotten hardly any of the attention paid by the Financial Accounting Standards Board to income statements and balance sheets.

As a result, CFOs are at sea about whether to classify many kinds of cash inflows and outflows in the operating, investing, or financing sections of the cash-flow statement. Investors, on the other hand, are confused about how to compare different companies in terms of how they use their cash.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Since launching the cash-flow statement in 1987 under Statement No. 95 (now dubbed Topic 230), which outlined the three sections and provided general rules and definitions for the statement, FASB has provided little in the way of specific instructions on how the statement should be comprised.

Thus, finance chiefs have have had to rely on their judgments to decide where on their companies’ cash-flow statement to put the cash receipts and expenses already recorded on their income statements. What’s been happening, for example, is that one entity might classify a cash payment in the operating activities section, while another company might classify the same item as a financing activity.

On August 26, however, FASB took steps to allay the situation by issuing an Accounting Standards Update of Topic 230 that addresses “eight specific cash flow issues with the objective of reducing the existing diversity in practice.”  

The cash-flow-statement issues clarified by the board include where to record cash flow involved in prepaying or extinguishing debt; settling zero-coupon bonds and similar debt instruments in certain situations; contingent consideration payments (such as earnouts”) made after a merger; and proceeds from insurance claims settlements.  

The other four pronouncements cover how to record cash flowing from corporate-owned life insurance (COLI) policy settlements, distributions of returns on investments in other companies, returns from securitizations, and how to classify payments that have more than one type of cash-flow characteristic (for example, when parts of the payment are cash for investing and other parts are cash for financing activities.)

The update will be effective for public companies for fiscal years starting after December 15, 2017, and for interim periods within those years. For all other companies, it’s effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, 2019.

The amendments in the update “are an improvement to GAAP because they provide guidance for each of the eight issues, thereby reducing the current and potential future diversity in practice,” FASB contends.

Cash-flow Conundrums

But what about cash-flow reporting conundrums that go beyond those eight very specific areas? While standardizing accounting practice in this case seems to have no downside for companies and investors, is a detail-by-detail, incremental approach the best way to achieve efficient and transparent financial reporting?

Baruch Lev

Baruch Lev, NYU

Not everyone thinks so. “The upside of such FASB clarifications is a certain increase in reporting uniformity,” according to Baruch Lev, an accounting and finance professor at the NYU Stern School of Business. “The downside: There is no end of regulating any transaction and variant of transaction.”

The co-author of a new book called The End of Accounting (Wiley), which argues that Generally Accepted Accounting Principles are overly complex and fail to reflect the true strategic and intangible values of today’s corporations, Lev wrote in an email to CFO that the FASB update “is not a game changer,” despite its 49 pages.

“It’s a response to very detailed questions of companies about the classification of certain cash flows in the cash flow statement. The transactions are very specific and infrequent,” he added. In Lev’s view, FASB’s attempt to improve cash-flow accounting by adding rules rather than creating a system that rests on broad general principles “increases GAAP complexity.”

Although Charles Mulford’s 2005 book Creative Cash Flow Reporting (Wiley) was brought out by the same publisher as Lev’s volume, the professors’ responses to the FASB cash-flow ruling are diametrically opposed. “Clearly, this goes against a principles-based approach,” Mulford says. “There are times when we need rules, we need specific guidance.”

Charles Mulford, Georgia Tech

Charles Mulford, Georgia Tech Financial statement

In fact, Mulford, an accounting professor at Georgia Tech, declared in a recent interview with CFO that “you cannot use a principles-based approach to the statement of cash flow.” As proof of that, he noted that while Topic 230 has long provided general guidance on how to classify cash flows, companies still aren’t following it in uniform ways.  

In contrast to Lev’s contention that the eight issues crop up infrequently, Mulford’s view is that they are “good examples of the many items that are getting inconsistent treatment on the cashflow statement … that are misclassified all of the time.”

Zero-coupon bonds are a case in point. To be sure, Topic 230 “is very clear” that payment of the principle on a loan should be classified as financing cash flow and that interest payments should be classified as operating cash flow, he notes.  

Although the payment of the coupon, or interest, on a zero-coupon bond is by definition zero, it’s commonly known that issuers are paying a form of interest because they ultimately pay investors the full face value of the bond even though their initial payment was less than that face value, according to Mulford. For instance, an investor might invest only $70 at the outset for a $100 zero-coupon bond, but receive the full $100 when the bond matures.  

The $30 a corporate bond issuer might ultimately pay is effectively an interest payment, and thus should be classified under operating cash-flow, he says.

But companies were universally reporting the entire amount as financing, rather than, as in the example, the $70 as financing and the $30 as operating, according to the professor, who regularly studies the cash-flow reporting of a wide swath of public companies.  “I couldn’t find any companies that didn’t do it that way. And that’s incorrect.”

In the update, FASB clarifies that the “interest” paid on a zero-coupon bond should be classified by the issuer as an operating cash outflow. “It seemed like companies would know to put the interest part as operating, but they weren’t. They put the whole thing as financing. So [the issue] was begging for clarification by FASB,” Mulford says.

Overall, although the update represents “a small start,” it’s a move “in the right direction” for FASB to pay more attention to the cash-flow statement because analysts have been paying a good deal more attention to it in recent years, says Mulford. More specifically, “the focus for analysts has been on operating cash flow and its very close cousin, free cash flow. They’re interested in what cash flows are ongoing, recurring, and sustainable,” he says. “Cash flows are the lifeblood of the company.”

Mulford thinks the update will help CFOs, too. “They are the ones who are classifying cash flows, facing them all the time. They need to decide how to classify that cash, he said, noting that the FASB provisions refer to “common events, everyday transactions that need to be reported. This gives them advice on how to do that. It makes their lives easier.”