Profits are good; cash flow critical<\/p>\n
By Djohan Pinnarwan<\/p>\n
JAKARTA (JP): \"Don't take cash flow for granted\" was certainly
\na lesson learned from the bankruptcy case of the W.T. Grant
\nCompany. The company showed a pattern of consistent profitability
\nand even some periods of income growth.<\/p>\n
Between the first and fourth year, the net income for this
\ncompany grew by 32 percent, from US$31 million to $41 million.<\/p>\n
Eighteen months later, this company filed for bankruptcy, in
\nwhat was then the largest bankruptcy filing in the United States.<\/p>\n
Closer examination of the company's financial statements
\nrevealed that the company had experienced several years of
\nnegative cash flow from its operations, even though it reported
\nprofits.<\/p>\n
This could happen partly because its sales reported on the
\nincome statement were made on credit and the company was having
\ntrouble collecting the receivables from the sales, causing cash
\nflow to be less than the net income.<\/p>\n
An analysis of the cash flow would have provided an early
\nwarning signal to W.T. Grant's operating problems.<\/p>\n
There is no doubt about the importance of cash flow
\ninformation. Although net income provides a long-term measure of
\na company's success or failure, cash is the lifeblood of a
\ncompany. Without cash, a company will not survive.<\/p>\n
In a recent survey of over 60,000 companies which failed, over
\n60 percent blamed their failure on factors linked to cash flow.
\nTherefore, to provide information that helps present and
\npotential investors, creditors and other users in assessing the
\namount, timing, and uncertainty of future cash flow, is regarded
\nas one of the objectives of financial reporting.<\/p>\n
The balance sheet, the income statement and the statement of
\nchanges in equity each present, to a limited extent, and in a
\nfragmented manner, information about the cash flow of an
\nenterprise during a period.<\/p>\n
For instance, comparative balance sheets might show what new
\nassets have been acquired or disposed of and what liabilities
\nhave been incurred or liquidated.<\/p>\n
The income statement provides information about resources, but
\nnot exactly the cash, provided by operations. The statement of
\nchanges in equity shows the amount of cash used to pay dividends
\nor purchase treasury stock.<\/p>\n
But none of these statements presents a detailed summary of
\nall the cash inflows and outflows, or the sources and uses of
\ncash during the period. To fill this need, the statement of cash
\nflows are required to be presented for financial reporting as
\npart of the basic financial statements.<\/p>\n
The primary purpose of a statement of cash flow is to provide
\nrelevant information about the cash receipts and cash payments of
\nan enterprise during a period. To achieve this purpose, the
\nstatement of cash flow reports (1) the cash effects of operations
\nduring a period, (2) investing transactions, (3) financing
\ntransactions and (4) the net increase or decrease in cash during
\nthe period. Cash flows from operating activities may be reported
\nby either the direct or indirect method.<\/p>\n
The direct method shows as its principal components operating
\ncash receipts and payments, such as cash received from customers
\nand cash paid to suppliers and employees, the sum of which is the
\nnet cash flow from operating activities.<\/p>\n
The indirect method starts with the net income and adjusts it
\nfor revenue and expense items that were not the result of
\noperating cash transactions in the current period to reconcile it
\nwith the net cash flow from operating activities.<\/p>\n
The indirect method thus does not disclose operating cash
\nreceipts and payments. Like most accounting standards in
\ndeveloped countries, the Indonesian accounting standard (PSAK)
\npermits either method for reporting net cash flows from operating
\nactivities although it encourages to use the direct method.<\/p>\n
But for the financial year beginning Jan. 1, 2000, listed
\ncompanies are no longer permitted to present their cash flow
\nstatement using the indirect method.<\/p>\n
The Capital Market Supervisory Agency (Bapepam) as stipulated
\nin its decree No. 06\/PM\/2000 dated March 13, 2000, requires all
\nlisted companies to prepare cash flows using the direct method.
\nThe issue is whether the requirement to prepare cash flow
\nstatements using the direct method really is the best solution
\nconsidering the current situation.<\/p>\n
The principal advantage of the direct method is that it shows
\noperating cash receipts and payments. That is, it is more
\nconsistent with the objective of a statement of cash flow -- to
\nprovide information about cash receipts and cash payments -- than
\nthe indirect method, which does not report operating cash
\nreceipts and payments.<\/p>\n
Knowledge of the specific sources of operating cash receipts
\nand the purposes for which operating cash payments were made in
\npast periods may be useful in estimating future operating cash
\nflows.<\/p>\n
Furthermore, information about amounts of major classes of
\nrevenues and expenses and their relationships to other items on
\nthe financial statements are presumed to be more useful than
\ninformation only about their arithmetic sum -- net cash flow from
\noperating activities -- in assessing enterprise performance.<\/p>\n
Such information is more revealing of an enterprise's ability
\nto generate sufficient cash from operating activities to pay its
\ndebt, to reinvest in its operations and make distributions to its
\nowners.<\/p>\n
The principal advantage of the indirect method is that it
\nfocuses on the differences between net income and net cash flow
\nfrom operating activities. That is, it provides a useful link
\nbetween the statement of cash flow and the income statement and
\nbalance sheet.<\/p>\n
Too often, users assume that information is a cost-free
\ncommodity. But providers of accounting information know that it
\nis not, particularly in the case of providing cash flow from
\noperating activities using the direct method as required by
\nBapepam.<\/p>\n
Therefore, the cost-benefit relationship must be considered:
\nthe costs of providing the information must be weighed against
\nthe benefits that can be derived from using the information.<\/p>\n
To justify requiring a direct method presentation of cash flow
\nfrom operating activities, the benefits perceived to be derived
\nfrom it must exceed the perceived and actual costs associated
\nwith it.<\/p>\n
Most corporate providers of financial statements do not
\npresently collect information in a manner that will allow them to
\ndetermine amounts such as cash received from customers or cash
\npaid to suppliers directly from their accounting systems.<\/p>\n
It would be costly for their companies to report gross
\noperating cash receipts and payments and it is less costly to
\nadjust net income to net cash flow from operating (indirect) than
\nit is to report gross operating cash receipts and payments
\n(direct).<\/p>\n
It would cost more to audit direct cash flow statements,
\nespecially where enterprises do not have the accounting systems
\nthat allow them to prepare cash flow statements using the direct
\nmethod.<\/p>\n
Moreover, the direct method, which effectively reports income
\nstatement information on a cash rather than accrual basis, may
\nerroneously suggest that a net cash flow from operating
\nactivities is as good as, or better than, net income as a measure
\nof performance.<\/p>\n
As benefits in general are not always evident or measurable,
\nbenefits of presenting cash flows using the direct method are
\nmore difficult to quantify than the costs.<\/p>\n
Supporters of the direct method, most of whom are commercial
\nlenders, generally contend that the amounts of operating cash
\nreceipts and payments are particularly important in assessing an
\nenterprise's external borrowing needs and its ability to repay
\nloans.<\/p>\n
They indicated that creditors are more exposed to fluctuations
\nin net cash flow from operating activities than to fluctuations
\nin net income and that information on the amounts of operating
\ncash receipts and payments is important in assessing those
\nfluctuations in net cash flow operating activities.<\/p>\n
But the constituents of financial reporting systems are not
\nonly the creditors. The providers of financial statements are
\nalso the constituents of financial reporting systems. There is
\nalways a conflicting interest of both the providers and users of
\nthe financial statements.<\/p>\n
The issue is whether Bapepam has carefully weighed the
\nexcessive implementation cost of providing direct cash flow
\ninformation with the perceived benefits that can be derived from
\nusing such information.<\/p>\n
Had the perceived benefits from using the direct cash flow
\ninformation exceeded its excessive implementation cost, the U.S.
\nFinancial Accounting Standard Board would not have \"recognized
\nthe advantages of both approaches and concluded that neither
\nmethod provided benefits sufficient to justify requiring one and
\nprohibiting the other\".<\/p>\n
Although it is recommended to use the direct method of
\nreporting cash flows from operating activities, the Securities
\nand Exchange Commission, the \"watchdog\" of U.S. capital markets
\nwhich is known as the model of transparency and integrity because
\nof its rigid and detailed reporting requirements, also permits
\nlisted enterprises to use either method.<\/p>\n
Had the perceived benefits from using the direct cash flow
\ninformation exceeded its excessive implementation cost, most U.S.
\ncompanies would have reported cash flows from operating
\nactivities using the direct method.<\/p>\n
But the fact revealed the opposite. From an annual survey by
\nthe American Institute of Certified Public Accountants presented
\nin Accounting Trends and Techniques-1998, only 10 companies out
\nof 600 surveyed used the direct method. This trend has been
\nrelatively consistent during the last five years.<\/p>\n
The writer is a professional staff member of the public
\naccountant firm Drs. Hadi Sutanto & Partner
\n(PricewaterhouseCoopers) and also serves as the secretary to the
\nBoard of Public Accountants' Professional Standards from the
\nIndonesian Institute of Accountants -- Compartment of Public
\nAccountants. The above views are personal.<\/p>",
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