Profits are good; cash flow critical

By Djohan Pinnarwan

JAKARTA (JP): "Don't take cash flow for granted" was certainly a lesson learned from the bankruptcy case of the W.T. Grant Company. The company showed a pattern of consistent profitability and even some periods of income growth.

Between the first and fourth year, the net income for this company grew by 32 percent, from US$31 million to $41 million.

Eighteen months later, this company filed for bankruptcy, in what was then the largest bankruptcy filing in the United States.

Closer examination of the company's financial statements revealed that the company had experienced several years of negative cash flow from its operations, even though it reported profits.

This could happen partly because its sales reported on the income statement were made on credit and the company was having trouble collecting the receivables from the sales, causing cash flow to be less than the net income.

An analysis of the cash flow would have provided an early warning signal to W.T. Grant's operating problems.

There is no doubt about the importance of cash flow information. Although net income provides a long-term measure of a company's success or failure, cash is the lifeblood of a company. Without cash, a company will not survive.

In a recent survey of over 60,000 companies which failed, over 60 percent blamed their failure on factors linked to cash flow. Therefore, to provide information that helps present and potential investors, creditors and other users in assessing the amount, timing, and uncertainty of future cash flow, is regarded as one of the objectives of financial reporting.

The balance sheet, the income statement and the statement of changes in equity each present, to a limited extent, and in a fragmented manner, information about the cash flow of an enterprise during a period.

For instance, comparative balance sheets might show what new assets have been acquired or disposed of and what liabilities have been incurred or liquidated.

The income statement provides information about resources, but not exactly the cash, provided by operations. The statement of changes in equity shows the amount of cash used to pay dividends or purchase treasury stock.

But none of these statements presents a detailed summary of all the cash inflows and outflows, or the sources and uses of cash during the period. To fill this need, the statement of cash flows are required to be presented for financial reporting as part of the basic financial statements.

The primary purpose of a statement of cash flow is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the statement of cash flow reports (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions and (4) the net increase or decrease in cash during the period. Cash flows from operating activities may be reported by either the direct or indirect method.

The direct method shows as its principal components operating cash receipts and payments, such as cash received from customers and cash paid to suppliers and employees, the sum of which is the net cash flow from operating activities.

The indirect method starts with the net income and adjusts it for revenue and expense items that were not the result of operating cash transactions in the current period to reconcile it with the net cash flow from operating activities.

The indirect method thus does not disclose operating cash receipts and payments. Like most accounting standards in developed countries, the Indonesian accounting standard (PSAK) permits either method for reporting net cash flows from operating activities although it encourages to use the direct method.

But for the financial year beginning Jan. 1, 2000, listed companies are no longer permitted to present their cash flow statement using the indirect method.

The Capital Market Supervisory Agency (Bapepam) as stipulated in its decree No. 06/PM/2000 dated March 13, 2000, requires all listed companies to prepare cash flows using the direct method. The issue is whether the requirement to prepare cash flow statements using the direct method really is the best solution considering the current situation.

The principal advantage of the direct method is that it shows operating cash receipts and payments. That is, it is more consistent with the objective of a statement of cash flow -- to provide information about cash receipts and cash payments -- than the indirect method, which does not report operating cash receipts and payments.

Knowledge of the specific sources of operating cash receipts and the purposes for which operating cash payments were made in past periods may be useful in estimating future operating cash flows.

Furthermore, information about amounts of major classes of revenues and expenses and their relationships to other items on the financial statements are presumed to be more useful than information only about their arithmetic sum -- net cash flow from operating activities -- in assessing enterprise performance.

Such information is more revealing of an enterprise's ability to generate sufficient cash from operating activities to pay its debt, to reinvest in its operations and make distributions to its owners.

The principal advantage of the indirect method is that it focuses on the differences between net income and net cash flow from operating activities. That is, it provides a useful link between the statement of cash flow and the income statement and balance sheet.

Too often, users assume that information is a cost-free commodity. But providers of accounting information know that it is not, particularly in the case of providing cash flow from operating activities using the direct method as required by Bapepam.

Therefore, the cost-benefit relationship must be considered: the costs of providing the information must be weighed against the benefits that can be derived from using the information.

To justify requiring a direct method presentation of cash flow from operating activities, the benefits perceived to be derived from it must exceed the perceived and actual costs associated with it.

Most corporate providers of financial statements do not presently collect information in a manner that will allow them to determine amounts such as cash received from customers or cash paid to suppliers directly from their accounting systems.

It would be costly for their companies to report gross operating cash receipts and payments and it is less costly to adjust net income to net cash flow from operating (indirect) than it is to report gross operating cash receipts and payments (direct).

It would cost more to audit direct cash flow statements, especially where enterprises do not have the accounting systems that allow them to prepare cash flow statements using the direct method.

Moreover, the direct method, which effectively reports income statement information on a cash rather than accrual basis, may erroneously suggest that a net cash flow from operating activities is as good as, or better than, net income as a measure of performance.

As benefits in general are not always evident or measurable, benefits of presenting cash flows using the direct method are more difficult to quantify than the costs.

Supporters of the direct method, most of whom are commercial lenders, generally contend that the amounts of operating cash receipts and payments are particularly important in assessing an enterprise's external borrowing needs and its ability to repay loans.

They indicated that creditors are more exposed to fluctuations in net cash flow from operating activities than to fluctuations in net income and that information on the amounts of operating cash receipts and payments is important in assessing those fluctuations in net cash flow operating activities.

But the constituents of financial reporting systems are not only the creditors. The providers of financial statements are also the constituents of financial reporting systems. There is always a conflicting interest of both the providers and users of the financial statements.

The issue is whether Bapepam has carefully weighed the excessive implementation cost of providing direct cash flow information with the perceived benefits that can be derived from using such information.

Had the perceived benefits from using the direct cash flow information exceeded its excessive implementation cost, the U.S. Financial Accounting Standard Board would not have "recognized the advantages of both approaches and concluded that neither method provided benefits sufficient to justify requiring one and prohibiting the other".

Although it is recommended to use the direct method of reporting cash flows from operating activities, the Securities and Exchange Commission, the "watchdog" of U.S. capital markets which is known as the model of transparency and integrity because of its rigid and detailed reporting requirements, also permits listed enterprises to use either method.

Had the perceived benefits from using the direct cash flow information exceeded its excessive implementation cost, most U.S. companies would have reported cash flows from operating activities using the direct method.

But the fact revealed the opposite. From an annual survey by the American Institute of Certified Public Accountants presented in Accounting Trends and Techniques-1998, only 10 companies out of 600 surveyed used the direct method. This trend has been relatively consistent during the last five years.

The writer is a professional staff member of the public accountant firm Drs. Hadi Sutanto & Partner (PricewaterhouseCoopers) and also serves as the secretary to the Board of Public Accountants' Professional Standards from the Indonesian Institute of Accountants -- Compartment of Public Accountants. The above views are personal.