Profits are good; cash flow critical

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.