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The statement of cash flows currently contains numerous distortions resulting from a view that the presentation of cash flows is merely a technical exercise, rather than applying an economic principle. This leads to the ability to easily structure the same transactions in a different legal form and arrive at a completely different reporting result in the statement of cash flows. This can have problematic implications for each of the three categories of the statement, including potential inflation of operating cash flows. In our view, an economic principle of presenting cash flows should be applied that ignores cash flow “shortcuts”, thereby providing more relevant information to investors. According to this principle, cash flows would be presented on a gross basis when the underlying transaction is a cash payment (or receipt) at the instruction, or on behalf, of the reporting entity to (or from) third parties, such as financial institutions with which the reporting entity conducts business. Additionally, the initial classification of cash flows should be “retained” according to the underlying transaction, even when the cash actually flows at a later date, such as the repayment of credit for the purchase of fixed assets that was originally provided by the supplier (“vendor financing”).
Although the statement of cash flows is a relatively “new” statement within the complete set of financial statements and became a mandatory requirement only in the 1990s, it holds significant importance today for investors in analysing the financial statements of non-financial companies. The distinction between the three categories of the statement of cash flows, operating, investing and financing activities, is highly significant. While the operating activities relate to a company’s ability to generate cash flows from the principal revenue-producing activities and is used to assess the quality of earnings in the statement of profit or loss, the investing activities reflect the extent of investments during the period and the financing activities represent the company’s ability to raise finance and meet its financial debt obligations. It should be noted that the revised Conceptual Framework issued in 2018 added presenting cash flows as a primary objective of financial statements, alongside presenting information on an accrual basis.
While the traditional accounting approach viewed the statement of cash flows as supplementary to the other financial statements prepared on an accrual basis (for example, to assess the quality of accounting earnings over time) rather than as a standalone statement, this is not necessarily the current view in practice. There are even investors and other users who tend to overvalue the statement of cash flows and view it as the only relevant statement, arguing that it is the only statement that, supposedly, reflects facts. This is obviously fundamentally flawed thinking, as the statement of cash flows is affected by the guidance of other IFRS accounting standards dealing with the accrual basis. The guiding principle in this context is that cash outflows should not be classified as investing activities unless they are recognised as assets in the statement of financial position. This can be clearly demonstrated by the change in the accounting treatment of operating leases by a lessee as purchase of an asset on credit in accordance with IFRS 16. While lease payments were previously classified in their entirety as operating activities, following the significant accounting change, the principal portion of the repayments are now classified as financing activities and the interest portion of the repayments are classified according to the lessee’s accounting policy (operating or financing) and followingIFRS 18only as financing activities.
An example of an accounting distortion in IFRS accounting standards that finds its way to the statement of cash flows is the accounting for transaction costs when acquiring an associate vs. acquiring a subsidiary in a business combination. Transaction costs for acquiring an associate are capitalised as part of the cost of the investment. Therefore, the related cash flows are classified as investing activities. However, transaction costs for acquiring a subsidiary are recognised as an operating expense and therefore the related cash flows are classified as an operating activity.
Significant judgments of management when applying IFRS accounting standards also impact the statement of cash flows. For example, classification in the statement of financial position of purchased land as inventory or as investment property will affect the cash flow classification (operating or investing activities, respectively). In addition, determining the commencement date for capitalising costs for an R&D project will determine the classification of the related cash flows as investing instead of operating activities.
In any case, the statement of cash flows currently bears significant weight in the view of investors and other stakeholders, much more than previously perceived. Therefore, more thought should be devoted to the accounting principles of its presentation as a standalone statement, which have received very little attention to date. All of this has led the IASB in the last two years to initiate a project on the statement of cash flows.A previous article addressed the need to improve the relevance of classification into the different categories and their presentation following IFRS 18. In this article we wish to address the importance of transitioning to an economic principle of cash flows, as opposed to the existing view of the presentation of cash flows as merely a technical exercise, resulting in countless distortions and potential manipulations.
Effects on Operating Activities Resulting from Technical Application of the Principles
An entity can take simple and legitimate actions to shift cash flows from period to period and significantly change the amounts included in the statement of cash flows, such as increasing or decreasing customer or supplier credit days near the reporting date. Beyond shifting cash flows from period to period, it is also easy to change the classification of cash flows between the three categories. An example of this is reverse factoring (supplier finance) arrangements, where an entity “transfers” to a bank its debt to a certain supplier, with an extension of the credit period. Assuming the conditions and indicators for continuing to classify liabilities as operating are not met, a significant transfer occurs in the statement of financial position from accounts payable (a classic operating liability) to bank liabilities reflecting financial debt, without any cash flow impact. According to the practice currently followed in the statement of cash flows, which was endorsed in the IFRIC decision on supply chain financing arrangements from 2020, payment of the debt will ultimately be classified in financing activities. As a result, this simple transaction creates a double distortion. First, operating activities will never include payment to the supplier and thus will be presented in a misleading higher than actual amount. Additionally, from a multi-year perspective, financing activities will include a cash outflow for loan repayment without recording the cash inflow for receiving it.
An example with similar significance, though opposite in direction, is trade receivable factoring that does not meet the requirements for derecognition and is therefore accounted for as a financial liability (secured debt). Based on generally accepted current practice under IFRS, the receipt would be classified as a financing activity, but since the financial liability will be repaid directly by the customer to the financial institution, no cash flow will be recorded at that time in the statement of cash flows. As a result, this case also leads to double distortion. First, the reporting entity’s operating cash flows will never include the receipt from customers, so the statement will be distorted by presenting a misleading lower than actual amount of operating cash flows. In addition, financing activities from a multi-year perspective will include cash inflows for the receipt of long-term credit without any cash outflow recorded for its repayment. It should be noted that under US GAAP, cash flows are presented gross in these situations.
Moreover, following the above IFRIC decision, diversity has also been created in current practice under IFRS when purchasing fixed assets on credit, where the credit provider transfers the payment directly to the seller, so that the payment does not pass through the reporting entity. Although most entities still apply the approach accepted under US GAAP and present cash flows on a gross basis in investing and financing activities, respectively, following the above IFRIC decision there are many entities that interpret the decision such that under IFRS only actual cash flows that the entity directly receives or pays should be reflected.
Gross Presentation of Amounts Paid to Third Parties at the Instruction, or on Behalf, of the Reporting Entity
In our view, the definition of cash flows should include amounts paid at the instruction, or on behalf, of the reporting entity to third parties, as well as amounts received at the instruction, or on behalf, of the reporting entity from third parties, by entities such as financial institutions with which the reporting entity conducts business. This economic principle that reflects gross cash flows, ignores cash flow “shortcuts”, thereby providing more relevant information to investors. A similar economic principle is routinely applied without controversy in the primary financial statements prepared on an accrual basis. For illustration, assume that an acquirer in a business combination bears transaction costs from which it is the primary beneficiary. Now, the acquirer requests the seller to pay the cash for these costs directly to the service provider, while the contractual consideration for the acquiree increases by the same amount. In this case there is no doubt, as determined in IFRS 3, that the business combination transaction will not be accounted for in the financial statements according to its contractual amounts but rather according to its economic substance. Therefore, the acquirer will recognise the transaction costs as an expense, while the consideration for the acquisition of the acquiree for accounting purposes will be lower than the contractual consideration.
If this economic principle is also adopted in the statement of cash flows, the problem presented in the above examples will be resolved. For example, in a supplier factoring transaction classified as financial debt, cash flows should be presented gross at the time of the factoring transaction. Since the bank pays the supplier at the instruction, and on behalf, of the reporting entity in return for the reporting entity incurring financial debt, cash flows should be presented gross even though technically the cash flow passed directly from the bank to the supplier. Therefore, at the time of the factoring transaction, the reporting entity will present a cash inflow in financing activities for receiving credit from the bank, alongside a cash outflow in operating activities for the payment to the supplier. From that point forward, the presentation of cash flows related to the credit from the bank will be presented in financing activities.
Similarly, numerous other distortions that currently exist will be resolved, such as the receipts from apartment buyers in a real estate development project paid directly into a restricted bank account that does not meet the definition of cash and cash equivalents, and receipts from investors for issuing securities, that are deposited in a trust account/deposit that does not meet the definition of cash and cash equivalents. As these are actual cash flows in which the reporting entity is involved, they should be presented gross in the statement of cash flows.
Purchase of Assets with “Vendor Financing”
In cases where there is no cash flow at the time of the underlying transaction, neither directly by the reporting entity nor indirectly at its instruction or on its behalf, in our view the initial cash flow classification should be “retained” according to the underlying transaction, even when the cash actually flows at a later date. A typical example is the repayment of credit for the purchase of fixed assets that was originally received directly from the supplier (“vendor financing”). Currently, under both IFRS and US GAAP, a distinction generally exists between, on the one hand, operating items such as inventory purchases or sales to customers on credit, and, on the other hand, other items such as purchases of fixed assets. While cash flows related to operating items remain in operating activities even when involving long-term credit, for other items a certain threshold is established, such that if the actual credit period exceeds the threshold, cash flows will be classified as financing rather than investing activities. In this regard, while under IFRS the deciding factor is generally whether the credit period is significant, under US GAAP the factor is whether payment is made soon after the transaction. The practical approach applied is generally a brightline of three months.
This accounting treatment leads to an absurd situation where analysts will never see this investing activity in the statement of cash flows. This is in complete contrast to an equivalent situation in the modern finance world, where credit to purchase fixed assets was obtained from a third party (investing activity on one side and financing activity on the other). This became even more significant with the transition to accounting for leases as asset purchases on credit according to IFRS 16.
Beyond harming coherence and comparability, the above accounting treatment in both accounting frameworks creates two additional major problems. One problem is the inconsistency in accounting between purchases on credit of different assets (as mentioned, inventory vs. fixed assets). But the second problem is even more serious, which is establishing an arbitrary threshold by which the entire cash flow is classified only as investing activity or only as financing activity.
The Economic Principle of Actual Cash Flows
The bottom line is that transforming the statement of cash flows from a statement that is based on a technical application of the principles to a substantive economic application, while improving its coherence and maintaining the overarching principle of reflecting actual cash flows, will lead to improving the relevance of the statement of cash flows as an important statement. The purpose of implementing the economic principle proposed above is obviously not to turn the statement of cash flows into a notional statement, but rather to identify actual cash flows and reflect them according to their economic substance.
This approach will significantly improve the relevance of the statement of cash flows and the ability of investors and other stakeholders to analyse each of an entity’s activities. For example, an analysis of an entity’s cash flow CAPEX in the preparation of a valuation or similar economic analysis. Additionally, the economic principle will reduce the lack of comparability that currently exists between different entities. This proposal can also impact the IASB’s current and important project dealing with improving the statement of cash flows and related issues.
(*) This paper was co-authored by Shlomi Shuv and Guy Tabibian, Head of the Professional Department, Deloitte Israel