LO 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency

In every type of business across the globe, it is important to understand the business’s cash position. Analyzing cash inflows and outflows, current cash flow, and cash flow trends, and predicting future cash flows all importantly inform decision-making. The US Securities and Exchange Commission (SEC) requires the statement of cash flows as the mechanism that allows users to better assess a company’s cash position. US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) set forth rules regarding the composition and presentation of the statement of cash flows.

• Method: Both GAAP and IFRS recommend and encourage the direct method of preparing the statement of cash flows but allow the indirect method. Under US GAAP, if the direct method is used, a reconciliation between net income and operating income must also be presented. This reconciliation is not required under IFRS.
• Presentation: The three categories—Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities—are required under both US GAAP and IFRS. US GAAP requires the presentation of only one year of information, while IFRS requires two years of data.
• Categorizing Transactions: IFRS is more flexible in where to present certain cash flow transactions than is US GAAP. This flexibility occurs around interest, dividends, and taxes. As shown in (Figure), US GAAP is more rigid in reporting.

Understanding the impact of these potential differences is important. The statement of cash flows is used not only to evaluate from where a company receives and spends its cash, but also to predict future cash flows. The flexibility of these reporting items in the statement of cash flows can result in decreased comparability between similar companies using different reporting methods. For example, Free Cash Flow (Operating Cash Flows less Capital Expenditures), will have different results if interest and dividends are classified in sections other than operating activities.

Let’s consider an example: World-Wide Co. is headquartered in London and currently reports under US GAAP because it is traded on the New York Stock Exchange (NYSE). World-Wide is considering switching to reporting under IFRS to make the company more comparable to its competitors, since most of them use IFRS. World-Wide has the following information in the operating activities section of its most recent statement of cash flows.

World-Wide had $1,000,000 in capital expenditures during the year, and they paid dividends of $80,000 to shareholders.

Based on this information, World-Wide’s Free Cash Flow would be as follows:

or

$2,500,000 − $1,000,000 = $1,500,000

If World-Wide switches to IFRS reporting, it has determined that its cash interest payments would be classified as financing activities because the payments are related to long-term debt. The interest received is from a short-term receivable and thus will remain classified as an operating activity, but the dividends received are from a long-term investment and will be reclassified to an investing activity. And, $60,000 of the taxes have been identified as being associated with tax consequences of an investing opportunity and therefore will be reclassified as an investing activity. With these reclassifications, the free cash flow of World-Wide would be as follows:

FCF = ($2,500,000 + $200,000 − $50,000 + $60,000) − 1,000,000 = $1,710,000

The take-away from this example is that the flexibility afforded by IFRS can have an impact on comparability between companies.

These, and other differences, between US GAAP and IFRS arise because of the more rules-based nature of the standards put forth by FASB versus the more principles-based rules set forth by IASB. The IASB, in creating IFRS standards, follows a substance-over-form viewpoint that allows firms more flexibility in assessing the intent of transactions. Anytime more judgement is allowed and/or utilized, there must be adequate disclosure to explain the chosen reporting methodology.