Relevance gained: FASB modifies cash flow statement requirements for banks.

Fears about the the banking system permeate all levels of American society. Depositors mobbed the Bank of New England in January of this year, forcing the Federal Deposit Insurance Corporation to take over the bank. Paul Samuelson, the Nobel prizewinning economist said recently, "I didn't think I'd live to see again the day when there are actually bank runs. " An official at both the FDIC and the Resolution Trust Corporation testified before Congress that the fund which guarantees banks' deposits is under substantial stress. As never before, stakeholders in banks need sufficient, reliable information to determine a bank's financial performance.

Cash flows are an important indicator of the viability of a particular bank. To survive, a bank must generate positive cash flows to meet withdrawals, liability maturities, loan commitments and to make investments. Cash flows also determine profitability. Over the life of an enterprise, profit equals cash inflows minus cash outflows. Accrual-based accounting may be too far removed from this relationship.

FASB REQUIREMENTS

To provide information about the cash flows of an enterprise during a particular period, Financial Accounting Standards Board Statement no. 95, Statement of Cash Flows, requires a statement of cash flows in a complete set of financial statements. Since July 15, 1988, this statement has replaced the statement of changes in financial position. FASB no. 95 contains two major reporting requirements for the statement of cash flows. One is the classification of cash receipts and payments according to the nature of the activity they represent. The other is the reporting of cash receipts and payments at "gross" with a limited amount of reporting as a net change in related balance sheet account balances. "Gross" means debit and credit transactions are reported separately.

For banks, these two requirements have been amended by FASB no. 102, Statement of Cash Flows-Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale, An Amendment of FASB Statement No. 95 which addresses the classification of certain cash flows from banking transactions, and FASB no. 104, Statement of Cash Flows-Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions, An Amendment of FASB Statement No. 95, which deals with net versus gross reporting of certain cash flows. These amendments make it easier for banks to comply with the reporting requirements of FASB no. 95 and provide relevant information about the performance of a bank to financial statement users.

The purpose of this article is to review and illustrate the application of FASB nos. 95, 102 and 104 to banks. The article includes a discussion of the classification of cash receipts and cash payments for banks according to FASB nos. 95 and 102. It also explains the net and gross reporting requirements of FASB nos. 95 and 104. A comprehensive illustration of the application of all three statements is provided by showing a statement of cash flows using the spreadsheet approach. CLASSIFICATIO OF CASH RECEIPTS AND PAYMENTS FASB no. 95 requires classification of all cash receipts and payments into operating, investing and financing activities. Cash received from interest and fee income is an operating activity; cash paid for the purchase of investment securities is an investing activity; and cash received from issuing capital stock is a financing activity. This classification results in the following format for the statement of cash flows:

  The Bank
         Statement of Cash Flows
     Year Ended December 31, 19Xl
Net cash provided by operating
   activities                          $xx
Net cash used in investing activities - xx
Net cash provided by financing
   activities                           xx
Net increase (decrease) in cash and
   cash equivalents                     xx
Cash and cash equivalents at
   beginning of year                    xx
Cash and cash equivalents at end
   of year                              xx

Classifying cash receipts and payments according to activities is straightforward for nonfinancial enterprises, which report buying and selling goods and services as operating activities. But a bank's major activities, which are making and collecting loans and accepting and returning deposits, are not included in operating activities according to FASB no. 95. Instead, loan transactions are investing activities and deposit transactions are financing activities. After issuing statement no. 95, the FASB considered this possible inconsistency, but decided a bank's loan and deposit activities are not similar to inventory transactions in a nonfinancial enterprise but are more like acquiring a new company or issuing bonds to finance a new plant. The FASB ruled that cash flows from loans are classified appropriately as investing activities, and cash flows from deposits are reported properly as financing activities.

A general rule for classifying cash receipts and payments for banks by activity, modifying the requirements of FASB no. 95, was issued in FASB no. 102, which requires that cash receipts and payments for purchases and sales of securities and any other assets acquired specifically for resale and carried at market value be classified as operating activities. This rule affects two types of transactions:

*Cash flows from loans originated or purchased specifically for resale, turned over rapidly and carried at market value or the lower of cost or market must be reported as operating activities. Cash flows from all loans were classified as investing activities under FASB no. 95.

* Cash flows for purchases and sales of trading account assets must be reported as operating activities. Cash flows from trading securities were classified as investing activities under FASB no. 95. The FASB contends trading securities held by banks are similar to inventory in other businesses in that they generally are acquired specifically for resale and turned over rapidly. In an effort to achieve greater comparability among banks, the classification of loans acquired for resale and trading securities as operating activities is a requirement not an option.

The following example demonstrates how reporting cash flows from trading securities as an operating rather than an investing activity changes the reporting requirements for banks. Assume the following:

* Trading securities with a carrying value of $12,000 were sold for $12,600.

* Trading securities had a net unrealized appreciation of $400.

* Trading securities were purchased for $15,000.

* The only income for the period was $1,000 from the gains above.

The differences between classifying the above transactions in the statement of cash flows as investing activities, according to FASB no. 95, versus classifying them as operating activities, according to FASB no. 102, are shown in exhibit 1, page 83.

The comparison in exhibit 1 assumes the indirect method for determining cash flows from operating activities. The indirect method starts with net income and converts it to net cash provided by operating activities. The net change is a cash outflow of $2,400, regardless of whether cash flows from the transactions are investing or operating activities. But from a recordkeeping point of view, it's much easier to report the net change in the trading securities account rather than maintain separate records for gains, losses, sales, and purchases of trading securities. Moreover, the size of the cash flows reported differs substantially. Instead of reporting a decrease in net income of $1,000, inflows if $12,600 and outflows of $15,000 to arrive at a net cash outflow of $2,400 from investing and operating activities, the decrease in net income from the increase in the trading securities account results in a net cash outflow of $2,400.

Cash receipts and payments from banking transactions can be classified according to whether they are for operating, investing or financing activities. Operating activities: Cash received from:

* Interest.

* Dividends.

* Fees for services.

* Sale of trading securities and loans acquired specifically for resale.

* Other receipts not defined as investing or financing activities. Cash paid for:

* Interest.

* Salaries and wages.

* Taxes, duties, fines and penalties.

* Purchase of trading securities and loans acquired specifically for resale.

* Other payments not defined as investing or financing activities. Investing activities: Cash received from:

* Collection of loans (including credit card receivables).

* Sale of loans other than those acquired specifically for resale.

* Sale or maturity of investment securities.

* Sale of premises and equipment. Cash paid for:

n Loans to customers (including credit card advances).

* Purchase of loans other than those acquired specifically for resale.

* Purchase of investment, securities.

* Purchase of premises and equipment. Financing activities: Cash received from:

* Acceptance of deposits.

* Issuance of equity securities capital stock).

* Issuance of debt (bonds, mortgages and notes). Cash paid for:

* Withdrawals of deposits.

* Payment of dividends.

* Redemption of debt.

* Purchase of treasury stock. (National banks, FDIC-insured banks and Federal Reserve member banks can't acquire their own stock. A bank holding company may.)

REPORTING CASH FLOWS

The second major requirement for the statement of cash flows is the reporting of cash receipts and cash payments at gross or as a net change in balance sheet account balances. FASB no. 95 permitted only a limited amount of net reporting for:

* Cash equivalents.

* Operating activities when the indirect method is used.

* Demand deposits.

* Investments, loans receivable and debt with maturities of three months or less.

After issuing Statement no. 95, the FASB considered the undesirable impact on banks of the gross reporting still required. For example, the high volume of transactions involving cash receipts and payments, which are common to banks, resulted in reporting gross amounts of some cash flows that were large in relation to others. Gross cash flows from time deposits reported in the statement of cash flows of one major bank totaled more than 600 times the year end balance of cash and equivalents.

Another impact of gross reporting was limited comparability of certain cash flows among banks. Although banks could report the net amount of investments, loans and debt with maturities of three months or less, some banks chose to report them at gross rather than keep the items separated by maturity. Comparability of cash flows among banks also was affected by different accounting procedures. For example, when a customer renews a certificate of deposit or a loan, the transaction can be recorded with or without debiting and crediting the customer's demand deposit account. Obviously, a bank that debits and credits the account reports higher gross cash flows than one that does not.

Because of these problems, a majority of FASB members acknowledged that gross cash flows may be no more relevant than net cash flows for certain transactions. The FASB issued Statement no. 104, which expands net reporting for banks by adding:

n Deposits placed with other financial institutions and withdrawals of deposits.

n Time deposits accepted and repaid.

n Loans made to customers and principal collections.

These provisions are effective for annual financial statements of fiscal years ending after June 15, 1990, with earlier application permitted. If the cash flows from the above activities are reported at net, comparative amounts in financial statements for earlier periods must be restated or reclassified.

Only deposits and loans are affected by FASB no. 104. Investments with maturities longer than three months still must be reported at gross; that is, all investment debit transactions must be reported separately from credit transactions. The FASB concluded that investing in securities is not an activity unique to banks. Further, the cost and difficulty of reporting gross cash flow information for investment security transactions are less than for deposit and lending transactions.

An example of the change brought about by FASB no. 104 is shown in exhibit 2, page 83. This example illustrates the effects o reporting the net cash flows from loan transactions on the statement of cash flows as opposed to reporting gross cash flows. With regard to exhibit 2, assume:

* Loans with maturities of three months or less increased a net amount of $5,000.

* Loans with maturities of longer than three months were made to customers in the amount of $20,000.

* Principal collections on loans to customers with maturities of more than three months were $10,000.

The recordkeeping required to report loans at net rather than gross is simplified. For net reporting, only the change in the loans to customers account is required. However, for gross reporting, loans to customers must be separated as to (1) loans made and principal collected on loans with maturities of three months or less, (2) loans made with maturities of more than three months and (3) principal collected on loans with maturities of more than three months. The size of cash flows reported differs (even though the net amount is the same) from $25,000 cash outflows and $10,000 cash inflows to $15,000 cash outflows.

PREPARATION OF A BANKS STATEMENT OF CASH FLOWS

The application of FASB nos. 95, 102 and 104 can best be illustrated by preparing a statement of cash flows for a bank using the spreadsheet approach. The indirect method for reporting cash flows from operating activities is used since it appears to be the method preferred by banks. In a survey by KPMG Peat Marwick of 100 bank financial statements prepared for 1989, 96 banks used the indirect method while only four used the direct method.

The accounts in a comparative balance sheet are analyzed to determine cash flows. The logic for this methodology is explained by the accounting equation, Assets = Liabilities + Stockholders' Equity. Because the target of the statement of cash flows is the change in the cash account, the equation can be solved as follows: *Cash = *Liabilities + Stockholders' Equity - *Assets Other Than Cash * represents the change in account balances from the beginning of the period to the end.

The traditional approach of preparing the statement of cash flows by analyzing current assets and liabilities and then noncurrent assets and liabilities is not feasible for banks. Their balance sheets are not classified as to current and noncurrent. Instead, the following approach can be used:

* Convert net income if the indirect method is used for operating activities, or revenues and expenses if the direct method is used, from accrual basis of accounting to cash basis of accounting to determine its (their) effects on cash flows.

* Analyze all balance sheet accounts, other than cash and those already analyzed in the conversion process above, to determine their impact on cash flows.

When the net change in an account balance does not provide sufficient detail to prepare the statement, additional information is needed.

For purposes of this illustration, the required information is given below, categorized by the appropriate activity.

Operating activities:

* Included a $20 deferred provision in the provision for income taxes. Investing activities:

* Sold investment securities with a carrying value of $5,000 for $5,200 and purchased investment securities for $10,000.

* Purchased equipment for $6000 to be leased under a leveraged lease. The equipment was financed by an equity investment of $2,000 and a long-term nonrecourse loan of $4,000. Of the rental payments collected, $98 was principal. Of the loan payments made, $30 was principal. (Note that two of these events are financing rather than investing activities. They are the long-term recourse note of $4,000 and the principal investing activities. After due consideration, FASB amended Statement no. 95 with Statement no. 102, which requires cash flows from purchases and sales of loans and other assets acquired specifically for resale and carried at market value to be classified as operating activities. This practice recognizes these assets are similar to inventory in other businesses.

FASB no. 95 also provided rules for reporting cash receipts and payments at gross or as a net change in related balance sheet account balances. Only a limited amount of net reporting was permitted under the initial pronouncement. Some of the general provisions for enterprises were not appropriate for the large cash flows unique to banks. After reexamination, the FASB issued statement no. 104 which extended net reporting for banks.

A summary of the the reporting requirements for banks can be found in exhibit 6, above. Included in the summary are the applicable FASB Statements and their effective dates. Because cash flows from any items omitted from this summary have not been specifically covered in FASB nos. 95, 102 or 104, the assumption is that they are reported at gross. RELIVANCE GAINED The amendments to the requirements for a statement of cash flows have had the following effects for banks:

* Recordkeeping has been reduced.

* The size of cash flows reported on the statement has been reduced.

* Comparability among banks has been improved. As a result of additional work by the FASB, the statement of cash flows is now more relevant to the unique characteristics of the banking industry. The statement should be more useful to depositors, stockholders and other investors in assessing financial performance.