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Preparing and presenting statements of cash flows.


Financial Accounting Standards Board Statement no. 95, Statement of Cash Flows, specifies what cash flow information companies must report and reduces diversity in reporting. Although the standard has made cash flow statements much more understandable to financial statement users, it doesn't address some of the problems CPAs may encounter in practice. This article discusses four possible problems and solutions.



Statement no. 95 says information about gross amounts of cash receipts and payments during a period generally is more relevant than information about net amounts. In practice, some netting of cash flows occurs in preparing cash flow statements. This may or may not be appropriate, depending on the circumstances. For example, if cash proceeds from an incurred liability are used to pay off another liability, should this be treated as a refunding and thus omitted from the statement? The answer is yes if no cash is exchanged. In a pure refunding, one liability merely replaces another. If there are two separate liabilities to two separate parties, incurrence of the second liability generally should be treated as a financing inflow and payoff of the first liability considered a financing outflow. This is consistent with the FASB's stated emphasis in the standard on gross rather than net cash flows within the statement of cash flows. The operating, financing or investing activities will be obscured if inflows and outflows are not reported separately.

The netting of inflows and outflows is appropriate only in three circumstances. The first is when there are exchanges between cash and cash equivalents. The second is for items characterized by quick turnover, large amounts and short maturity (paragraph 13 says items that qualify for net reporting are cash receipts and payments pertaining to (1) investments other than cash equivalents, (2) loans receivable and (3) debt, providing that the original maturity of the asset or liability is three months or less). The third is when there is an exception involving financial institutions.

FASB Statement no. 104, Statement of Cash Flows - Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions, permits banks, savings institutions and credit unions to report in a cash flow statement net cash receipts and payments for deposits placed and withdrawn, time deposits accepted and repaid, and loans made and collected.

CPAs should ensure the netting of cash receipts and cash payments does not misrepresent the underlying transactions and should be careful when using a worksheet to prepare the cash flow statement. Deriving cash flow transactions merely by comparing ending balances to beginning balances in various accounts could produce an inappropriate netting of cash receipt and payment transactions.

For example, a company could pay off or pay down a demand note and then reissue the note or borrow again. If it begins the year owing $100,000 on a demand note and ends the year owing $160,000, a mere comparison of worksheet balances without considering intervening transactions would indicate a financing inflow of $60,000. But what if the $160,000 ending balance occurred because the company paid back $50,000 in March and then borrowed an additional $110,000 in December? Determining net financing inflows by subtracting the beginning balance in notes payable from the ending balance would result in the statement of cash flows inappropriately netting cash receipts and payments. The company in this example should report both a financing outflow of $50,000 and a financing inflow of $110,000.


The treatment of bank overdrafts is another problem encountered in preparing cash flow statements. On the balance sheet, an overdraft in a checking account must be reported as a current liability unless funds in another account in the same bank are sufficient to cover it. Since they will be deducted from cash fairly soon, should overdrafts be netted back against the cash balance in other accounts in the cash flow statement, which could mean reporting a negative cash balance? The answer is no because this approach would produce a cash balance in the statement different from that reported on the balance sheet. The statement should reconcile beginning and ending cash and cash equivalents, which means cash balances on the cash flow statement should relate to the amounts reported on the balance sheet. Because netting bank overdrafts (a liability) against cash in the cash flow statement would prevent agreement between the two cash balances - and since overdrafts can neither be reported as cash nor meet the definition of cash equivalents (only investments can qualify as cash equivalents) - it generally is inappropriate to net them against cash.

An overdraft is merely short-term borrowing and should be reported as a financing inflow, unless the overdraft is treated similarly to accounts payable. A business might operate consistently "on float" with a regular bank overdraft. If the cash flow statement reports operating cash flows using the indirect method, then the change in balance of such an overdraft could be treated as an adjustment to operating cash flows. Repaying an overdraft is either a financing outflow or a reduction of accounts payable.



According to Statement no. 95, amounts paid for insurance policies are to be reported as operating outflows. For term insurance policies, whether life or casualty, any premium paid is for insurance alone and should be expensed on the income statement and classified as an operating cash outflow in the statement.

However, when a business pays the annual premium on an employee's whole-life insurance policy, part of the premium usually increases the policy's cash surrender value. For financial reporting purposes, the insurance premium is prorated between insurance expense and an investment account. The increase in cash surrender value increases the investment in the policy while the remainder of the premium is reported an insurance expense. Interest, since typically immaterial, is disregarded. The increase in cash surrender value should then be reported as investing outflow in the cash flow statement and the remaining (expensed) portion treated as an operating outflow.

Some life insurance policies can be very complex, though. For example, what if a business paid off a whole-life policy within five years? During the premium payment period, premiums would be reported as operating and investing outflows as above. However, since the cash surrender value is building rapidly, interest revenue in an amount likely to be material is earned each year. Accounting Principles Board Opinion no. 21, Interest on Receivables and Payables, implies that interest revenue, if material, should be reported separately from insurance expense in the income statement. No cash is being received, however, and thus the interest produces no operating cash flow.

During later years, the company would recognize insurance expense even though premiums are no longer being paid. The policy's cash surrender value increases as the investment earns interest; insurance expense causes the cash surrender value to rise less than interest earned. Neither the resulting interest revenue nor the insurance expense produces cash inflows or outflows and thus should not be reported on the cash flow statement. Cash surrender values cannot be reported as cash equivalents because they are not short term in nature. If the indirect method is used to determine the net operating cash flows, an increase (decrease) in cash surrender value would need to be reported as a subtraction (addition) in adjusting net income to net operating cash flows. This is because the interest revenue added and insurance expense deducted in computing net income do not in this case involve a cash receipt or expenditure.




A study published in the February 1990 CPA Journal found that 21 out of 94 companies that had adopted Statement no. 95 by 1988 failed to disclose cash payments (operating outflows) for interest and taxes. This lack of disclosure is not in accordance with the statement's provisions.

When issuing Statement no. 95, the FASB considered two principal alternatives for reporting net cash flow from operating activities: the direct method and indirect method. The direct method shows as its principal components operating cash receipts and payments, including

* Cash collected from customers, including lessees and licensees.

* Interest and dividends received.

* Other operating cash receipts, if any.

* Cash paid to employees and other suppliers of goods or services, including suppliers of insurance and advertising.

* Interest paid.

* Income taxes paid.

* Other operating cash payments, if any.

The indirect method starts with 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 to net cash flow from operating activities. This method doesn't disclose some of the details involving operating cash receipts and payments. For this reason, the FASB indicated a preference for the direct method, but in response to complaints from financial statement providers about the expense of separate reporting of gross operating cash receipts and payments, the board allowed use of either method. However, Statement no. 95 does require entities using the indirect method to report net cash flows from operating activities at least to disclose the cash paid for interest and income taxes and to report separately changes in inventory, receivables and payables. The resulting information allows users to make their own rough approximations of operating cash receipts and payments. CPAs should be sure to provide this required information.


The guidance provided by an authoritative pronouncement may be conceptually clear, but, as is often the case, questions not specifically addressed in the literature may arise once it is applied in practice. CPAs should be aware of the four problem areas discussed in this article and understand how to avoid them.

C. Wayne Alderman, CPA, DBA, Coopers & Lybrand Professor of Accountancy, and Donald H. Minyard, CPA, PhD, assistant professor of accountancy, Auburn University, Auburn, Alabama, describe solutions to problems in applying FASB Statement no. 95.
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Author:Minyard, Donald H.
Publication:Journal of Accountancy
Date:Jan 1, 1991
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