The Decision Usefulness of the Traditional Set of Financial Statements

There is widespread sentiment that the traditional set of financial reports, particularly the balance sheet and income statement, lack in decision usefulness. To combat this alleged problem accounting academicians, standard setters, and preparers are searching for new reporting formats. Two such general formats are the cash flow statement and the value added statement. While the cash flow statement has been around for some time, there exist many differences of opinion in regard to the report both in theory and in preparation. Piper Jaffray, Bahnson, Ijiri, and Lee articulate many of these differences. The value added statement (VAS) is a relatively recent phenomenon, especially in the United States. The VAS considers not only the information needs of the shareholder/investor, but the needs of all stakeholders in the business. Meek and Gray comment on the benefits of adopting a value added approach to reporting while Price and Porcano consider the potential of using value added for tax revenue producing purposes. In this paper I will discuss many of the theoretical aspects of these reporting alternatives from the perspectives of this week’s writers. I will conclude with my opinions and recommendations as they relate to the issues discussed.
In a letter to FASB Chairman Jenkins regarding SFAS No. 95 – Statement of Cash Flows, Daniel Donoghue of Piper Jaffray Inc. (Piper) cites his firm’s concerns with current cash flow reporting and provides recommendations meant to improve the usefulness of the cash flows statement. Piper’s main area of dissatisfaction is the use of the indirect method of cash flow statement preparation. Piper explains that deriving a statement of cash flows from the accrual-based income statement is a “cumbersome analytical process”, and one that is likely to omit important information that would otherwise be contained within the statement of cash flows if the direct method were used (Piper, 3). Piper specifically addresses problems that arise using the indirect method as a result of uncollectible debts, depreciation, and cash interest (Piper, 3-4). Piper cites a higher level of comprehension and added detail allowing “more accurate and sophisticated cash flow analysis” as two major reasons for its recommendation to the FASB to require the direct method of cash flow preparation (Piper 5). In addition to problems with the indirect method, Piper disagrees with the following current practices: including installment sales, interest income, and dividends received in operating cash flows (OCF); lack of disclosure in regard to maintenance versus discretionary capital expenditures; bundling non-cash financing and investing activities within the statement of cash flows, and; the general lack of precision in cash flow reporting (Piper, 6-7).
In their article “Nonarticulation in Cash Flow Statements and Implications for Education, Research and Practice”, Bahnson, Miller, and Budge (henceforth referred to as Bahnson as a matter of convenience), reiterate many of Piper’s concerns. Bahnson’s major problem with current cash flow reporting is a lack of articulation between the cash flow statement and balance sheet. Bahnson concludes that this nonarticulation is primarily attributed to the use of the indirect method. As a result, Bahnson recommends (like Piper) that the direct method of preparation be required by the FASB (Bahnson, 10). Bahnson also seems to agree with Piper in regard to the precision issue. “Preparers tend to aggregate changes in several current accounts from the balance sheet into single items on the cash flow statement” (Bahnson, 2). This implies that there is a kind of carelessness involved with preparing the statement of cash flows relative to the other financial reports. It is easier to group items together in an expedient manner rather than to separate the cash flow effects of each individual item. This lack of precision is not as acceptable when it comes to other financial reports. Piper and Bahnson agree that this outlook must change.
In Piper’s letter, Donoghue comments on the current practice of including only the cash portion of an investing or financing transactions in the statement of cash flows while disclosing any non-cash portion of the same transaction as a footnote (Piper, 7). Piper recommends an end to this practice on the grounds that this type of reporting is “potentially misleading” to users. Through this type of reporting, Piper contends that, “the opportunity to highlight an important capital decision is lost” (Piper, 7). It is doubtful that Bahnson would agree with the idea of including non-cash item on the face of the statement of cash flows. Under Bahnson’s concept, nominal cash accounts would be used such as “Collections from Customers” and “Payments to Employees” (Bahnson, 12). All of the entries to these nominal accounts would be accompanied by cash consequences. No mention is made in regard to reporting non-cash items on the face of the statement. Perhaps Bahnson’s objective is to provide cash flows in the most literal sense, while Piper’s motive is to provide information relevant to users when evaluating a firm’s capital expenditures. Piper seems to believe that even when transactions are not financed wholly with cash, that the real effect is that of a cash transaction and should be reported in the cash flows statement as such.
Possibly even more than Piper and Bahnson, Ijiri sees the statement of cash flows as potentially the most valuable tool for assessing managerial performance and predicting future cash flows. Ijiri argues that management is currently placed in what Ferrara termed an “intolerable position” (Ijiri, 332). That is, management bases its investment decisions on projected future cash flows and is then evaluated by the bottom line of the income statement. The problem with this, according to Ijiri, is that it is possible that the investment decision could end up looking good from the cash flow perspective, but not so good from the income statement perspective (Ijiri, 332). To remedy this problem, Ijiri suggests that management should be evaluated no the same basis by which it makes its decisions and that the statement of cash flows is the preferred performance evaluation tool.
In Ijiri’s cash flow model the operating section of the cash flow statement is completely eliminated. Ijiri’s fundamental cash flow equation sets investment cash flows equal to financing cash flows. This format highlights the investment and recovery aspects of investment cash flows and the financing and repayment aspects of financing cash flows. By emphasizing the recovery rate of an investment, a valuable indicator of management performance is provided (Ijiri, 340). The recovery rate helps users of the statement of cash flows determine the investment’s payback period, and, as an extension, the likelihood of a return over and above recapture. In regard to better predicting future cash flows Ijiri suggests that the recovery and repayment rates shown on the face of his cash flow statement are a “useful means by which to make such a prediction” (Ijiri, 341).
I believe that Ijiri’s model eliminates many of the problems associated with the indirect method of cash flow statement preparation cited by Piper. This is because the information contained within Ijiri’s model is determined independent of the income statement. In addition, it seems that Ijiri’s model would provide better disclosure regarding the nature of capital expenditures; be they maintenance expenditures or discretionary. I also believe that Ijiri’s model would result in more precision. At the same time, I doubt Piper or Bahnson would agree with the idea of eliminating the operating section of the statement. The operating section seemed of paramount importance to both writers.
Lee’s proposed cash flow model is significantly different from Ijiri’s. Under Lee’s model the emphasis is placed on two functions. The first function is that of measuring and reporting relevant data. Lee sees this function as the responsibility of the statement preparer. The second function is that of overall valuation. Lee sees this function as the responsibility of the user (Lee, 278). This second function is somewhat of a departure from other cash flow theorists. Lee recommends that users be provided with a database that they may use for the purpose of deriving whatever valuations are relevant to the decision at hand. Ijiri differs in that measuring, reporting, and valuation are all considered to be the responsibility of the preparer. Perhaps Lee’s model would satisfy the information needs of a broader group of financial statement users. A second area of difference between Ijiri and Lee is in regard to the predictive value of cash flow reporting. As explained above, Ijiri sees the ability to project cash flows as one of the strengths of his model. On the contrary, Lee is hesitant to agree that accounting information based on accrual-based historical data could have much relevance to events yet to occur (Lee, 280). It is quite possible, however, that the revolutionary approach to cash flow reporting suggested by Ijiri would serve to appease Lee’s fears since Ijiri’s model is not accrual-based.
Lee suggests that one benefit of his approach to cash flow reporting is that it will largely avoid the problem of allocations (Lee, 278). If this is true, many of the frailties of the indirect method identified by Piper would be greatly reduced. On the other hand, Lee, like Bahnson, seems to ignore the non-cash aspects of cash flow reporting that were of concern to Piper. Stating that “cash is the life blood of a business entity” Lee’s cash flow model only reports those items having cash ramifications (Lee, 280-281). So Lee’s model would not satisfy Piper’s concern about non-cash financing and its presentation in the statement of cash flows.
Meek and Gray (henceforth referred to as Meek as a matter of convenience) suggest that traditional financial reports typically provide information relevant to the wealth created by the firm attributable to shareholders. Viewing this limited scope as inadequate, they recommend the adoption of a financial statement that reports the wealth created and attributable to all stakeholders (Meek, 73). In other words, the suggested statement considers the value created by the firm and attributable to employees (in the from of wages, benefits, etc.), to the government (in the form of taxes paid and grants received), to providers of capital (including owners and creditors), and also in terms of reinvestment in the business (Meek, 76). More than just a rearrangement of the income statement, this so-called value added statement is considered by England’s Accounting Standards Steering Committee to be the “most immediate way of putting profit into proper perspective” (Meek, 73).
One use of the VAS identified by Meek is that it measures the total wealth created by the reporting company (Meek, 77). In this regard the VAS is useful as a performance evaluation tool. Another use of the VAS is that it emphasizes stockholder interdependence (Meek, 78). By indicating how wealth is distributed amongst stakeholders, the VAS “highlights the interactive effect of policy decisions” (Meek, 78). In this way, the VAS may lead to improved cohesiveness between various stakeholders and to a better understanding of the basic direction of the firm. A third use of the VAS identified by Meek is that it helps to condition employee expectations regarding pay and prospects (Meek, 78). The VAS may indicate a firm’s ability to increase employee compensation, and thus may be a valuable bargaining chip for employees during labor negotiations. A final benefit of the VAS according to Meek is that it can “from the basis for productivity incentive schemes” (Meek, 78). In general, the VAS provides a reporting company a way to provide information relevant to the information needs of a broader audience as compared to more traditional financial statements.
An interesting application of this value added concept is identified by Price and Porcano in their article “The Value-Added Tax.” The argument here is that the IRS could potentially increase tax revenue by eliminating the federal corporate income tax, and replacing it with a value added tax. The typical way of computing the value added tax is by multiplying the value added rate by a company’s sales and subtracting an amount equal to the value added rate multiplied by a company’s purchases (Price, 44). Price and Porcano identify several benefits of the value added tax including: (1) the tax does not affect business profits; (2) the tax can raise a tremendous amount of revenue; (3) the tax is self-enforcing; (4) it provides an incentive to save (this is debatable), and; (5) it provides a “textbook answer to the nation’s balance-of-payments problem (Price, 44). While there may be many benefits to the value added tax, there are several potential drawbacks as well. These drawbacks include the following: (1) the tax is potentially regressive barring a conscious attempt by lawmakers to mitigate the regressivity; (2) administering the tax would be costly – at least initially; (3) implementing the tax would have an inflationary impact all other things held equal – at least initially; (4) a fear that the government will become too powerful due to the massive amount of revenue generating potential; (5) the tax may lack neutrality.
In regard to cash flow reporting, I agree with Piper for the most part. I can see how the indirect method may lead to misleading information. At the same time, I am not persuaded by Piper’s argument to include non-cash portions of transactions in the cash flow statement. While I see how failing to do so may create confusion, I see how reporting non-cash items in a statement of cash flows would create confusion as well. I think that the best option in this regard is disclosure. In general, I am on board with any attempt to provide information to users useful in making decisions so long as the information is reasonably reliable. I feel like the VAS discussed by meek is particularly useful in this regard. The VAS sheds new light on information already contained within traditional statements, and is seemingly more relevant to a wider array of users. In regard to the value added tax, I am opposed to any such effort. In addition to the reasons cited in the Price article, I am generally proposed to any tax that would take power away from the people and put it in the hands of the government. Furthermore, the value added tax is not what Adam Smith would consider a “good tax.” There is concern that the tax could not be administered equitably due to its regressive qualities. Also, it is probably that the additional revenue generated would be offset by the high cost of administration. Finally, the tax seems to lack simplicity. The process of applying for credits, and the resulting lag prior to refund would be a definite thorn in the sides of businesses.