By Koh Wei Chern and Patricia Tan Mui Siang
The International Accounting Standards Board (IASB) initiated a project on primary financial statements in June 2015 as part of IASB’s plan to promote better communication in financial reporting. Stakeholders have expressed various concerns regarding the classification and presentation choices allowed in the statement of cash flows. Hence, in a bid to improve comparability and transparency of companies’ performance reporting, the Board is proposing targeted improvements to the statement of cash flows.
International Accounting Standard (IAS) 7 currently allows some presentation choices to firms. Firstly, under paragraph 18, firms can choose to report cash flows from operating activities using either (a) the direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed, or (b) the indirect method, whereby profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.
Secondly, under the indirect method specified in paragraph 18(b), firms are required to adjust “profit or loss” to derive the cash flows from operating activities. However, “profit or loss” is currently not defined in the standard and firms can make their own choices as to which profit or loss line to start off with.
Thirdly, paragraph 33 states that generally, interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution and that “there is no consensus on the classification of these cash flows for other entities. Interest paid and interest and dividends received may be classified as operating cash flows because they enter into the determination of profit or loss. Alternatively, interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows respectively, because they are costs of obtaining financial resources or returns on investments”. Dividends paid may be classified as a financing cash flow because they are a cost of obtaining financial resources or alternatively, classified as an operating cash flow in order to assist users to determine the ability of an entity to pay dividends out of operating cash flows (paragraph 34).
In other words, IAS 7 allows firms to choose to classify dividends paid and interest paid as either operating cash flows or financing cash flows and to choose to classify dividends received and interest received as either operating cash flows or investing cash flows. As a result, classification varies, even among entities in the same industry (Basis of Conclusions to Exposure Draft General Presentation and Disclosures (BC) paragraph 189).
IASB issued the proposed amendments to IAS 7 in December 2019 with a call for comments that is due on 30 June 2020. With respect to the above three presentation choices, IASB has the following proposed amendments. Firstly, IASB continues to allow a choice between the direct and indirect methods when reporting cash flows from operating activities.
Secondly, under the indirect method, IASB proposes to require operating profit as the single starting point for reporting cash flows from operating activities.
Thirdly, IASB proposes to eliminate options for the classification of the cash flows from interest and dividends in the statement of cash flows. In BC paragraph 190, “users of financial statements have indicated that the diversity in classification between entities in the same industry: (a) reduces comparability, making their analysis more difficult, and (b) is often not meaningful – that is, the different classifications of these cash flows do not necessarily convey information about the role of interest and dividends in the entity’s business activities”.
For non-financial entities, the proposed approach is for dividends paid and interest paid to be classified as cash flows from financing activities, while for dividends received and interest received to be classified as cash flows from investing activities. This approach seeks to align the classification in the statement of profit and loss with the classification in the statement of cash flows, thus increasing the understandability of the information.
For financial entities, dividends paid are to be classified as cash flows from financing activities. For dividends received, interest paid, and interest received, the proposed amendments require the entity to classify each of the above categories by reference to the classification of the income or expenses corresponding to such cash flows in the statement of profit or loss.
In an example cited in the proposed amendment, if an entity classifies all its interest expenses in the financing category of the statement of profit or loss, then it will classify its interest paid as cash flows from financing activities. Should an entity classify some of its interest expenses in the operating category and some in the financing category of the statement of profit or loss, then the entity has to make an accounting policy choice to classify the interest paid as either operating cash flows or as financing cash flows.
We obtain a list of the top 30 companies listed on the Singapore Exchange that make up The Straits Times Index and examine how these firms are making their presentation choices. We review one year of annual reports of these 30 companies with financial year ending between 30 June 2018 and 31 March 2019. There are 26 non-financial companies and four financial companies.
First, we examine whether most firms adopt the indirect method of presenting cash flow from operating activities. Indeed, all 30 firms use the indirect method.
Second, we examine the starting points used for the indirect method. We note that there are three common starting points used for the indirect reconciliation of cash flows from operating activities. Seventeen firms (57% of the sample) use net profit before taxation. Seven firms (23% of the sample) use net profit after taxation and only six firms (20% of the sample) use operating profit before tax. Hence, there is variation in practice. Specifying a common starting point as proposed by IASB will reduce variability and increase comparability. However, if the current practices of the sample firms are indicative of the presentation choices by the overall population of the firms, and if IASB pushes through with operating profit as the starting point, then 80% of the firms are likely to have to make changes in the presentation of their cash flow statements.
Third, we examine the classification choices of interest and dividend. In the case of dividends paid, 29 of the firms (97% of the sample) classify it as cash flows from financing activities. Given that IASB is proposing for all firms, regardless of whether financial or non-financial, to classify this as cash flows from financing activities, there should be minimal impact should this amendment be effected.
Given that the proposed classification choices for interest paid, dividends received and interest received differ for non-financial and financial firms, we shall examine the 26 non-financial firms first. Table 1 summarises the findings. Fourteen companies (54% of the non-financial sample) classify interest paid as cash flows from financing activities. Nineteen companies (73% of the non-financial sample) classify dividends received as cash flows from investing activities. Fifteen companies (58% of the non-financial sample) classify interest received as cash flows from investing activities. It can be noted that the majority of the firms appear to classify interest and dividend-related cash flows in line with what IASB proposed for the non-financial firms.
Table 1 Classification choices of the 26 non-financial firms
*classified part as investing cash flows and part in operating cash flows
**did not report any dividend income
Next, we describe the presentation choices of the remaining four financial firms. Three of them are banks. For interest paid, one bank classifies it as from financing activities, while two other banks classify it as from operating activities.1 For interest received, all three banks classify it as from operating activities. For dividends received, one bank classifies it as from investing activities, while two other banks classify some as from investing activities and some as from operating activities.
IASB proposes for financial firms, when classifying their cash flows, to follow the classification per their statement of profit or loss. It can be seen from these three banks that there appears to be variability, but given that the sample is small, it is difficult to assess the impact of the proposed amendment put forth by IASB.
The findings in this article show that firms are relatively varied in their starting point for the indirect method for reporting cash flows from operating activities and their presentation choices for interest and dividend cash flows as permitted under IAS 7. Hence, IASB prescribing a single starting point for the indirect method and requiring consistent classification for these various items can likely help increase comparability of financial information.
Koh Wei Chern is Associate Professor, Accountancy Programme, School of Business, Singapore University of Social Sciences, and Patricia Tan Mui Siang is Associate Professor of Accounting, Nanyang Business School, Nanyang Technological University.
1 The remaining non-bank financial firm has no interest paid
This article was first published by ISCA Journal. You can read the original version here.