Cashflow is finally on the International Accounting Standards Board’s (IASB) work plan (see previous AB coverage), so I thought it might be helpful to offer an investor’s perspective on how to improve the current standard. I and many other users have been lobbying for better cashflow disclosure for at least 15 years, and I doubt I will ever understand why it has taken so long.
Companies almost always fail because they run out of cash. There may be other official reasons – fear of trading while insolvent, crippling liabilities, etc – but it is lack of cash that usually administers the coup de grâce.
Conversely, it is almost always strong cashflow that delivers maximum value to shareholders. Promising young companies may sometimes trade at stratospheric valuations, but those that prosper are the ones that go on to deliver the cashflow that their early multiples promised. Think of the current tech titans that generate more cash than they know what to do with. Some have even started paying dividends.
Torching the standard
My point is that cashflow is of overwhelming importance and yet the current standard is, in my opinion, by far the most unsatisfactory of the current crop. The only useful suggestion I can make is to gather all paper copies of it and arrange a spectacular bonfire.
Cashflow statements should be all about flow, not about movement in balance sheet entries
The problem starts with the second paragraph of IAS 7, which states that its objective is to ‘require the provision of information about the historical changes in cash and cash equivalents’. This is both misguided and contradicts the first paragraph, which correctly notes that users need to be able to assess the ability of an entity to generate cash. To state the obvious, cashflow statements should be all about flow, not about movement in balance sheet entries.
More precisely, the statement should show how an entity generates cash from its business, invests the cash both internally and externally, and then distributes any surplus. When you think about it, this is a good definition of the reason a company should exist.
Wishlist
I am delighted that the IASB has recognised the importance of ‘operating profit’ with IFRS 18, which becomes a mandatory disclosure from January 2027, many decades after investors started using it. This provides a near-perfect place to start a useful cashflow statement. Operating profit should be a measure of the nominal surplus of revenues over operating costs.
The next sub-total should be operating cashflow, which I define as operating profit adjusted for working capital movements and other direct cash costs. Then we need sub-totals for internal investments, such as tangible and intangible assets, and for financing costs. Non-cash items such as impairments should be kept out of the cashflow as much as possible.
Most major corporate frauds would have been easier to spot if it had been possible to decipher the cashflow
Acquisitions are often a company’s largest consumer of cash and deserve separate disclosure. It should be possible to derive the effective cost of acquisitions in the statement, including acquired debt, shares issued to the seller and anything else of value that has changed hands. The same standard should apply for divestments.
Lastly, the cashflow should finish with a reconciliation to the movement in net debt. The IASB attempted to address this in 2016, but the amendment was ineffectively drafted and implementation has been disappointing, to put it politely.
Fraud-spotting
There is another, less intuitive, reason to make cashflow statements do what they are supposed to do. Almost every example of major corporate fraud I have encountered would have been much easier to spot if it had been possible to decipher the cashflow.
Fixing this long-standing weakness in standards would be a win for everybody. I just hope it doesn’t take another 10 years.
