The United States Statement of Cash Flows

Jerome J. DeRidder, Ph.D.

Franklin P. Perdue School of Business

Salisbury University

Salisbury, Maryland 21801

Contact:

Jerome James Deridder

E-mail: jjderidder@salisbury.edu

Telephone: 410-543-6326

Fax:  40-546-6208

1101 Camden Avenue

Salisbury University

Salisbury, MD  21801

The United States Statement of Cash Flows

Abstract

Financial statements in the 1800’s reported the results of operations at the end of each month or year.  Neither the balance sheet nor the income statement provided the statement user with detailed facts desired for decision making.

A financial report designed to provide the statement user with detailed facts concerning the source and use of funds was first presented in 1893.

The paper identifies how this simple 1893 funds report became the United States Statement of Cash Flows.

Historically, financial statements developed in response to the need to provide information to outside interest groups concerning the impact of management on the income stream.  The basic financial statements are (1) the balance sheet, (2) the income statement, (3) the retained earnings statement, and (4) the statement of cash flows.

            The balance sheet  shows  a financial picture of an organization at a specific point in time.  In essence the statement reports  aggregates—it does not show transaction details.^I

When comparative balance sheets showing the balances at the beginning and end of the period are presented, the statement users can reconstruct some of the details; however, they cannot ordinarily identify whether changes in assets and liabilities resulted from profitable operations, new equity, or from using assets to pay debts, acquire other assets or make distributions.

The Retained Earnings Statement presents net income and items such as dividends and adjustments of the net income of prior periods.  The income statement presents the results of the firm’s profit directed activities for the period in terms of revenue, expenses, gains and losses; however, neither the balance sheet, the income statement, nor the retained earnings statement show in detail the significant transactions which were entered into during the period to finance the firm.

Accountants were aware that the balance sheet, income and retained earnings statement did not provide statement users with all of the relevant facts desired for efficient decision making.  A statement specifically designed to provide information concerning the source and utilization of resources came to be included as part of the financial reports of many firms on an optional basis.

The first funds statement which showed changes in all balance sheet accounts was presented in a financial report of the Missouri Pacific Railway, entitled Statement Showing Resources and Their Application During the year 1893.²

The first textbook to recommend the preparation of a statement reporting the sources and uses of funds was written in 1908 by Harvard University professor William Moore Cole and entitled  Accounts, their Construction and Interpretation.³  Cole classified all balance sheet accounts as “where got” (source) and “where gone”  (uses).  He regarded the statement as useful for forecasting bankruptcies and not as a means of providing supplementary information to the balance sheet.⁴

Funds statements emphasizing changes in working capital were introduced in the 1920’s primarily through the efforts of H. A. Finney who, as the author of a leading textbook and the editor of the “Student Department” of the Journal of Accountancy, was able to influence current accounting thought toward the adoption of a major statement which showed the causes of changes in working capital.⁵

During the 1950’s and 1960’s a favorite issue for accounting debate was the concept of funds which should be used in preparing funds statements.  Among the many views debated the two most popular issues were that (1) the function of the funds statement was to report changes in solvency but that a cash or near cash funds concept was more appropriate than working capital, and (2) the purpose of the funds statement was not to report changes in solvency but to explain changes in all balance sheet accounts.⁶

In 1961 the American Institute of Certified Public Accountants published what may be considered as the first major research on the funds statement entitled, Accounting Research Study Number 2.  This study concluded that (1) funds should be defined as purchasing or spending power resulting from external transactions, (2) the funds statement should report all changes in financial position, and (3) the funds statement should be a major financial statement included in all corporate annual reports.⁷               

After the Accounting Research Studies were adequately circulated and a consensus watch for, the Accounting Principles Board in October 1963, issued the first official pronouncement on the funds statement entitled Opinion No. 3, “The Statement of Source and Application of Funds.”

The pronouncement recommended that a funds statement be included in corporate annual reports as supplementary information.⁸

Probably the most important contribution of APB Opinion 3 was that it recognized the need for furnishing statement users with supplementary information concerning all the financial resources of the firm, thereby providing a basis for the later development of Accounting Principles Board Opinion No. 19 (APB Opinion 19).⁹

APB Opinion No. 19 was the second major United States pronouncement on funds statements.  It superseded APB Opinion 3 and made it mandatory for all firms to present a statement of changes in financial position as a basic financial statement for all periods in which both the balance sheet and the income statement are presented.

            Four different fund concepts are mentioned approvingly by the Board in Opinion 19: cash, cash and temporary investments combined,all quick assets, and working capital , but only working capital and cash or its equivalent was given more than passing note.

 A traditional funds flow statement prepared under Opinion 19 is shown in Example I.¹⁰

Example I   Statement of Changes in Financial Position

(Working Capital Format)

Statement of Changes in Financial Position

For Year Ended December 31, XXXX

Source of Working Capital:

   Operations during the year:

         Income exclusive of extraordinary item   $XXXXX

         Add items not decreasing working

         capital during the year:                                           XXXXX

              Depreciation                                                              XXXXX             

        Sale of investments                                                         XXXXX

        Issuance of common stock at par for land                   XXXXX          $XXXXX

Application of Working Capital:

    Purchase of equipment                                                   $XX,XXX

    Purchase of land by issuance of common

    stock at par                                                                       $XX,XXX

    Retirement of bonds payable                                         $XX,XXX

    Declaration of cash dividends                                       $XX,XXX              $XX,XXX

Increase in working capital                                                                 $XX,XXX

            The foregoing type of funds statement was presented by all corporations that were required to prepare  a complete set of financial reports during the years 1972-1987.

            In the early 1980’s the debt load of many companies increased significantly so that the risk of financial insolvency accelerated.  Investors became increasingly concerned that the variety of accounting methods resulted in a net income figure which was not an accurate indicator of the earning power of the company.  The financial community became increasingly concerned that the financial statements prepared under accrual accounting were becoming distant from the actual cash flows of the firm.  The funds statement was criticized because it used the net income figure which was already suspect and in addition the statement did not consider the impact of inflation so that it was obvious that the funds statement could not accurately reflect the firms actual earning ability.

            In 1981 the Financial Executive Institute suggested that the working capital basis for the preparation of funds statements be replaced by cash flow.  In 1984 the Financial Accounting Standards Board recommended a cash flow statement in its concepts statement No. 5.  Finally, in 1987 the Financial Accounting Standards Board issued Standard No. 95 “Statement of Cash Flows” which required all funds statements prepared after July 15, 1988 to use a cash flow format.¹¹

            Cash flow was considered a more reliable indicator of the firm’s actual earning power because it more accurately reflects the financial flexibility and  near term liquidity of the firm which makes cash flow a more useful measure to use in evaluating the firms stability and performance.

            The primary purpose of the cash flow statement is to provide information on cash receipts, cash payments and net changes in the cash balance, classified into the following major categories:  (1) cash from operating activities; (2)  cash from investing activities, and (3) cash from financing activities.  The statement may use a direct method or indirect method as illustrated in the following examples II and III.

Example II Cash Flow Statement (Direct Method)

Statement of Cash Flows

For Month Ended December 31, XXXX

Cash flows from operating activities:

     Cash received from customers                                      $XX,XXX

     Deduct cash payments for expenses

     and  payments to creditors                                            $XX,XXX

     Net cash flow from operating activities                       $XX,XXX

Cash flows from investing activities:

     Cash payments for acquisition of land                        (XX,XXX)

Cash flows from financing activities:

      Cash received from sale of capital stock                    $XX,XXX

      Net cash flows and Dec. 31, XXXX cash Balance                                    $XX,XXX

 

Example III  Cash Flow Statement (Indirect Method)

Statement of Cash Flows

For Month Ended December 31, 19XX

Cash flows from operating activities:

     Net income, per income statement                               $XX.XXX

     Add increase in accounts payable                               $XX,XXX

                                                                                                $XX,XXX

     Deduct increase in supplies                                          $XX,XXX

     Net cash flow from operating activities                       $XX,XXX

Cash flows from investing activities:

     Cash payments for acquisition of land                        (XX,XXX)

Cash flows from financing activities:

      Cash received from sale of capital stock                    $XX,XXX

Net cash flows and Dec. 31, 19XX cash balance            $XX,XXX

                The direct method reports operating activities in terms of changes in income statement accounts whereas the indirect method reports operating activities in terms of balance sheet accounts.  Regardless of which method is used the operating activities section includes activities that relate to the firms normal operating transactions not classified as investing or financing.  The investing activities section involves the purchases and sales of productive plant assets or loans to outside firms.  Financing activities involve borrowing or repaying loans and transactions with owners.

Conclusions and Implications

            The cash flow statement now more accurately answers the following questions:

1.                  What were the sources of cash during the period?

2.                  How was the cash used during the period?

3.                  What is the current cash balance and did it increase or decrease during the period? 

The cash flow statement provides the potential investor with a more effective measure to determine the liquidity and financial flexibility of the firm which should enhance the investment process by facilitating decision making.

The cash flow statement could be modified to enhance its usefulness for decision making.  For example, Reporting Cash Provided From Operating Activities ignores the fact that the company usually invests in new fixed assets just to maintain its competitive position and current investors expect a current level of dividends so cash from operating activities is not entirely available to expand the business.   Free Cash Flow would be cash available for new expansion such as:

Cash Provided by Operations                                       XXX

Less:    Normal Planned Capital Expenditures      XX

Less:    Normal Expected Dividends                                 XX

            = Free Cash Flow Available for Expansion            XX

Liquidity and Solvency Ratios could be provided using data from the cash flow statement rather than the income statement such as the Debt Coverage Ratio.    The investment section could indicate whether it was asset replacement, acquisition of new capacity or the expansion into a new product line.¹²  The statement could provide the statement users with a summary of managements expectations concerning capital resource allocation and expected future cash flow. 

The increase in world trade has stimulated the demand for “a level playing field”.   The cash flow statement has the potential to provide the essential linkage between the United States financial statements and those in other countries thereby enhancing the worldwide process of international trade and worldwide investment. .

NOTES

¹American Institute of Certified Public Accountants, APB Statement No. 4, reprinted (Chicago:  Commerce Clearing House, p. 442).

²L. S. Rosen and Don T. DeCoster, “Funds’ Statements:  A Historical Perspective”,  The Accounting Review, (January 1969), p. 125.

³Karl Kafer and V. K. Zimmerman, “Notes on the Evolution of the Statement of Sources and Application of Funds”, The International Journal of Accounting (Spring 1967), p. 91.

            ⁴Loyd C. Heath, “Financial Reporting and the Evaluation of Solvency”,  Accounting Research Monograph 3, (New York:  AICPA, 1978), p. 88.

            ⁵Earl Richard Brownlee II, An Investigation and Analysis of the Usefulness of the Statement of Changes in Financial Position to Selected Users of Corporate Financial Information, (Ph.D. dissertation, Georgia State University, 1975), p. 29.

            ⁶Loyd C. Heath, Accounting Research Monograph 3, p. 91.

            ⁷Perry Mason, “Cash Flow Analysis and the Funds Statement”,  Accounting Research Study No. 2 (New York:  American Institute of Certified Public Accountants, 1961), p. 91.

            ⁸Patrick S. Kemp, “Reporting Changes in Financial Position—Interpretation and Evaluation”, The New York Certified Public Accountant (August 1971), p. 559.

            ⁹Joseph R. Oliver, “The Statement of Changes in Financial Position”, The National Public Accountant (August 1972), p. 22.

            ¹⁰Accounting Principles Board Opinion No. 19.  “Reporting Changes in Financial Position”.  American Institute of Certified Public Accountants (1971), p. 5.

            ¹¹Fiancial Accounting Standards Board, Standard No. 95.  Statement of Cash Flows.  1987, pp. 1-5.

            ¹²Kimmel, Weygandt, Kieso, Financial Accounting Tools for Decision Making, 4^th edition, 2007, John Wiley & Sons, Inc., pp. 605-607.