Direct and Indirect Methods of Reporting Cash Flows from Operating Activities

According to FRS 1, cash flows from operations are those generated by operating and

trading activities. Cash flows with respect to provisions are also included in the cash flows from operations. In addition, dividends received from equity accounted firms are considered as the cash flows from operations where the results are included as part of operating profits. FRS 1 allows firms to present operating cash flows using either the

direct or indirect method, but the preference is for the indirect method, which is the most common method of presenting cash flows from operating activities in practice.

Under the indirect method, operating cash flow is calculated by adjusting the operating profit reported in the profit and loss accounts for any non-cash items in the income statement. FRS 1 provides an illustrative format for the reconciliation of

operating profit to net cash inflow from operating activities (see Table 2.3).

Table 2.3

Reconciliation of Operating Profit to Net Cash Inflow from Operating Activities (FRS 1 Format) Operating profit xx Depreciation charges xx Increase in stocks xx Increase in debtors xx Increase in creditors xx

Net cash from operating activities xx

With regard to the direct method, there is no illustration under FRS 1, but there

is under IAS 7. Here, the indirect method starts with the reported profit before tax. In

fact, in practice, UK firms have used different starting points to calculate cash flows from operating activities; for instance, before 2005 they used operating profit, and since then some of them have used operating profit before tax and others net income as a starting point in the reconciliation. Under the direct method, the operating cash flow is shown as the gross cash receipts less the gross cash payments. Theillustrative format in

IAS 7 refers to this subtotal as „cash generated from operations‟ (see Table 2.4).

Table 2.4

Cash Flows from Operating Activities (IAS 7 Format)

Cash receipts from the sale of goods and services xx

Cash payments to suppliers xx

Cash payments to and on behalf of employees xx

Cash generated from operations xx

Interest paid xx

Income taxes paid xx

Net cash from operating activities xx

Whilst the IASB recommends that firms report operating cash flows under the direct method, under FRS 1 firms have the choice to use the direct method or the

indirect method, although the ASB prefers the indirect method. The main advantages of the indirect method over the direct method are that the cost of implementing it is lower and that it indicates the difference between earnings and cash flow from operations. The main advantage of the direct method is that it is more easily understandable by users who wish to know how cash flow has been generated, and it allows a better comparison.

In theory, the results of using either the direct or the indirect method to compute cash flows from operating activities should be the same. However, there is an argument with respect to the greater usefulness of the direct method. As mentioned in the previous section, the discussion in IAS 7 suggests that the indirect method does not provide the

necessary disaggregated information required to predict future cash flows, and the CFA Institute (2007) calls for the disclosure of the direct cash flow computation, again to facilitate the prediction of future cash flows.

Two recent studies that have investigated the role of the direct method in predicting future cash flows and earnings have been motivated by the FASB, IASB and CFA Institute comments discussed above (Orpurt and Zang, 2009, and Arthur et al, 2010).

Orpurt and Zang (2009) investigate the predictive ability of the direct method of cash flow disclosure in predicting both future cash flow and future earnings, extending Barth et al (2001) and Cheng and Hollie (2008). Regarding the FASB, IASB and CFA institute‟s comments with respect to the usefulness of the direct method of cash flow information to users, these authors point out that computing cash flow using this method is still not necessarily reliable. They provide evidence of the articulation errors that may occur when the Balance Sheet and Income Statement are used to compute the cash flow of US companies using the direct method, by comparison with the direct cash flow published by small numbers of these companies. They also examine the effect of adding

these articulation errors to models of future cash flows. Using the published cash flow, they find that adding articulation errors improves the predictive ability of models and conclude that the direct method of cash flow statements enhances the prediction of future cash flows.

Using annual Australian data, Arthur et al (2010) investigate the ability of the decomposition of cash flow from operations to predict future earnings, again using the direct method. They argue that disaggregated cash flows with accruals provide helpful information in predicting future earnings, and partition the components of cash flows into core and non-core cash flows components - they use the classifications suggested in

IAS 7 and consider cash generated from operations as the core operating cash flows.

They conclude that the disclosure of the components of the direct method cash flow from operations is informative with regard to the prediction of future earnings.

With regard to the UK, however, it should be noted that there is no information in commercial databases at present regarding the use of the direct method by UK firms. Therefore, this study is restricted to Statement of Cash Flows data based on the indirect method.