Statement of cash flows: the direct vs. indirect method debate continues.

• Author: Smith, G. Robert, Jr.

A survey of finance officers reveals their preferences concerning the method to be used in preparing the statement of cash flows and the reasons why.

The Governmental Accounting Standards Board (GASB) recently issued its preliminary views (PV) Governmental Financial Reporting Model: Core Financial Statements. This PV sparked an interesting and hotly contested debate on the future preparation of governmental financial statements. In what may be one of the more controversial positions taken in the PV, the GASB proposes to require presentation of the statement of cash flows (SCF) for proprietary funds using the direct method. The board uses as part of the justification for this position previously unpublished research by G. Robert Smith, one of the authors of this article. The results of that research are discussed in this article, and the authors encourage the GASB to consider going beyond the SCF reporting requirements proposed in the PV.

The Research

Three hundred finance directors from cities and counties throughout the United States were randomly selected to participate in a summer of 1993 survey of statement of cash flows reporting practices and preferences. The finance directors were selected from cities with a population of more than 50,000 and from counties with a population of more than 100,000. One hundred twenty-six responses were received for a response rate of 42 percent, which is excellent for this type of research.

As a part of the survey, the finance directors were asked to assess which method of preparing the SCF - the direct method or the indirect method - best presents operating cash flow information. Exhibit 1 shows the description of each method given to the finance officers, which includes an explanation that current generally accepted accounting principles (GAAP) require the preparation of a reconciliation of operating income to net cash flows from operating activities whenever the direct method is used. Because the goal of the survey was to test the direct method and the indirect method individually, however, the finance directors were instructed to ignore the reconciliation requirement and to examine the two methods independently. In addition to the discussion of current GAAP, two cash flows from operating activities schedules were presented - one for each method.

Finance directors were asked to select the method - direct or indirect - that best supports each of the five objectives for evaluating the operating activities section of the SCF that are listed below:

1) presents the best information about "operating" cash flows (quality),

2) use does not require presentation of other financial statements (stand alone),

3) language requires little expertise in accounting to understand (understandable),

4) most clearly presents the results of cash flows from operations (clarity), and

5) does not present unnecessary information about "operating" cash flows (brevity).

The finance directors then were asked to indicate the degree of preference for each selection on a scale of one to four.

Responses for Each Objective

Exhibit 2 presents the finance directors' preferences between the direct and indirect SCF method for each of the five objectives.

Objective #1: Quality. In evaluating the "quality" objective, each finance director was asked whether the direct method or indirect method best presents information about operating cash flows. An often-debated SCF issue is which format best reports cash flow information that is not available in other financial statements. The direct method uses terms that are similar to but not the same as terms in other financial statements. For example, "other operating revenues" also may be found in the operating statement. In the operating statement, the amount represents what was earned as measured by the accrual basis of accounting. In the SCF, however, the amount reported is the amount of cash received from this source. Other terms, such as "cash received from customers' and "cash paid to employees," are unique to the SCF.

The indirect method uses many of the same account titles found in other financial statements, but these similarities could confuse some users examining the SCF. For example, the SCF operating section begins with "operating income" and "depreciation." Both of these line titles are in the operating statement. Depreciation is added back to operating income on the SCF, whereas it is a deduction in the operating statement. The "changes in assets and liabilities" subsection presents the increases and decreases in the current asset and current liability accounts, which also are reported in a comparative balance sheet.

The responses presented in Exhibit 2 indicate that most finance directors - by more than a...