DRAFT
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Statement
of Cash Flows
Hypothesis to
Presentation method
Introduction
Currently, the U.S. GAAP
requires the methodology of the Statement of Cash Flows (SCF) to be based on
"strict set" theory: cash flows events (CFEs) are each classified as exclusively either a
result of Operation, Investing or Financing activities. In itself these
classifications are valid as they represent a dimension of the generic
organizational structure of business entities today.
However, the SCF and the
embodied CFEs lack comprehension in the utility to the user, especially in
light of the complexity of instrument available to management of organization
that can lead to distorted reporting. Although misreporting may be done
intentionally to manipulate figures, even under the best of conditions the
application of GAAP to a variety of activities may be inconsistent between
companies, because of the required use of judgment in determining the class of
an event.
For example, retirement of
secured bonds, either on a timely or premature basis may initially seem a
financing activity because the issue of a bond is a financing activity.
However, the release of the attachment of a secured asset, falls under
"operation" or perhaps "investing", depending on the exact
terms of the bond and the most likely effect of the bond on the company's asset
liquidity. Currently, such classifications are left to the discretion of
managers or the professional judgment of the engaged practitioner.
This hypothesis proposes a
multi-dimensional concept whereby cash flow events are classified according to
the degree of membership of the event in the three traditional sets: Operation,
Investing, Financing.
Regardless of the "true
answer" to any particular circumstances, increasingly the easy yet simple
framework is too weak to hold the definitions of modern business activities.
Additional dimensions are needed to make the presentation of the SCF and its
underlying CFEs, more consistent and thus more useful to the user. Currently, a
cash flow event is classified on a simplistic, single dimension, which provides
incomplete information about the essence of the underlying transactions. A
multi-dimension presentation can enhance the utility of the SCF by disclosing
more of the nature of the CFEs, not necessarily by providing more detail, but
by providing a degree of relationship to the three general areas in the SCF.
Enter the 2nd and 3rd
dimensions...
In reality, a CFE can belong
to any of three general areas of the SCF. Currently, the managers or the
accountant must choose the lesser of all evils when determining the to which
general class a particular CFE "most" belongs. However, such a choice
by it nature distorts the presentation of the underlying transaction. What this
hypothesis offers is a breakup of the "all or nothing" framework. As
such, a CFE can be essentially allocated between the three, using elements of
set theory known as "Fuzzy Logic".
To some this might feel a lot
like applying a weight to balance, and aggregating to results. In fact there
are some general differences in how these "weights" are used in
certain computations, because they are not
actually weights. Suffice it to say, thought that they represent degrees of
membership of an event to a class of cash-flow events (more about this
difference in the example below).
Fuzzy Logic, mocked by some
politicians as a "feel good" math, deserves a more serious look by
practitioners. In practice Fuzzy Logic is a common sense mathematical concept
of relating members to a group; in this case, relating CFEs to the general
areas of the SCF.
In its purest form, the
traditional set theory is a "crisp
logic" theory. Under the crisp-logic doctrine, a member
belongs to a set, or the member does not belong to a set, and there is no
middle ground. However, crisp-logic might be seen as a special case of the
"fuzzy logic"
framework. Under the latter, a member of a set belongs to the set to a degree
between 0.0 and 1.0. Thus, crisp-logic is just a special case of fuzzy logic.
In crisp logic, a set or sets exist where members have only 0.0 or 1.0 level of
membership.
SCF: Second Dimension
For example, an operational
activity such as "Sales Revenues" is typically a crisp-logic event.
It is 1.0 member of the "Cash from Operation" set, and is 0.0 for the
other two sets. However, in reference to the secured bond example above, a
retirement of bond as a CFE may be considered for example a 0.4 membership in
"Cash from Operation" and 0.6 as an event of "Cash from
Financing".
Example:
|
|
Strong
Membership 0.8-1.0 |
Moderate
Membership 0.3-0.7 |
Weak
membership 0.0-0.2 |
|
Operations |
Revenue
from Sales |
|
Bond
Retirement |
|
Investing |
|
Certain
Equity Instruments |
Revenue
from Sales |
|
Financing |
Bond
Retirement |
Certain
Equity Instruments |
Revenue
from Sales |
The table above can help
classify each CFEs into the three SCF classes with a degree of membership in
all three.
Third Dimension:
The reason for the SCF's
birth is to provide primarily for the question of 'going concern', or the
ability of an entity to continue its operations and viability within a
foreseeable period of time, typically defined as twelve months.
In light of the definition of
the objective of the SCF, the objective of predicting "going concern"
can be mostly achieved if the effects of CFEs can be measured and reported in
terms of their timing. For example, a replacement sale and purchase of a fixed
asset such as a plant or major equipment is an event that has a timing effect
of typically one year. Thus, gain or losses from a capital exchange can be
generalized to "short term" CFEs. By contrast, amortization of
goodwill from purchase of a subsidiary, currently done over 20 years from
inception, is added back to the Net Income to produce the SCF. Amortization can
be generalized as a "Long Term" CFEs.
Example:
|
|
Short
Term |
Long
Term |
|
Operations |
Revenue
from Sales |
In
Flow from Long Term Commitment |
|
Investing |
Gain
on Asset Disposal |
Amortization
(add back) of Goodwill |
|
Financing |
Bond
Retirement |
Certain
Equity Instruments |
The table above can help
classify each CFE into the three SCF classes with either long- or short-term
effect on the company's financial position.
Hypothesis
The prime objective of the
SCF is the projective nature it embodies to the user. In other words, the
utility of the SCF is measured by its ability to convey to the user a
projection of future event. The SCF was called for, and should be designed
appropriately to meet this objective.
The current single dimension
of the SCF can be supplemented by additional dimension by further classifying
CFEs on either a degree-of-membership scale or timing-effect scale, or both.
Graphically, the last proposition is of course not easy to present. But at
least in theory, it should be the most effective way to communicate the
projected timing and nature effects of the various CFEs on the financial
position of a company as of the end of its financial reporting period.
The underlying assumption to
this hypothesis is that an efficient market place will be able to make use of
this information. It is further assumed that the cost of accounting for these
additional dimension will be lower, possibly much lower, than the expected
benefits.
Example
1D
Presentation
|
Operating |
|
Cash Revenues |
$1,000
|
|
Investing |
|
|
Bond Retirement |
600
|
|
Financing |
|
|
Sale of Intangible |
400
|
|
TOTAL |
$
2,000 |
In the 1D example, a crisp
logic method is used. This poses difficulty in properly placing and presenting
some transaction. If the sale of intangible asset in the example above relates
to a specific patent for the production of Widgets, a case can be made as to
the inclusion of some or all of the transaction's balance in "Cash from
Operation". Similarly, if the bond retirement transaction is in essence a
convertible bond or debt on operating assets, a case can be made to the effect
of the transaction on financing or operating cash flow, respectively.
2D
Prsentation
|
Operating
|
Investing
|
Financing
|
||
|
Operating |
||||
|
Cash Revenues |
$1,000
|
1.00
|
-
|
-
|
|
Investing |
||||
|
Bond Retirement |
600
|
-
|
0.60
|
0.40
|
|
Financing |
||||
|
Sale of Intangible |
400
|
0.20
|
-
|
0.80
|
|
TOTAL |
$
2,000 |
1,080
|
360 |
560 |
In the 2D example some of the
issues from the 1D example are resolved. The Sale of intangible in this
particular situation is shown to be mostly relates to financing but has some
bearing on operation. However, this is not an "allocation" per-se: if
the 2D were to "collapse" into a 1D form, the 0.80 would command the
inclusion of all of the transaction's balance in the Financing section,
because fuzzy logic uses "min/max" instead of "and/or", as
in crisp logic.
3D
Prsentation
|
Short Term |
Long Term |
||||||
|
Operating
|
Investing
|
Financing
|
Operating
|
Investing
|
Financing
|
||
|
Operating |
|||||||
|
Revenues |
$1,000
|
1.00
|
-
|
-
|
-
|
-
|
-
|
|
Investing |
|||||||
|
Bond Retirement |
600
|
-
|
0.10
|
0.20
|
-
|
0.50
|
0.20
|
|
Financing |
|||||||
|
Sale of Intangible |
400
|
0.20
|
-
|
-
|
-
|
-
|
0.80
|
|
TOTAL
|
$2,000
|
1,080
|
60
|
120
|
-
|
300
|
360
|
In the 3D example, a new
dimension is introduced above and beyond the weighted "allocation" of
the transactions among the three general areas. In this dimension, not only the
underlying nature of the transaction disclosed, but also the time effect. In
this example, the disclosure shows that the retirement of bonds is not only
"allocated" between investing and financing, as in the 2D example,
but that the CFE's 0.60 membership in the Investing area, is really broken down
between 0.10 of short term and 0.50 of long term. The 3D presentation includes
additional disclosure; the 2D presentation simply presents the transaction in
its proper place.
DRAFT
Fall
2001 Revised May 2002 ©
Reproduction of this article without
the written consent of the author is prohibited
Yigal Rechtman