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Cash is king, even when it comes to validating a company's financial performance. While an income statement helps users evaluate a company's financial performance, there is a need to cross-validate this through cash flows. After all, a business that earns income but does not generate sufficient cash is doomed.
If cash is that important, are we exerting the right effort in making cash flow information more understandable?
IAS 7 Statement of Cash Flows allows preparers to use either the direct method or the indirect method to report cash flows from operating activities. Under the direct method, the preparer presents major sources of gross receipts and gross payments. In contrast, under the indirect method, the preparer derives the cash flow amount by considering the effects of non-cash transactions, working capital, and investing and financing activities on profit or loss (or operating profit, if IFRS 18—the new presentation and disclosure standard—has been adopted).
Cash flows from operating activities reported using the direct method are easier to comprehend. Despite this, some preparers still use the indirect method in reporting cash flows from operating activities. This is not a mortal sin, but it would be worth considering a shift to the direct method to make cash flow information easier to understand—especially since IAS 7 itself encourages preparers to use the direct method.
Beware, however: since the choice of method is an accounting policy option, a subsequent change of mind comes with implications. Transitioning from the indirect method to the direct method is considered an accounting policy change and must be accounted for retrospectively, among other implications. [Click here to access previously released article on Why growing companies must think twice before choosing an accounting option.]
A shout-out to new, growing companies that have yet to prepare their first statement of cash flows—please consider using the direct method in presenting cash flows from operating activities.
If you're navigating growth and need finance function guidance, contact VMC.
VMC's views are general insights—not one-size-fits-all advice. Every company's situation is unique.
