I have been diving in to the FASB’s (and IASB’s) newly-energized discussions on cash flow reporting.  One of the most contentious aspects of the issue is that users want direct cash flow data that reports the inflows and outflows, broken down by the function and nature of the spending.  For example, is that cash outflow part of the cost of goods sold or an administrative expense?  Is it for labor or the leasing of fixed assets?  The comment letter of the Investors Technical Advisory Council is pretty typical of the user view:

“[D]isaggregation by nature provides the most relevant information for financial decision-making. As the DP itself recognizes, disaggregation by nature better reflects the economic drivers and provides information investors need to evaluate risks and trends and to better assess the amounts, timing, and riskiness of a company’s future cash flows.”

Preparers argue that providing such information would be prohibitively expensive, because internal bookkeeping and reporting systems are not typically devised to provide this information.  A comment letter from the Institute of Management Accountants goes even further, arguing that the high cost of changing systems also proves that the information would not be useful to users.  From the letter:

“It is important to note that management is generally not generating or utilizing direct cash flow data to run their businesses. They rely primarily on operating earnings metrics, supplemented by balance sheet metrics and cash flow data generated through the use of indirect-method processes. Companies have spent millions of dollars designing and installing financial systems to gather this data. If management felt additional cash flow granularity was an important information component for understanding and running the business, they would have already made choices to invest in this or similar capabilities. Therefore, we question the necessity of this detail and the value it would provide for outside investors.”

I have heard many times that FASB staff and Board members are skeptical of preparers’ views of what users do or should find useful.  After all, users are in a much better position to judge their own information needs.  However, this argument seems to have more merit, as it isn’t simply cheap talk – preparers are putting their money where their mouths are.  But is the interpretation so simple?  Some observations:

  • The foundation of principal-agent theory is that managers’ objectives differ from the objectives of those that hire them (the stockholders).  So clearly the IMA argument is not the end of the story.
  • On the other hand, the existence of some moral hazard doesn’t completely kill the argument — stockholders implement incentive schemes to align managers’ and shareholders’ objectives (albeit imperfectly).  To the extent that reporting serves a stewardship function (influencing managers’ actions) rather than purely a capital allocation function, I think the argument is reasonably persuasive unless we believe that moral hazard problems are very severe.
  • However, if we ignore the stewardship function of reporting, there might be a completely different counterargument. Even if there were no moral hazard issues, and managers and investors’ interests were perfectly aligned, it might still be that the information useful in running a business is simply different from the information useful in valuing a business.

There must be some literature on this topic … any insights would be greatly appreciated!

Rob