Of all the recent financial-reporting reforms, Securities and Exchange Commission chief accountant Donald Nicolaisen thinks the most important has yet to be proposed: requiring companies to use the direct method to report their cash flow.
At a November conference hosted by Financial Executives International, Nicolaisen said that despite Sarbanes-Oxley and the slew of new rules issued by the Financial Accounting Standards Board, corporate efforts to improve reporting have "fallen far short" of his expectations. "The single thing in my view that would go furthest toward improving disclosure," he said, would be to mandate direct-method accounting.
The direct method calculates operating cash flow as a product of actual cash flows in and out—collections from customers, cash payments to suppliers, and so on. The indirect method, by contrast, arrives at that figure by adjusting net income for noncash expenses (such as depreciation and amortization), accruals, deferrals, and changes in working-capital accounts. Although both produce the same number, "the indirect method can hide a multitude of sins," says Charles Mulford, an accounting professor at the Georgia Institute of Technology.
Still, the indirect method has always been the method of choice for most companies. Back in 1987, when FAS 95 established standards for cash-flow reporting, FASB left the indirect method as an alternative, bowing to corporate concerns about the expense of tracking all cash items, recalls Grant Thornton CEO Ed Nusbaum. And since companies using the direct method must provide a reconciliation to net income using the indirect method anyway, says Mulford, it's no surprise that most simply continued to use the latter.
To date, Nicolaisen has never directly suggested that the SEC or FASB change the requirement. At the November conference, however, he did remark that "the status quo is not acceptable" and "there's more that we have to do." The question then, says Nusbaum, who is also a member of FASB's advisory council, is whether analysts and other financial-statement users really want to make the change.
Still, the cash-flow methods may soon find their way to the table. "This is a back-burner item that is slowly moving forward," says Mulford.