It’s hard to read through the Financial Accountant Standard’s Board latest update on recognizing credit losses, which dictates a new method called current expected credit losses (CECL), and not think, should we just go back to cash accounting? The update requires companies to recognize all expected losses over the life of an asset at the time of purchase or origination. Prior to this, the codification dictated companies recognize probable current losses on those assets. The update is a response to the lack of sufficient loss reserves financial institutions had on their balance sheets prior to the financial crisis of 2007.
This codification adds another layer of judgmental inputs to the complex fair value calculations companies must perform in order to be compliant with GAAP. Although the justification is that CECL more accurately represents the true value of a company’s assets, the future value is based on what we know today, which will be different from what we know tomorrow. Sure, you could make that argument about any line item on the financials, but fair value allows you to recognize material non-cash earnings before they are realized, which is unique.
Here is where the cash flow statement comes in. Looking at cash inflows and outflows year over year provides meaningful analysis without the timing intricacies and judgement of GAAP. The three main sections tell you the following: how much cash the company generated from their main operations, net of the cash required to operate; how much cash the company used to invest in growth (or to scale back); and how much cash the company needed in order to finance its operations. What else do you need to know?
The cash flow statement also tells you everything about what I just condoned. Since it reconciles to the income statement, you can see how much assets have appreciated or depreciated over time. Year over year comparisons in the worth of a company’s assets is more meaningful than one period of judgmental calculations.
Of course it’s always best to look at all four financial statements together, hence why all four are required by regulators. But if I’m stranded on a desert island and can only have one financial statement – Cash is King.