IN Chapter 5 Segmented Funds Statements IN THE PRECEDING CHAPTERS, we proposed a plan for segmenting a corporation's income statement so that it would reveal data that investors could use to estimate the future growth of company earnings. Other financial statements than the income statement can also provide data that will assist the investor in forming a judgment of these growth rates. Specifically, the source and application of funds statement represents a potentially valuable source of data to the investor in a diversified firm. Segmented funds statements can provide an understanding of the firm's economic affairs which is not directly available from an examination of its balance sheet and income statement. There are several reasons for this. First, a segmented funds statement would give the investor a basis for evaluating the correspondence between earnings growth and management's deployment of funds among segments. Secondly, a segmented funds statement would provide the investor with a framework for estimating a company's future capital requirements. Finally, we believe that a segmented funds statement can help the investor estimate the productivity of capital that is employed in the various growth rate segments. Early Funds Statements According to Anton,1 today's funds statements evolved from Cole's original "where got" "where gone" statement published in 1915. Over the years, both the form and content of funds statements have gradually evolved toward the statements now commonly appearing in annual reports. The dramatic rise in the presentation of funds statements in annual reports in recent years is in large measure attributable to Opinion Number 3 of the Accounting Principles Board, issued in October, 1963. 1 Hector R. Anton, Accounting for the Flow of Funds, Boston: Houghton Mifflin Company, 1962, pp. 46-47. 37 While stating that the inclusion of funds statements is not mandatory, the Board did strongly recommend that funds statements be presented as supplementary information in financial reports. This recommendation, in turn, received the endorsement of the major stock exchanges. The impact of this support for funds statements can be gleaned from the following statistics taken from the American Institute of Certified Public Accountants annual survey of the annual reports of 600 industrial and commercial corporations, Accounting Trends & Techniques (1968 edition): Interestingly, in 1955 only 124 companies or 21% of the surveyed companies presented funds statements. The concept of “funds" used in funds statements has varied in practice. Although the most common definition of "funds" is working capital, other approaches such as cash, cash and marketable securities, quick assets, and all financial resources have also appeared in corporate annual reports.2 Traditional funds statements have been criticized in the past because of their narrow definition of funds. Thus, a definition of funds such as cash and working capital means that transactions not directly affecting these accounts are excluded from the statement. Since there may be significant transactions of this type, a broader view of funds suggested by the term "all financial resources" is required. For example, if one of the narrower concepts of funds is used, acquisitions in exchange for common stock, bonds and various convertible securities are not disclosed in the funds statements. These are, however, important sources of financing for acquisition minded companies.3 2 Illustrations can be found in Perry Mason, "Cash Flow" Analysis and the Funds Statement, Accounting Research Study 2, New York: American Institute of Certified Public Accountants, 1961, and in Cash Flow Analysis for Managerial Control, Research Report 38, National Association of Accountants, 1961. 3 While some observers have suggested that financial changes such as the conversion of debentures or preferred stock into common stock also be reflected on the funds statement, we favor separate disclosure of such transactions. This view is based on the notion that the extent of detailed disclosure required for changes within debt and equity accounts would in many cases make the funds statement unnecessarily cumbersome and consequently would detract from the significance of other important disclosures in the statement. A second criticism can also be levied against the traditional funds statement. This is that the traditional funds statement, like the traditional income statement, does not provide the investor of a diversified firm with any information on the "basic activities" for which funds are expended. Thus, the traditional statement would reveal that total capital outlays were x dollars. However, no information would be provided, except perhaps in the text of the annual report, as to whether the funds were expended to support activities in industry A or industry B. Moreover, the traditional statement does not reveal which activities of the company were net suppliers of funds and which were net users. Investors interested in the growth of earnings and dividends of a company can properly ask the following important questions: (1) Is the company committing its funds primarily to high-growth potential activities, or are the funds being deployed to support lowgrowth activities? (2) Are there major low-growth activities that constitute a significant drain on corporate funds? (3) What is the productivity of the funds that are invested in the various segments? (4) Based upon the best estimates of sources and uses of funds during the next year or two, will the company require external financing? (5) Based upon estimates of earnings and capital requirements during the next few years, what changes in dividend rates can be expected? A basis for answering these questions may be gained from an analysis of segmented funds statements. A Segmented Funds Statement To meet the criticisms of the traditional funds statement that were discussed above, we propose that a new source and application of funds statement be developed. This statement should be designed to better meet the investor's needs for estimating the future growth of the company. Such a statement can be developed if sources and applications are segmented by the growth rate of different basic activities. The proposed statement is presented as Exhibit 5-1. This statement makes use of the same earnings contribution growth rate intervals established in Chapter III. Thus the column headings, 0-5%, 5-10%, and 10-15% correspond with the intervals in Exhibit 3-3. While the proposed funds statement is segmented by growth-rate categories, recall that the "basic activities" within each growth-rate segment are disclosed in the "Basic Activities" Index (See Exhibit 3-3). For example, we know that the "basic activity" components of the *Expensed development costs not included in "capital expenditures" figures are $150, $100, $200, and $250, respectively. 0-5% growth rate are fishing equipment, sporting goods, milk ing, and text publishing. process Some companies may wish to prepare a segmented funds statement by industry as well as by growth rate. While such disclosure would undoubtedly be welcomed by many analysts, we would recommend that it supplement but not replace disclosure by growth-rates. Companies wishing to consider even greater disclosure, could examine the merits of preparing funds statements segmented by "basic activities." The column heading "Corporate Office" appearing on the segmented funds statement includes all funds changes not specifically traceable to individual “basic activities." The company's financing, business acquisition program, dividends, and operating costs not traceable to "basic activities" would ordinarily be included under the "corporate office" classification. Note, for example, that the $298,000 of operating costs not traceable to "basic activities" appearing on the funds statement is equal to the sum of the $224,000 expenses common to an industry and the $74,000 of corporate expenses appearing in the segmented Earnings Statement (Exhibit 3-3). Question 1-Where is a company committing its funds? The amount of funds used for capital expenditures is a prime indication of management's commitment to the future prospects of “basic activities" within a growth-rate segment. In addition to capital expenditures, most firms spend significant sums of money on development projects for the future that for accounting purposes are expensed. This category of outlays is ordinarily dominated by research and development costs. Hence, in evaluating the extent of management commitment to the future, consideration should be granted not only to capital expenditures but to expensed development costs as well. Note that the ex-. pensed development outlays are disclosed by growth rate segments as a footnote to the funds statement. The company's resources committed to intermediate and long-range benefits may be summarized as follows: Growth rate segment Whether viewed from an absolute basis or on a basis of commitment relative to earnings contribution or sales, it is apparent that a greater |