What is a Cash Flow? A cash flow is the receipt or payment of cash. When related to a capital project, cash flows arise from the purchase,operation and disposition of the capital asset. Cash receipts arise from revenues of the project that have been earned and collected, savings generated by reduced operating costs of the project and inflows from the sale of the assets. Cash payments include expenditure made to acquire the capital asset. Additional working capital investment and costs incurred for direct material, direct labour and overhead items.
Cash Flow Statements
Managers realise that for the organisation to survive, two requirements must be met: 1 Profitability in the long-run 2.Liquidity on a continual basis
Cash flow statements (CFS) provides information about the cash impacts of the three major categories of business activities i.e operating, investing and financing. Such knowledge can assist in judging the ability of the organisation to handle fixed cash outflow commitments, to adapt to adverse changes in business conditions, and to undertake new commitment
Also, because the CFS identifies the relationships between net income and net cash flow from operations, it assists managers in judging the quality of the organisation`s earnings. Originally, the balance sheet and tie profit and loss account were the primary financial statements. However, In more recent years, cash flow statements have also come to be regarded as primary financial statements, Emphasis is placed on the need for financial statements to provide an effective communication channel accessible to interested parties. The main aim of the primary financial statements is a means of communicating information to the differing stakeholders associated with the enterprise. These statements are based on the accounting records of companies and have to comply with requirements of law. They deal with three main aspects of the financial affairs of the organisation, namely: I) 2) 3). resources and the funding of resources,(balance sheet) performance in terms of the profit derived from trading activities(profit and loss) sources of the company's cash inflows and the ways in which this cash flow has been applied (cash flow statement)
A positive cash flow is vital for the continuing success and existence of any organisation because they will become insolvent if they run out of cash to pay their bills. As pointed out by Glynn et at
"the accounting profession was slow in requiring the provision of cash flow information in financial statements, because of a reluctance to abandon profit as the ultimate indicator of corporate performance
It was apparent that many users of accounts were confused between the distinction of profits and cash. There was great emphasis put on profit as an indicator of financial success and it was widely believed that a profitable company must be building cash balances. This has proved to be untrue in that companies which concentrated on book profits without ensuring adequate finances to support the profit-making activities inevitably became insolvent and were wound up. The liquidity of the company was often ignored.
Terry Smith (1996) in his book 'Accounting for Growth "pointed out that "profits are someone`s opinion (or 'true and fair view,) whereas cash is a fact And cash is more important than profits - it pays the dividends, and lack of sufficient cash is the reason businesses fail, not lack of profit".
The second edition of his book, Chapter 8 on Cash Flow Statements quotes Lord Weinstock as follows: "We get suspicious when a business reports profits without generating cash"
The Background to the Cash Flow Statement SSAP 10 The Accounting Standards Committee (ASC) introduced statements of Standard Accounting Practice (SSAPs) to lay down standardised bases for accounting and financial reporting which would be used in the preparation of annual financial statements. The work of the ASC represented the.first major attempt in the UK to put order and consistency into corporate financial reporting at a detailed level In 1975, with Statement of Standard Accounting Practice No. 10, Funds Flow Statement (SSAP 10), it was made compulsory for companies to include in their annual financial statements, a report on their flow of hinds for each accounting period, through the use of statements of sources and application of funds.
SSAP 10 had aroused criticism for the following reasons: it was flexible about the definition of funds, usually incorporating cash funds and working capital funds it focused on movements of working capital rather than cash and bank balances it was also flexible about the way in which flows of funds should be presented SSAP 10 did not specify a layout which led to differing interpretations Under the auspices of the 1989 Companies Act, the Accounting Standards Board(ASB) was set up to take over the role of the ASC in the formulation and publication of accounting standards The hope was that, as the ASB got increasingly into its stride: “the scope of creativity in financial reporting will be greatly diminished.”
Financial reporting standards (FRSs) are the new documents issued by the ASB which will gradually replace the SSAPs still in existence when the ASB was formed Until this time, the SSAPs remain in force. However, one which has been replaced is SSAP 10, Statement of Sources and Application of Funds, which was succeeded by FRS 1, dealing with cash flow statements.
The Case for Cash Flow Accounting(FRS 1) Financial reporting standard 1 was issued by the Accounting Standards Board in August 1991. It requires that companies publishing accounts after 23 March 1992 should issue a cashflow statement instead of a statement of sources and application of funds. The objective of FRS 1 is: "to require entities, falling within its scope, to report, on a standard basis their cash generation and cash absorption for a period To this end, the cash flow statements should provide cash flow information under the standard headings of 'operating activities; return on investment and servicing of finance; 'taxation", 'investing activities", and financing. This structure aims to assist users---- in their assessment of the reporting entity's liquidity, viability and financial adaptability"
FRS 1 identifies five main elements of a company`s cash flows:
I. 2. 3. 4. 5.
Net cash flow from operating activities Returns on investment and servicing of finance Taxation Investing activities Long-term financing transactions
Glynn et al believe that the cash flow statement required by FRS 1 is unquestionably a valuable addition to the information about the activities of a company contained in its financial statements because: it is a flow statement supplementing the information contained in the balance sheet and the profit and loss account. it focuses on the flow of cash through the company, and, it directly addresses the cash flow/financial management decisions of the company and their repercussions for its financial health
Other advocates include Lee (1992) who believes that FRS 1: “will avoid the effect of the periodic accounting accruals and cost allocation"
and Harvey (1992) who contends that FRS I: has potential to provide extra dimension to corporate reporting and hence corporate performance appraisal.
The Case Against Cash Flow Accounting Cash flow accounting is not without its critics. The main advocator is R.Rutherford who in his article "The Interpretation of Cash Flow Reporting and Other Allocation Problems (1982), voiced arguments; Cashflow accounting is not allocation free therefore suggesting judgmental
problems similar in nature and impact to those associated with the conventional allocation based system of accounting. distinction between capital expenditures and revenue expenditures would give scope for allocation problems transactions taking place in a form of by-passes of cash window dressing' of cash flow accounting reports caused by management responsible for cash flow cutting off; accelerating, or delaying cash receipts or paynents
Other critics included Thomas (1980), Meyers (1976), Wans and Zimmerman (1979) Ashton (1976) and more recently, Harvey (1992). In his article he discusses the practical pitfalls for preparers and users in implementing FRS 1. Therefore, although a cash flow accounting system was proposed as free of discretionary allocation. evidence against it suggests that there is scope for allocation and subsequent manipulation. However, whatever the argument for or against cash flow accounting "introducing anew standard related to cash flow accounting by the US Financial Accounting Standard Board (FASB) and the ASB of the UK may reflect the usefulness of the cash flow accounting for decision makers'
TYPICAL CASH FLOW STATMENT
Net Cash Flow - Operating Activities
X
Net Cash flow - Returns on Investment and Servicing Finance Interest received Dividends received Interest paid
x x
x x
Net Cash Flow – Taxation X
Net Cash Flow - Capital Expenditure: Payments to acquire fixed assets Receipts from sales of fixed assets X Net Cash Flow - Dividends X X
x
Net Cash Flow - Financing Issue of share capital Issue of loan capital Expenses paid - share issues
x
x x
Repayment of loans Increase/Decrease in Cash/Equivalent X Notes to the Cash Flow Statement
x
x
1.
Reconcilation of operating profit to net cash flow from operating activities:
Operating Profit Depreciation charges Profit/Loss on disposal of fixed assets Change in Stock Change in Debtors Change in Creditors Net cash Flow from Operating Activities
x
x x x x x x
2.
Reconciliation of net cash flow to the movement in net debt: Opening Closing x x Xx
x
Cash flow x x
Cash in hand/at bank Overdrafts x
x x
x