AAT Articles

Where did all the money go?

A common question asked by non-financially orientated individuals is “ok, so we’ve made so much profit but the bank balance doesn’t have that much in it – where has all the money gone?”

This article by Steve Collings is the first article in a series which will consider the requirements of the various UK and international accounting standards and illustrate the contents of the article by considering an example.  We start with FRS 1 “Cash Flow Statements” and is particularly relevant for those students studying a financial reporting paper under the UK stream.  The international equivalent is dealt with under IAS 7 “Cash Flow Statements”.  The next article in the series considers IAS 19 “Employee Benefits”.

Financial statements are prepared under the accruals basis of accounting.  That is where transactions and events are accounted for as they arise, rather than when they are paid to enable the financial statements of a reporting entity to reflect a true and fair view.  Of course, financial statements often contain items which require judgement on behalf of the management such as provisions.  Because of the requirement to prepare financial statements under the accruals basis, profits or losses yielded by a reporting entity will very rarely reflect the balance held at the bank.

One way of enabling the users of a set of financial statements to see how cash generated by the business has been spent is to produce a cash flow statement.  The cash flow statement strips out the non-cash items contained in the financial statements.  One such example of a non-cash item would be depreciation.

The headings used in the cash flow statement are usually:

• Operating activities;
• Returns on investments and servicing of finance;
• Taxation;
• Capital expenditure and investments;
• Acquisitions and disposals;
• Equity dividends paid;
• Management of liquid resources; and
• Financing activities

It is worth mentioning at this point that the cash flow statement is one of the primary financial statements and as such should be given the same prominence as that of the profit and loss account and the balance sheet.

The cash flow statement deals with cash and cash equivalents.  Cash is cash in hand and deposits repayable on demand e.g. bank overdrafts.  Deposits are repayable on demand if they can be withdrawn at any time without notice and without penalty or if a maturity or period of notice of not more than twenty-four hours or one working day has been agreed.

Liquid resources are current asset investments held as readily disposable stores of value.  An example of a readily disposable investment is one that is disposable by the reporting entity without disrupting its business.

FRS 1 requires the cash flow statement to be split into various component parts which we shall consider as follows:

Operating activities

Operating activities are those activities that are the core part of the reporting entity’s principal activity.  In other words, operating activities are those activities that generate cash by undertaking its normal day to day operations.  FRS 1 requires a reconciliation is undertaken between the operating profit reported in the reporting entity’s profit and loss account and the net cash flow from operating activities.  This reconciliation starts with operating profit and then adjusts this profit or loss for increases or decreases in stocks, debtors, creditors and strips out the effects of non-cash items used in arriving at the profit or loss in the entity’s profit and loss account.

Returns on investments and servicing of finance

Typically these are the costs of finance (i.e. loan interest) and interest received on deposit or current bank accounts.  Dividend income is also classed as a return on investment.

Taxation

These are payments made to the taxation authorities in respect of the reporting entity’s profit and loss.  Often when constructing a cash flow statement the figure used in respect of taxation paid is cross-referenced to a working as the reported tax figure in the profit and loss account is often the current period’s tax charge – not the tax that has been paid to the taxation authorities in respect of the prior period’s profit.

Capital expenditure

This cash flow heading relates to expenditure in respect of fixed assets and/or other investments.  Disposal proceeds on the sale of fixed assets are also accounted for under this heading.

Acquisitions and disposals

Often the items falling under this heading can be confused with that of the capital expenditure heading.  The cash flows that fall under the acquisitions and disposals heading are related to the acquisition or disposal of any trade or business or of an investment in an entity that is either an associate, joint venture or subsidiary.

Equity dividends paid

These cash flows relate to dividends actually paid to the shareholders of a reporting entity.

Financing

Financing activities are those activities which involve raising finance such as the reporting entity entering into a bank loan or issuing shares.

Preparing a cash flow statement can be quite complex, especially when you have to adjust the profit per the profit and loss account to arrive at the net cash from operating activities.  The difficulty arises when it comes to deciphering whether or not to add or deduct various increases and decreases in working capital so we shall address these difficulties as follows:

Increases/decreases in stocks

Increases in stock are treated as a deduction from operating profit.  This is because it represents a cash outflow as the increase in stock has not been converted into cash as it has not yet been sold.  Conversely, a decrease in stock means that the previous surplus stock has been converted into cash and is therefore a cash inflow.

Increases/decreases in debtors and creditors

If you adopt the same method of thought as above, then an increase is debtors means that there has been less cash received from debtors than on the previous reported period and as a consequence this represents a cash outflow so is treated as a deduction from operating profit.

An increase in creditors is positive because cash is being retained and not used to pay off creditors.

There are two methods which can be adopted in cash flow statement preparation.  The two methods are the direct and the indirect method.  The direct method shows the major classes of receipts and payments as gross.  The indirect method (which is the most common method used) is the method whereby profit or loss is adjusted to take into account the effects of non-cash items on the profit or loss reported in the profit and loss account.

So let us consider a practical example using the indirect method..

You have been asked to prepare the cash flow statement of Arbor for the year ended 31 December 2007.  You have been provided with Arbor’s profit and loss account and balance sheet as follows:

Required Prepare the cash flow statement of Arbor Limited as at 31 December 2007.

Preparing cash flow statements can be quite complex in certain areas – especially when an incomplete records approach has to be adopted.  Time pressure is also a significant factor but with lots of practice students will become more familiar with their preparation. Clare Finch of Kaplan has authored a book entitled “A Students Guide to International Financial Reporting Standards” which comprehensively explains IAS 7 “Cash Flow Statements” (the international version of FRS 1).  It can be purchased from www.kaplanpublishing.co.uk

Steven Collings FMAAT ACCA is Audit Manager at Leavitt Walmsley Associates Limited.