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Cash flow statements Learning objectives After you have studied this chapter, you should be able to: l explain the purpose of cash flow information l explain the difference between cash flow and profit l prepare a cash flow statement for a company following the format given in FRS 1 l explain the differences between the requirements of FRS1 and IAS 7 l prepare a cash flow statement for a company following the format given in IAS 7 Introduction In this chapter, you ll build on what you learnt in Business Accounting 1 relating to cash flow statements. You will learn more about the nine standard headings withi n a cash flow statement prepared on the basis of FRS 1 and be reminded of the layout s as given in FRS 1 and shown how to use them in practice. You ll also be reminded o f the layout of a cash flow statement prepared on the basis of IAS 7. Background Business Accounting 1 introduced cash flow statements and this chapter moves on to consider in more detail the two accounting standards relating to these statem ents - FRS 1: Cash flow statements and the equivalent informational accounting standard, IAS 7: Cash flow sta tements. We will look first at FRS 1. FRS 1 requires that a cash flow statement be prepared according to prescribed fo rmats for all companies other than those exempt from doing so, either because they are small , as defined by the Companies Act (see Section 11.2), or because they are subsidiary undertaking s and the group they belong to is publishing group financial statements in the European Union. T he standard requires that the statement be included as a primary statement within the financ ial statements, i.e. it has the same status as the profit and loss account and the balance sheet . FRS 1: Standard headings The objective of FRS 1 is to ensure that reporting entities report the cash gene ration and cash absorption for a period by highlighting the significant components of cash flow in a way that facilitates comparison of the cash performance of different businesses; and that they provide information that assists in the assessment of their liquidity, solvency and fina ncial adaptability. For this reason, the statement must show the flows of cash a nd cash equivalents for the period under the headings: 1 operating activities 2 dividends from joint ventures and associates 3 returns on investments and servicing of finance 4 taxation 5 capital expenditure and financial investment 6 acquisitions and disposals 7 equity dividends paid 8 management of liquid resources 9 financing. The first seven headings should be in the order shown. The other two can be comb ined under a single heading provided that each of their cash flows are shown sep arately and separate subtotals are given. Operating cash flows can be presented by either the direct method (showing the relevant constituent cash flows) or the indirect method (calculating operating cash flows by adjustment to the operatin g profit reported in the profit and loss account). The standard indicates in which section various items are to be located and thes e are described in Sections 14.4 -14.11. Further guidance concerning where items appear in the statement can be seen in the examples presented later in this cha pter. The standard requires that either adjoining the statement, or in a separate note , reconciliations are presented between operating profit and net cash flow from operating activities for the period, and between the movement in cash in the per iod and the movement in net debt. Neither reconciliation forms part of the state ment. The reconciliation to net debt should identify the cash flows of the entit y, the acquisition or disposal of subsidiary undertakings (excluding cash balanc es), other non-cash changes, and the recognition of changes in the market value and exchange rate movements. FRS 1 and cash flow Cash flow is defined in paragraph 2 of FRS 1 as an increase or decrease in an amo unt of cash . Anything that falls outside this definition is not a cash flow and s hould not appear in the statement (though it could appear in the notes). Cash is defined as cash in hand and deposits repayable on demand with any qualify ing financial institution, less overdrafts from any qualifying financial institu tion repayable on demand . Deposits repayable on demand are deposits that can be withdrawn at any tim e without notice and without penalty or if a maturity or period of notice of not more than 24 hours or one working day has been agreed. Cash includes cash in hand and deposits denominated in foreign currencies. FRS 1: Operating activities and cash flows Operating activities are generally the cash effects of transactions and other ev ents relating to operating or trading activities. The net cash flow from operati ng activities represents the net increase or decrease in cash resulting from the operations shown in the profit and loss account in arriving at operating profit . The reconciliation between operating profit and net cash flow from operating act ivities for the period should disclose separately the movements in stocks, debtors, and cred itors related to operating activities, and other differences between cash flows and profits. It s hould also show separately the difference between dividends received and results taken into acco unt for equity accounted entities. In the cash flow statement, operating cash flows may be shown using either the i ndirect method or the direct method. Using the indirect method, it would be laid out in a manner similar to that shown in Exhibit 14.1. Exhibit 14.1 £ Operating profit 12,000 Depreciation charges 500 Loss on sale of tangible fixed assets Increase in stocks ( 200) Increase in debtors ( 100) 10 Increase in creditors 300 Net cash inflow from operating activities 12,510 FRS 1 requires that a reconciliation be shown between the net cash flow from ope rating activities and the operating profit as shown in the profit and loss accou nt, which is precisely what is produced if the indirect method is adopted. Conse quently, by adopting the indirect method, as the detailed information is to be i ncluded in a reconciliation, the main part of the statement may only include a s ingle line net cash flow from operating activities . Thus, instead of being include d in the body of the cash flow statement, the details shown in Exhibit 14.1 woul d be included in the notes to the statement. When the indirect method is adopted , no details of the equivalent direct method analysis is required. On the other hand, when the direct method is adopted for preparation of the stat ement, the reconciliation (i.e. the indirect method analysis) must also be prepa red and included as a note to the statement. The direct method would produce an analysis in the cash flow statement similar to that shown in Exhibit 14.2. Exhibit 14.2 Operating activities £ Cash received from customers 120,000 Cash payments to suppliers ( 40,000) Cash paid to and on behalf of employees ( 60,000) Other cash payments ( 7,490) Net cash inflow from operating activities 12,510 It is generally easier for an entity to adopt the indirect method - the figures are readily available from the profit and loss account and balance sheet data. The direct method, on the other hand, requires that the Cash Book is analysed. Despite there being much more wor k involved in preparing it, in Appendix III to FRS 1, the ASB encourages the use of the direct method when the potential benefits to users outweigh the costs of doing so - it does help provid e a far clearer view of cash flow than the bookkeeping adjustments to profit that are undertaken unde r the indirect method. Note: In an examination, if sufficient information on cash flows is provided for you to adopt the direct method, you should assume that is the approach to take - however, you would still need to adopt the indirect method when completing th e reconciliation if that was also required by the question.