the cash flow statement

the cash flow statement

while the income statement lists the amounts revenues and expenses - incurred over a period of time, the cash flow statement reports the actual cash received and paid out in fact, not all the revenues are directly and immediately related to an inflow of cash, as well as not all the expenses imply a pay out revenues (expenses) that are not related to a cash flow (cash outflow) are referred to as non monetary revenues (expenses)
2

credits and debts

the first reason for the existence of non monetary revenues and expenses is linked to the practice in business transactions of selling products on credit and buying them on debt when a product is sold on credit (bought on debt) a revenue (expense) is reported in the income statement even if no cash is still received (paid) by the company if the credit (debt) term is such that at the end of the period the payment isnt performed yet, we will have a revenue (expense) in the income statement, but no cash flow (cash out flow) in the cash flow statement
3

credits and debts: an example

assume that company X sells goods on a three-month term credit on 1 April on 1 July it will receive the payment at the end of the financial year (31 December)
both the revenue and the cash flow will be reported in the respective reports no credit will be reported in the balance sheet

if the same selling conditions are applied on 1 November, the company will receive the payment only on 1 February at 31 December
the revenue is reported in the income statement the credit is reported in the balance sheet no cash flow is reported in the cash flow statement
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amortization
amortization is a typical non monetary cost as a matter of fact the value of amortization is listed into the income statement after the accrual convention, but it does not correspond to an actual cash outflow the cash outflow paid for the purchase of an asset can be even precedent to the receipt of the asset itself, while the amortization is contextual to the use of it
5

amortization: an example
assume a company orders a piece of machinery on 15 November 2007 and arranges to pay the total amount in three installments: 5,000 at the moment of the order, 10,000 after six months and 5,000 on delivery, expected on 31 December 2009; the machinery has an expected life of 5 years on December 2007
a 5,000 cash outflow is reported for the period a deposit of the same amount is reported in the balance sheet no cost is reported in the income statement a 10,000 cash outflow is reported for the period a 15,000 deposit is reported in the balance sheet no cost is reported in the income statement a 5,000 cash outflow is reported for the period the asset is reported in the balance sheet at its whole historical value ( 20,000) no cost is reported in the income statement (if the machinery is delivered on 31 December the asset isnt used yet)

on December 2008

on December 2009

on December 2010
no cash outflow is reported for the period a 16,000 asset is reported in the balance sheet a 4,000 cost is reported in the income statement
no cash outflow is reported for the period a 12,000 asset is reported in the balance sheet a 4,000 cost is reported in the income statement

on December 2011

... 6

how to calculate the cash flow

indirect method NET PROFIT + AMORTIZATION - CREDITS VARIATION + DEBTS VARIATION = CASH FLOW direct method MONETARY REVENUES - MONETARY EXPENSES = CASH FLOW
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balance sheet, income statement and cash flow statement

the cash flow statement, as well as the income statement, gives a dynamic view of the business, pointing out all incoming and outgoing benefits deriving from the activities of the business the difference between the two reports is that the former is drawn up after a cash point of view, the latter after the accrual one conversely, the balance sheet gives a static description of the business, pointing out all the assets and liabilities of the business at a given moment of time both the cash flow and the income statement can be used to understand how the balance sheet evolves from one year to another
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the regulatory framework

the international regulatory framework

each country has its own regulatory framework for accounting and preparation of annual accounts however, there is also an international regulatory framework that is gaining in importance as investors seek to invest in global markets the International Accounting Standard Board issued a number of standards that have to be followed in preparing financial accounts further, the European Union also entered the arena of international regulations in terms of the Directives on company law that it has issued (Fourth and Seventh Directives): all listed (see slide 27) companies in Europe have to prepare their accounts in accordance with international standards
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IASs and IFRSs

the potential benefits of internationalising accounting practices led to the creation of the International Standard Accounting Committee (IASC) in 1973 the IASC was set up with the aim of achieving improvement and harmonisation of accounting standards and during its life issued a number of international accounting standards (IASs) the IASC was restructured and renamed the International Accounting Standard Board (IASB) in 2001 the objectives of the IASB are to
develop a single set of high quality, global accounting standards that require transparent and comparable information in financial statements promote the use and application of such standards work towards the convergence of national accounting standards

the IASBs pronouncements are called international financial reporting standards (IFRSs) but the board also adopted the IASs

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national vs. international frameworks

even if listed companies are required to prepare their accounts in accordance with IASs/IFRSs, small and medium-sized firms will still be able to use the national standards of the country they operate in this means you will find companies from the same country using two different sets of standards in their reporting:
national standards for unlisted companies international standards for listed companies
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why standards are important?

we have already seen how both the balance sheet and the income statement can vary according to the basic assumptions we make about how and what we should measure
for example, the gross profit will vary if we change our assumptions about inventory rotation, and use FIFO instead of AVCO as a basis of inventory valuation

in other words, the economic health of a business can apparently vary not only with the reality of economic changes, but also with how we choose to account for that reality the approach that accountants have chosen to place reliance on the financial statements is a two-stage technique
to agree on explicit underlying assumptions, and then to develop accounting practices that are consistent with those generally accepted assumptions, and hence lead towards a true and fair view
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a true and fair view

this phrase comes from the UK Companies Act and is the over-riding legal requirement for financial statements in most countries, that is they must show a true and fair view of the economic situation of the business in UK the phrase is not defined in the ACT, so it is implicitly left to accountants to define in practice it is held to be achieved primarily through adherence to the accounting standards the Fourth EU Directive exported the idea of true and fair view from the UK to all other European countries, so that each national regulatory framework in Europe was influenced by acknowledging such directive
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concepts
the concepts are the underlying ideas of accounting they have usually been implicit and understood as a common culture of accounting given that such principles can radically change the view the financial statements give of an entity, it should be obvious that preparers and users of those statements should be very clear about the principles that have been applied to any given set of statements requiring such an explicit declaration of the accounting practices they result in for a given entity is the large part of the purposes of IAS 8 Accounting Policies, changes in Accounting Estimates and Errors at the hearth of IAS 8 is the assumption that all financial statements will be consistent with a few basic, specified principles, the concepts IAS 1 Presentation of Financial Statements highlights two concepts, going concern and accruals, as being pervasive even though we have already seen most of the concept in the two previous lessons, for completeness they will be fully reported here
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concepts
going concern: is the assumption that the business will continua to operate for the foreseeable future, implying that the usual basis of assets valuation is historical cost accruals: when preparing the income statement, revenue and profits are matched with the associated costs and expenses incurred in earning them, meaning that revenues and expenses are recognised when they are incurred, rather than when the related cash is received or paid consistency: once you have chosen an accounting treatment, you should stick with it from one year to the next in order to promote comparability prudence: we should always aims to show a treatment free from bias, explicitly avoiding overstatement under conditions of uncertainty and recording of all losses - both actual and expected - in full, while profits should not be recognized until they are realized separate valuation: it is not allowed to show the net amount between positive and negative items in a statement (i.e. assets and liabilities or incomes and expenses). Assume that A has sold goods on credit to B worth 600 and has purchased goods on credit from B for 400: A is not allowed to register the net credit of 200, but has to register both the credit and the debt
16

concepts
business entity: the business has an identity and existence distinct from the owners, so that it can and should record an amount owing to its owner, i.e. the capital duality: in relation to any economic event, two aspects are recorded in the accounts, that is the source of funds and the related applications monetary measurement: only those events that can be reasonably objectively measured in money terms are recorded objectivity: it is a required attribute of accounting that competent individuals working independently should arrive at the same or very similar measures of given economic events or situations historical cost: the usual method of arriving at an objectively agreeable quantification of an event is to value it at what the item costs materiality: a very small mistake in the financial statements will not invalidate the statements themselves if they still show a true and fair view
17

characteristics
given such set of concepts, we can identify the characteristics of good accounting
relevance, asserting that good financial information is information which is relevant in helping users to make decisions about the organization reliability, that is essentially a matter of freedom from bias and material error comparability, meaning that accounting policies should normally be the same from one year to the next and ideally also between organisations understandability, making the point that financial information should be understandable by users
18

reliability
in relation to reliability, four characteristics can be identified
faithful representation, that consists of a valid description, free from errors, and depending on the idea of substance over form neutrality, meaning that the information presented must be free from bias prudence, while we should aim to reflect an unbiased view of an event - according to neutrality - under condition of uncertainty it will be helpful to select a prudent view completeness: the more complete the information is, the better
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determinants of the accounting framework

willing to compare different regulatory frameworks, we have to consider the factors determining the regulatory framework in a country
who are the providers of finance? how much the accounting profession is determining? what can we say about the economic environment? which is the tradition of law in the country? how much other countries have had some influence? which is the politics trend in the country?
20

providers of finance
when providers of finance of a business are also involved in the management of the business itself (typically for sole proprietorships and partnerships), the owners are aware about all the events concerning the business when providers of finance are single shareholders not involved in the management of the business, they require detailed information on stewardship (i.e. the management of the companys assets), leading to the establishment of a legal framework: this is what typically happens in the UK on the contrary, if we consider Germany, the providers of finance are very often large banks, able to force companies to provide financial information to their requirements: thus there is no pressure for full public disclosure
21

accounting profession
the role of the accounting profession is also important to determine the kind of framework for instance, in the UK, the Institute of Chartered Accountants in England and Wales (ICAEW) was successful in promoting the idea of the true and fair view in the 1940s on the contrary, in France the accounting profession is government controlled and its role in defining norms and rules is minor

22

economic environment
the economic environment can have an effect on the framework, since it represents the habitat in which companies have to operate for example, the high levels of inflation suffered in Europe in the 1970s led to a consideration of alternatives to historical cost accounts, to reflect changing values
23

tradition of law
two main traditions of law can occur
the common law system, based on broad principles with the detail being left to case law or the other forms of regulation (for example the accounting profession standards): this is typical of UK and USA the Roman law system - settled in Latin countries such as Italy and France - based on detailed rules and regulations

thus, according to the tradition of law, the regulatory framework will have a more or less codified set of rules
24

foreign influences
depending on its history, the framework of accounting in one country can also be influenced by another country for example, many British Commonwealth countries have a system of regulation derived from the UK on the other hand, during the occupation of France in the Second World War, Germany introduced a General Accounting Plan that was retained by France even after the liberation, as it provided the government with a means of control when rebuilding French industry
25

politics
last but not least, the politics trend of a country is a powerful determinant of the accounting framework for example, the Chinese framework is highly influenced by the long history of communism and is now undergoing a massive change China has only recently developed contract and commercial law, but this is still tightly controlled by the government many institutions and investments will still remain under state control stock markets are operating only since 1990s the accounting profession prior to 1980 was almost non-existent this obviously influences the regulation framework market-orientated principles are being taken on board but a socialist theme is still maintained new accounting laws are being introduced, substantially based on IASs/IFRSs, but standards are simpler and more rigid, allowing less choice and judgement

26

accounting for limited companies

the nature of limited companies

a limited company is an artificial person created by law this means that a company has many of the rights and obligations that real people have
for example, it can sue or be sued by others and can enter into contracts in its own name this contrasts sharply with other types of business - sole proprietorship and partnership - where it is the owner(s) rather than the business that must sue, enter into contracts and so on because the business has no separate legal identity

as a limited company has its own legal identity, it is regarded as being quite separate from those who own and manage it this fact leads to two important features of limited companies: perpetual life and limited liability
28

perpetual life

a limited company is normally granted a perpetual existence and so will continue even where an owner of shares in the company dies the shares of the deceased person will simply pass to the beneficiary of his/her estate therefore, the life of the company is not affected by changes in ownership that arise when individuals buy and sell shares in the company though a company may be granted a perpetual existence when it is first formed, it is possible for either the shareholders or the courts to bring this existence to an end
shareholders may agree to end the life of the company where it has achieved the purpose for which it was formed or where they feel that the company has no real future the courts may bring the life of the company to an end where creditors have applied to the courts for this to be done because they have not been paid amounts owing

when this is done, the assets of the company are sold off to meet outstanding liabilities any surplus arising from the sale will be used to pay the shareholders

29

limited liability
since the company is a legal person in its own right, it must take responsibility for its own debts and losses this means that once the shareholders have paid what they have agreed to pay for the shares, their obligation to the company, and to the companys creditors, is satisfied in this way, shareholders limit their losses to that which they have paid, or agreed to pay for their shares though limited liability has this advantage to provides of capital, it is not necessarily to the advantage of all others who have a stake in business limited liability is attractive to shareholders because they can, in effect, walk away from the unpaid debts of the company this is likely to make any individual or entity, that is considering advancing credit, wary of dealing with the limited company
30

limited liability vs. business entity

Note that the legal separateness of owners and the company (i.e. limited liability) has no connection with the business entity convention of accounting, which applies equally well to all business types, including sole proprietorships where there is certainly no distinction between the owner and the business
31

legal safeguards
the fact that a company is limited must be indicated in the name of the company itself
this is mainly to warn individuals and entities contemplating dealing with a limited company that the liability of the owners is limited

another important safeguard for those dealing with a limited company is that all limited companies must produce annual financial statements (income statement, balance sheet and cash flow statement) and make these available to the public
all the norms and rules fixed by the accounting regulatory framework concern the financial statements of limited companies; sole proprietorships and partnerships can present easier statements, only for taxation purposes
32

taxation
another consequence of the legal separation of the limited company from its owners is that companies must be accountable to the Inland Revenue for tax on their profits and gains this introduces the effects of tax into the accounting statements of limited companies the charge for tax is shown into the income statement the tax charge for a particular year is based on that years profit, even though the company can either postpone part of the payment, thus creating a current liability that will be reported in the balance sheet

33

transferring share ownerships

the point has already been made that shares in a company may be transferred from one owner to another the desire of some shareholders to sell their shares, coupled with the desire of others to buy those shares, has led to the existence of a formal market in which shares can be bought and sold the Stock Exchanges around the world provide marketplaces in which shares in limited companies may be bought and sold share prices are determined by the laws of supply and demand, which are, in turn, determined by investors perceptions of the future economic prospects of the companies concerned only the shares of certain companies (listed companies) may be traded on the Stock Exchange in order to be listed a company should have certain requisites as to its governance and a specific entity in each county is devoted to the control of listed companies

34

presenting financial statements

IAS 1 presentation of Financial Statements sets out the structure and content of financial statements for limited companies and the principles to be followed in preparing these statements according to IAS 1, the financial statements consist of:
a balance sheet an income statement a statement of changes in equity a cash flow statement notes on accounting policies and other explanatory notes
35

the balance sheet

IAS 1 prescribes the minimum information that should be presented on the face of the balance sheet
property, plant and equipment investment property intangible assets financial assets (such as shares and loan held) stocks (inventories) trade debtors and other receivables cash and cash equivalent trade creditors and other payables provisions financial liabilities (excluding payables and provisions shown above) tax liabilities issued capital and reserves (equity)

additional information should be also shown where it is relevant to an understanding of the financial position of the business
36

the balance sheet: reserves

reserves are profits and gains that have been made by a company and that still form part of the shareholders claim because they have not been paid out to the shareholders reserves are classified as either revenue reserves or capital reserves revenue reserves arise from
trading profits that by law can not be divided among shareholders in order to create a margin of safety for creditors, or gains made on the disposal of non-current assets

capital reserves arise for two main reasons

issuing shares at above their nominal value revaluing (upwards) non-current assets
37

the balance sheet: format

the standard normally requires a distinction to be made on the balance sheet between current and non-current assets and current and non-current liabilities the standard does not prescribe a format for the balance sheet thus some countries (e.g. UK) prefer the vertical format, while others (e.g. Italy) the horizontal one
38

the income statement

IAS 1 sets out the minimum information to be presented on the face of the income statement
revenue finance costs gain or losses on the sale of assets or settlement of liabilities arising from discontinued operations tax expense profit or loss

however, the standard makes it clear that further items should be shown on the face of the income statement where they are relevant to an understanding of performance
39

the income statement: formats

the standard suggests two possible ways in which expenses can be presented on the face of the income statement
the former is to analyse the expenses according to their nature, such as depreciation, employee expenses and so on the latter is to analyse expenses according to business functions, such as administrative activities, distribution and finance

the choice between the two approaches will depend on which the directors believe will provide the more relevant and reliable information
the second form of presentation is potentially more relevant to users, by revealing how much of the revenue generated is absorbed by different functions, which may provide a better insight to the efficiency of the business however, it is not always easy to attribute costs to specific functional areas, particularly where facilities and other resources are being shared

40

the income statement: formats

classification of expenses according to their nature
revenue other income total income changes in stocks raw materials used employee expenses depreciation and amortisation impairment of property, plant and equipment other expenses finance costs total expenses profit before tax corporation tax profit for the period (65) (100) (91) (22) (25) (10) (8) (321) 362 (120) 242 distribution costs administrative expenses other expenses finance costs total expenses profit before tax corporation tax (102) (115) (14) (20) (251) 109 (24) 576 107 683

classification of expenses according to business functions

revenue cost of sales gross profit other income 690 (350) 340 20 360

profit for the period

85
41

the statement of changes in equity

the statement of changes in equity aims to help users to understand the changes in share capital and reserves that took place during the period the general rule is that the income statement should show all income and expenses, including gains and losses, for the period, that have already been realised this contrasts with gains arising from an upward valuation of an asset that remains with the company: these do not affect the income statement, but go directly to a revaluation reserve another exception to the general rule is exchange differences that arise when the results of foreign operations are translated into national currency: once again, any gain or loss bypasses the income statement and is taken directly to a currency translation reserve
42

the cash flow statement

the cash flow statement tries to help users to asses the ability of a company to generate cash flows, and to assess the requirements for these cash flows the presentation requirements for this statement are set out in IAS 7 Cash Flow Statements

43

explanatory notes
the notes play an important role in helping users to understand the financial statements they will normally contain the following information
a statement that the financial statements comply with relevant IASs/IFRSs a summary of the measurement bases used and other significant accounting policies applied (e.g., the basis of stock valuation) supporting information relating to items appearing on the income statement other disclosures such as future contractual commitments that have not been recognized managements objectives and policies

44

explanatory notes: material items

as a further aim to understanding, all material expenses must be separately disclosed in the notes to the financial statements the sort of material items that may require separate disclosure include
write down of stocks to net realisable value write down or disposal of property, plant and equipment disposal or investments restructuring costs discontinuing operations litigation settlements
45

directors report
In addition to preparing the financial statements, it is required the directors to prepare an annual report to shareholders an other interested parties this report contains information of both a financial and a non-financial nature and goes beyond that which is contained in the financial statements the information disclosed covers a variety of topics including details of share ownership, details of directors and their financial interests in the company, employment policies and charitable and political donations
46