Cash Flow and Cash Flow Structures
Cash Flow and Cash Flow Structures
Cash Flow and Cash Flow Structures
2. Historical development of cash flow and Cash flow Structures
3. Current GAAP
4. Similarities and differences between GAAP and IFRS on Cash Flow Statements
5. Problem areas revealed in the debate arena
6. Analysis of points 2 and 3 in relation to the Conceptual Framework
7. Appropriate courses of action
Cash Flow and Cash Flow Structures
In order to understand the concepts of cash flow structures, it is essential to first understand what a cash flow statement is. A cash flow statement is among the most vital financial statements for a business or project. The cash flow statement can simply be one page analysis or may comprise of several schedules that feed significant information into a core or central statement. It refers to a listing of the cash that is brought in and out of the project or business. Taking an example of a checking account in a bank, the cash inflow is represented by deposits while the cash outflows are represented by withdrawals that one makes in a bank. The balance in one’s checking account represents the net cash flow at a certain point of time. A cash flow statement may also be defined as a listing of cash flows, which occurred in the past accounting period (Rich, 2010). A cash flow budget refers to a projection of future cash flows. A statement of cash flow is concerned with the amount both the amount and timing of cash flows. A majority of cash flows are constructed with multiple periods of time. For example, the statement may list cash flows of each month over a time of one year. It projects the balance of cash remaining at the end of each month and years.
According to Rich (2010), working capital is a crucial element in the analysis of cash flow. Working capital refers to the amount of cash required to enhance business transactions and operations. Calculating the working capital amount provides one with a fast analysis of the business’ liquidity over the accounting period in the future. If the amount of working capital appears adequate, then creating a budget of cash flow may not be necessary. However, if working capital appears inadequate then a budget of cash flow may outline liquidity challenges, which may take place during the following year. Most cash flow statements are formed in order to identify the item behind in flow or outflow (Rich, 2010).
Historical Development of cash flow and cash flow structures
Cash flow statements ate the financial statements that give the movement of cash that comes in and goes out of the business or a project. In other words, the cash flow statement is the central component of the business and an essential technique for investors and managers that reveal how changes in the balance sheet and the income statement affect cash (Rich, 2010). The notion is to provide the basis for a general image of how cash flow generated by a firm is doing with dealing with the outstanding expenses that are incurred during the business transactions and operations. This section, therefore, discusses the history of cash flow statement, as well as, how the statement has been developed with time. The income statement and the balance sheet have been mandatory statements for companies for many years. However, the cash flow statement has been officially mandatory in the United States only as from 1988. Cash flow statements, however, have in some form or another had a lengthy history in the United States of America. During 1863, there was the issuance of a summary of financial transactions by Northern Central Rail Road (Steyn and Hamman, 2012). This summary included an outline of the firm’s cash receipts and disbursements for that period (year).
As current assets may be thought of as assets that are almost been converted to cash and current liabilities as the liabilities that are almost being paid in terms of cash, an option to getting concerned on cash flow is to assess the net alteration in the working capital of a business or project. During the year 1902, the Steel Corporation in the United States offered a report that outlined the main causes of the alteration in funds during that year. In this case, funds were being defined as current assets less accounts payable. In fact, it was only after 1920 working capital funds became common (Steyn and Hamman, 2012).
The statement of cash flow’s history can be traced back during the year 1863. During this period, a company by the name Dowlais Iron Company had recuperated from a collapse of business. However, the company had no financial resources for making investments of a new Blast furnace despite having made a profit. In giving an explanation on why they did not have cash for investments, the company’s manager formed a new financial statement known as comparison balance sheet. In this statement, it was revealed that the firm held too much inventory. As a matter of fact, the statement was the start of Cash Flow Statements that is applied in the present (Steyn and Hamman, 2012). 1971 made a turning point in relation to cash flow statement. During this period, in the United States, the Financial Accounting Standards Board (FASB) identified and defined the rules and regulations, which made it compulsory under the Generally Accepted Accounting Principles (GAAP) of the United States to uses and sources of funds (financial resources). However, the history of the cash flow statement reveals that the definition of resources during that time was not comprehensible. During that period, the net working capital might be known as cash or may imply the difference between current assets and current liabilities. The history further reveals that from the period of the late 1970s to the mid 1980s, the Financial Accounting Standards Board assessed the significance of forecasting future cash flows (Epstein et al., 2009).
During 1971, as mentioned the APB issued Opinion No.19 that required that a statement of funds to be included as among the three fundamental financial reports to stakeholders of firms and it must be covered by the report of the auditor. However, it did not specify a single concept or definition of finances or a needed statement’s format. This statement was referred to as the statement of alterations in the financial position of a company. In the 1970s, the funds statements was not given much concern and was not even discussed in the introductory courses of financial accounting. In the early 1980s, there was encouragement of members of the Financial Executives Institute to implement a funds emphasis in the changes, in financial position statements. Only 10 percent of the Fortune firms applied a funds focus in 1980 (Hodder et al., 2008). The rest reported only net changes in the working capital. By the year 1985, however, about 70 percent applied the cash focus after it was made compulsory by FASB. This suggested that a statement of cash flow should be a component of a complete set of statements of finance of firms (Hodder et al., 2008).
The Financial Accounting Standards Board adopted the Statement of Financial Accounting Standard (SFAS) 95 with the title Statement of Cash Flows during the year 1987. The statement of this standard made it mandatory that companies should give cash flow statements. The International Accounting Standard was formed in 1992 while in 1994; cash flow statements became effective and made it mandatory that companies should provide cash flows statements. Therefore, whereas owner financing can be traced back into history, the period of 1980s was the year that saw the start of the Cash Flow Industry. Presently, there are more than sixty streams of income that can be bought and sold (Kousenidis, 2011).
As the required statement of cash flow is relatively new, it at times, does not get much attention as it deserves as part of the three essential financial statements. In fact, a majority of textbooks on accounting still hold up cash flow statement coverage until the end of the books. Furthermore, most of the old techniques of analysis of financial statements do not include the use of cash flow data. As the traditional tools and techniques of analysis were created during the period when the data of cash flows was not available, analysts must go to great depths in approximating numbers of cash flows. This is because they are not aware that since the year 1988 the numbers have been simply available in the statement of cash flow. A majority of them, for instance, used depreciation, earnings before taxes and interests, and amortization in evaluating a company’s wellbeing in the industry or market. When asked for the reason behind the application of earnings before interest, taxes, depreciation, and amortization (EBITDA), a financial analyst would state that this figure estimates the operating cash flow of a business. The reason why financial analysts do not use the true numbers of cash flow in the analysis is because the information from the cash flow statement is not included in the analytical tradition although it will be incorporated (Kousenidis, 2011). In the real sense, an important way of impressing others that one is well-trained, modern, and future-looking specialist or professional is to be proficient in the analysis and preparation of cash flow statements.
There are Generally Accepted Accounting Principles in the United States that govern the reporting of information to be presented in the cash flow statements. Some business transactions may be classified as distinct types of cash flows under IFRS and GAAP accounting standards. Generally Accepted Accounting Principles are defined as the standard framework of principles, guidelines, rules, and conventions that accountants are expected to adhere to in the processes of recording, summarizing, and preparation of financial statements within any given jurisdiction. Under FASB summary of Statement No. 95 requires companies to prepare cash flow statements. Under this section, the statements necessitate the reporting of cash flow through established standards (Henry et al., 2009). This statement surpasses APB Opinion No. 19 on Reporting Financial Position changes and necessitates the preparation of a statement of cash flow as a component of a complete set of financial statements of business entities or projects.
The statement requires that a statement of cash flow should categorize all cash receipts and payments depending on whether they are from investing, operating, or financing activities or business operations and also gives definition of each classification. The statements promote the reporting of cash flows from operating activities of enterprises directly through revealing key classes of operating cash payments and receipts (direct method). Business entities that do not reveal their operating cash payments and receipts should report the same amount of cash flows from operating activities, but indirectly (Henryt et al, 2009). This is done through indirectly adjusting their net income to reconcile to net cash flow from operating activities. The effects of all accruals of anticipated future operating cash payments and receipts, as well as, all deferrals of the operating cash payments and receipts are and items that are incorporated in net income that have no effect on the operating cash payments and receipts. This implies that if the direct method is applied then a reconciliation of net cash flow from operating activities and net income is necessary to be given in a different schedule.
In addition, the statement requires that a cash flow statements report the reporting currency that is equivalent to the foreign currency cash flow, applying the present rate of exchange at the period of the cash flows. The exchange rate changes effect on cash that is held in the currencies of foreign countries is reported as a distinct item in the reconciliation process of the starting and ending balance of cash and cash equivalents (Henry et al, 2009). The statements also requires that information on financing and investing activities not resulting in cash payments or receipts during the period be given separately. The statement is effectual for all annual financial statements for fiscal periods (years) that end after July 15, 1988. Therefore, financial statements’ restatement for earlier periods (years) offered for comparative reasons is enhanced, but not mandatory (Bellandi, 2012).
Similarities and differences between GAAP and IFRS on Cash Flow Statements
GAAP, as mentioned above refers to the standard framework of principles, guidelines, rules, and conventions that accountants are expected to adhere to in the processes of recording, summarizing, and preparation of financial statements within any given jurisdiction. On the other hand, IFRS are the main standards of accounting system that are applied outside the United States. GAAP and IFRS differ in their classification of a number of cash flows including payment of dividends (Shamrock, 2012). For instance, some activities categorized as investing or financing under one system are operating in another. Significant operating activities such as selling or manufacturing of products may appear on the statement of income rather than the statement of cash flow as cash has not yet been received or given out.
The relevant standards that apply in IFRS is IAS 7 while for U.S. GAAP are SFAS 95, 102, and 104. Under the IFRS, there are no exemptions while, for GAAP, there are exemptions including defined benefit pension plans, and other employee benefit plans and investment firms that meet the specified criteria that are highly liquid (SFAS 102.10). For IFRS, cash movement in the statement of cash flows comprises of cash equivalents, which include short-term investments that are highly liquid and are easily and readily convertible into certain defined cash amounts and with inconsiderable uncertainties of value changes (IAS 7.6 and IAS 7.7). Under GAAP, the statement of cash flow shows alteration in cash and cash equivalents that is short-term investments that are highly liquid and are easily and readily convertible into certain defined cash amount and are near their maturity period and reflect inconsiderable risk of value changes due to interest rate changes (Bellandi, 2012). In general, only those investments that have original period of maturities of three months or less than these are treated as cash equivalents. (SFAS 95.8). Under IFRS, the borrowings from the bank are generally regarded as financing activities. In some countries, however, bank overdrafts that are payable at the time of demand form a core part of the business’s cash management. During such conditions, bank overdrafts are incorporated as an element of cash and cash equivalents. A trait of such arrangements of banks is that the balance in the bank frequently changes from being positive to overdrawn (IAS 7.8). On the other hand, under GAAP, bank overdrafts are incorporated in liabilities. Additionally, they are excluded from cash equivalents. Any changes in balances overdraft are treated as financing activities (Henry et al., 2009).
Under IFRS, the main standard categories are operating, investing, and financing. Dividends and interests are categorized consistently from year to year under the heading that is the most appropriate. Paid dividends and interests may be reflected as investing or operating cash flows. Dividends and interest received may be revealed as investing or operating cash flows. But, banks reveal interest paid and received as operating cash flows under (IAS 7.31-34). On the other hand, taxation cash flows are revealed distinctively under operating activities unless they can be defined specifically with financing or investing cash flows (IAS 7.14(f) and IAS 7.35-36). Under GAAP, the main categories are financing, operating, and investing just like the case of IFRS. Dividends and interests received, and paid interest are categorized as operating activities. Paid dividends are categorized as financing activities (SFAS 95.14-23). Taxation cash flows, on the other hand, are categorized as operating activities (SFAS 95.23). Under IFRS, IAS 7.18 lets the cash flows from operating activities to be shown through either the indirect method (adjusting profit for non-cash movements or the direct method that involves showing the main classes of gross payments and receipts. According to Shamrock (2009), the IAS 7.20 recommends two alternative methods of presentation for the indirect method. Under GAAP, SFAS 95 lets for either indirect or direct methods. However, it requires that the presentation of financial statement to incorporate a net cash flow reconciliation from operating income to net income, in any case.
Under IFRS, cash payments and receipts that are made on behalf of customers are reported on a net basis when the cash flows represent the customer’s activities rather than the enterprise’s activities. In addition, cash payments and receipts for items in which turnover is fast and the amounts are large, and the standard requires cash flows associated with disposal or purchase of an entity to be incorporates in investing activities, but with separate disclosure, such are also reported on a net basis (IAS 7.22). On the other hand, under GAAP, cash payments and receipts must be shown gross (Henry et al., 2009). Particular items may be reflected net due to their quick turnover, large amounts, and short maturities. In addition, items, which qualify for reporting as net are those cash flows related to loan receivable, investments other than cash equivalents, and debt given that the initial maturity of the item either a liability or asset is three or less months (SFAS 95.11-13). The cash flows pertaining to the disposal or purchase of a business entity are categorized as investing activities.
IFRS 7.39 necessitates the disclosure of the cash flow amounts that are attributable to a business operation that is discontinued under the standard titles. However, the standards do not make it mandatory for separate disclosure of the consequence of cash flows from acquisitions from each heading in the statement of cash flow. Under GAAP, separate disclosure of cash flows pertaining to discontinued operations of an entity is not mandatory for presentation. If a business enterprise decides to report cash flows separately from discontinued activities, then the entity must not sum investing, financing, and operating cash flows from discontinued activities into one line item, rather it should reveal them separately. Under IFRS, the components of cash and cash equivalents are disclosed and reconciled to balance sheet. Under GAAP, the total amount of cash and cash equivalents at the beginning and end of time reflected in the statement should be similar to those in the balance sheet (Shamrock, 2012).
The IFRS standard requires that foreign branches or subsidiaries cash flows to be converted using approximations from weighted averages or rates at the cash flow period (IAS 7.25- IAS- 7.27). Whereas the unrecognized losses and gains are not treated as cash flows, the differences in exchange must be reflected in the cash flow statements to reconcile cash equivalents and cash at the start and end of the period that is reflected separately from investing, financing, and operating activities. On the other hand, under GAAP, cash flows of cash currency are reported by using the rates of exchange in use at the time of the cash flows. In addition, the weighted average rate may be applied if the outcome is significantly similar to that which may be have gotten while using the real rate at the time the cash flow takes place (Bellandi, 2012). The impact of changes in exchange rates on cash balances of foreign currency is reported separately during the process of reconciliation (SFAS 95.25).
Problem Areas in Cash flow and Cash flow structures
There are a number of challenge areas associated with cash flow and cash flow structures. These have been everywhere on the debate arena. The first one is on lack of clarity that makes it hard to make comparisons between two organizations. Additionally, cash flow statements do not have the ability to distinguish mandatory from discretionary cash flow. The statements only show the main applications and sources of cash by the business. The real solvency and status of the business cannot be shown by the information. Complete disclosure helps users learn about appreciating the cash flow generated by firms. This lets the analysis of the entity’s flexibility. There is, however, no clear definition of cash equivalents by IAS7, which implies that two firms may categorize similar items in a different way (Steyn and Hamman, 2012).
Another problem has to do with the issue of ignorance of future cash flows. The reason behind this is that they are based on cash flows from the past years. This implies that duplicate of cash flows of the past may not be accurate. The statements for future business expansion are not reflected. Consequently, the reports do not reveal the vital information to highlight the cost for future growth. Another challenge is that cash flow statements allow for more than one alternative treatment that may pose challenges for users of information in the statements (Steyn and Hamman, 2012).
Analysis of points 2 and 3 in relation to the Conceptual Framework
Cash flow statements are crucial to any business. This being the case, IFRS and GAAP are essential in relation to the Conceptual Framework governing firms in different regions. It is a legal requirement for companies to prepare cash flow statements. Without these statements, the importance of accounting may not be felt. Cash flow statements have a variety of uses such as coordination and planning of financial operations of a business; it is used as a control device for the management of organizations, it is useful in internal financial management, it enables the management of organizations to account for a situation when business has gained big profits. In addition, the information from the statements may be used for short-term financial decisions in organizations (Shamrock., 2012). As mentioned, it is a legal requirement for every medium and big business to produce a statement of cash flow in order to enable accounting information users to make appropriate analysis of the financial statement. The IFRS and GAAP are essential as they provide the guidelines in which to produce these statements, although they differ in their standards but not by far.
Appropriate courses of action
Bearing in mind the multiple advantages associated with cash flow and cash flow structures, some essential measures need to be taken by both the institutions for settling accounting standards to ensure that the process of reporting on cash flow statements is simplified. This will ensure that even entities that do not produce such statements due to difficulties experienced during the preparation do so in a simple manner. In addition, the IFRS and GAAP should work on their differences regarding the concept in question to ensure that there are no significant variations in their reporting. This would clear out the challenge of lack of clarity on reporting and reinforce the usefulness of the cash flow statements by users of financial information.
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