Repository for all documents: www.uwcentre.ac.cn/haut Welcome to ACF 201 and ACF 202 Lecturer: Cynthia Fortin, CPA, CMA Email: cynth_fortin@yahoo.ca Wechat: cynthia20131001 Repository for all documents: www.uwcentre.ac.cn/haut

Accounting and Reporting on a Chapter 1 Accounting and Reporting on a Cash Flow Basis

By the end of this chapter, you should be able to: explain how cash flow accounting satisfies the information needs of shareholders and managers; prepare a cash budget; explain the characteristics that makes cash flow data a reliable and fair representation; critically discuss the use of cash flow accounting for predicting future dividends.

Managers tell the story of how well a company performed. e.g. What happened in the company over the past period? Help predict future cash flows Report on how well Managers took care of the company assets (stewardship)

Accounting communicates What? Reliable and relevant financial information How? Via Financial statements When? Annual Quarterly Monthly To whom? Users What kind of users? Internal – Managers External – Shareholders Why? Internal to control business and make decisions External to evaluate how managers perform.

OWNS the COMPANY Has only some information Why? Public information could help competitors Directors make judgement calls Regulated by: IFRS Company Act Market regulations e.g. LSE How can Managers be trusted? Rely on a clean audit report Maintain confidence BOD

External users – Restricted information Quality of information Tensions between investors’ needs and management’s willingness to provide projections based on “best” estimates General-purpose reports Cannot provide detailed information for all user needs Shareholders’ primary concern. They are the owners and providers of economic resources

External users expect accountants Technical expertise – IFRS compliance Commercial awareness – substance over form e.g. that transactions should be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

Internal users – Accountants and Managers have: Access to detailed financial budget/actual results Have moral obligation to keep external investors fully informed on the nature of the business and events affecting business, profitability and financial stability Companies operate on ‘need to know’ basis managers only get the information they need to carry out their responsibilities to the best of their abilities

Internal reports accountants’ skills Able to provide reports specific to the needs; so, they are a good basis for decisions Skilled communicator (to tell the story) Reports are clear and precise

Internal reports accountants’ skills User confidence that reports are: Relevant (to user’s needs) Timely (only what happened in the period) Objective (no judgement involved) Verifiable (transactions have taken place) Reliable (free from bias) Complete (nothing missing, all transactions recorded) Fair representations of what happened.

Steps when reporting to users. Figure 1.1 General financial decision model to illustrate the user/accountant interface

Cash flow information is relevant Why? Forecast cash flows: Capital investments Business proposals Confirms Actual cash flows: Compares decision to invest to actual results Why? To managing working capital. How much cash does a company need to operate on a daily basis?

Let’s illustrate Mr Norman is considering whether to start up a retail business by acquiring the lease of a shop for five years at a cost of £80,000. Mr Norman is a profit satisficer who is looking to achieve at least a 10% return, which represents the time value of money. Cash to be invested in the lease is £80,000 and that the realised operating cash flows over the life of the investment in the shop are as shown in Figure 1.4. This shows that there is a forecast of £30,000 annually for five years and a final receipt of £29,000 in 20X6 when he proposes to cease trading.

Forecast of realised operating cash flows Cash in Cash out Figure 1.4 Forecast of realised operating cash flows

llustration of cash-based statements Initial investment appraisal NPV of cash flows – criterion is positive NPV at 10% Investment data Capital outlay 80,000 (cost of lease) Forecast income 30,000 annually for 5 years Final receipt 29,000 in year 6.

Illustration – NPV calculation Figure 1.5 NPV calculation using discount tables NPV tables.docx

we will prepare half-yearly accounts for Mr Norman – Cash budget Figure 1.6 Forecast of realised operating cash flows

We assume that, having applied the net present value appraisal technique to the cash flows and ascertained that the NPV was positive, Mr Norman proceeded to set up the business on 1 January 20X1. He introduced capital of £50,000, acquired a five-year lease for £80,000 and paid £6,250 in advance as rent to occupy the property to 31 December 20X1. He has decided to prepare financial statements at half-yearly intervals. The information given in Figure 1.7 concerns his trading for the half-year to 30 June 20X1.

Illustration – first 6 months actual cash flows for monthly sales Figure 1.7 Monthly sales, purchases and expenses for 6 months ended 30 June 20X1

Illustration – realised operating cash flows Figure 1.8 Monthly realised operating cash flows

Illustration – realised operating cash flows for first 6 months Figure 1.9 Realised operating cash flows for the 6 months ended 30 June 20X1

The figure of £15,650 needs to be compared with the forecast cash flows used in the investment appraisal. This is a form of auditing. It allows the assumptions made on the initial investment decision to be confirmed. The forecast/actual comparison (based on the information in Figures 1.6 and 1.9) is set out in Figure 1.10

Illustration – budget/actual comparison Figure 1.10 Forecast/actual comparison

What characteristics make this data relevant? Objective (no judgement) Consistent (between forecast and actual) Confirmatory (helping users confirm or correct their past assessments) Predictive (provide a basis for revising the initial forecasts) Accounting standards only required when judgements have to be made – Eg. estimating bad and doubtful debts Cash based; so, no need for IFRSs.

Statement of financial position under cash flow concept needed as: Basis to assess stewardship The accounting system records all transactions Includes capital cash flows Preparation of a statement of financial position Basis to evaluate working capital policies.

Characteristics that make data Prudence Reasonable, but NOT excessive Neutrality Present best picture for business, but not a misleading one Completeness adequate internal control procedures in operation. Faithful representation Cash flows can be depended upon by users to represent faithfully what they purport to represent provided, of course, that the completeness characteristic has been satisfied. Substance over form Cash flow accounting does not necessarily possess this characteristic which requires that transactions should be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

Summary – cash flow accounting How useful is it for internal decision-making? Forecast CFs are relevant for investment appraisal Actual CFs are relevant for confirmation of the investment decision Both forecast and actual CFs are relevant for working capital management

Summary – cash flow accounting How useful is it for making management accountable? Realised cash flows are useful for capital investment decision and monitoring Note that unrealised cash flows are also necessary for stewardship purposes.

Summary – cash flow accounting How useful is it for external reporting? Relevant for stewardship and accountability Reliable Objective Consistent Prudent Neutral.

Reference Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 18th Edition chapter 1