Accounting and reporting on a cash flow basis CHAPTER 1

1.1 Introduction

Accountants are communicators. Accountancy is the art of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of the management. The art lies in selecting the information that is relevant to the user and is reliable.

Shareholders require periodic information that the managers are accounting properly for the resources under their control. This information helps the shareholders to evaluate the performance of the managers. The performance measured by the accountant shows the extent to which the economic resources of the business have grown or diminished during the year.

The shareholders also require information to predict future performance. At present companies are not required to publish forecast financial statements on a regular basis and the shareholders use the report of past performance when making their predictions.

Managers require information in order to control the business and make investment decisions.

Objectives By the end of this chapter, you should be able to: ●  explain the extent to which cash flow accounting satisfies the information needs of shareholders and managers; ●  prepare a cash budget and operating statement of cash flows; ●  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.

1.2 Shareholders

Shareholders are external users. As such, they are unable to obtain access to the same amount of detailed historical information as the managers, e.g. total administration costs are disclosed in the published profit and loss account, but not an analysis to show how the figure is made up. Shareholders are also unable to obtain associated information, e.g. budgeted sales and costs. Even though the shareholders own a company, their entitlement to information is restricted.

The information to which shareholders are entitled is restricted to that specified by statute, e.g. the Companies Acts, or by professional regulation, e.g. Financial Reporting Standards, or by market regulations, e.g. Listing requirements. This means that there may be a tension between the amount of information that a shareholder would like to receive and the amount that the directors are prepared to provide. For example, shareholders might consider that forecasts of future cash flows would be helpful in predicting future dividends, but the directors might be concerned that such forecasts could help competitors or make directors open to criticism if forecasts are not met. As a result, this information is not disclosed.

There may also be a tension between the quality of information that shareholders would like to receive and that which directors are prepared to provide. For example, the shareholders might consider that judgements made by the directors in the valuation of long-term contracts should be fully explained, whereas the directors might prefer not to reveal this information given the high risk of error that often attaches to such estimates. In practice, companies tend to compromise: they do not reveal the judgements to the shareholders, but maintain confidence by relying on the auditor to give a clean audit report.

The financial reports presented to the shareholders are also used by other parties such as lenders and trade creditors, and they have come to be regarded as general-purpose reports. However, it may be difficult or impossible to satisfy the needs of all users. For example, users may have different time-scales – shareholders may be interested in the long-term trend of earnings over three years, whereas creditors may be interested in the likelihood of receiving cash within the next three months.

The information needs of the shareholders are regarded as the primary concern. The government perceives shareholders to be important because they provide companies with their economic resources. It is shareholders’ needs that take priority in deciding on the nature and detailed content of the general-purpose reports.¹

1.3 What skills does an accountant require in respect of external reports?

For external reporting purposes the accountant has a two-fold obligation:

●  an obligation to ensure that the financial statements comply with statutory, professional and Listing requirements; this requires the accountant to possess technical expertise;

●  an obligation to ensure that the financial statements present the substance of the commercial transactions the company has entered into; this requires the accountant to have commercial awareness.²

1.4 Managers

Managers are internal users. As such, they have access to detailed financial statements showing the current results, the extent to which these vary from the budgeted results and the future budgeted results. Examples of internal users are sole traders, partners and, in a company context, directors and managers.

There is no statutory restriction on the amount of information that an internal user may receive; the only restriction would be that imposed by the company’s own policy. Frequently, companies operate a ‘need to know’ policy and only the directors see all the financial statements; employees, for example, would be most unlikely to receive information that would assist them in claiming a salary increase – unless, of course, it happened to be a time of recession, when information would be more freely provided by management as a means of containing claims for an increase.

1.5 What skills does an accountant require in respect of internal reports?

For the internal user, the accountant is able to tailor his or her reports. The accountant is required to produce financial statements that are specifically relevant to the user requesting them.

The accountant needs to be skilled in identifying the information that is needed and conveying its implication and meaning to the user. The user needs to be confident that the accountant understands the user’s information needs and will satisfy them in a language that is understandable. The accountant must be a skilled communicator who is able to instil confidence in the user that the information is:

●  relevant to the user’s needs;

●  measured objectively;

●  presented within a time-scale that permits decisions to be made with appropriate information;

●  verifiable, in that it can be confirmed that the report represents the transactions that have taken place;

●  reliable, in that it is as free from bias as is possible;

●  a complete picture of material items;

●  a fair representation of the business transactions and events that have occurred or are being planned.

The accountant is a trained reporter of financial information. Just as for external reporting, the accountant needs commercial awareness. It is important, therefore, that he or she should not operate in isolation.

1.5.1 Accountant’s reporting role

The accountant’s role is to ensure that the information provided is useful for making decisions. For external users, the accountant achieves this by providing a general-purpose financial statement that complies with statute and is reliable. For internal users, this is done by interfacing with the user and establishing exactly what financial information is relevant to the decision that is to be made.

We now consider the steps required to provide relevant information for internal users.

1.6 Procedural steps when reporting to internal users

A number of user steps and accounting action steps can be identified within a financial decision model. These are shown in Figure 1.1.

Note that, although we refer to an accountant/user interface, this is not a single occurrence because the user and accountant interface at each of the user decision steps.

At step 1, the accountant attempts to ensure that the decision is based on the appropriate appraisal methodology. However, the accountant is providing a service to a user and,

Figure 1.1 General financial decision model to illustrate the user/accountant

while the accountant may give guidance, the final decision about methodology rests with the user.

At step 2, the accountant needs to establish the information necessary to support the decision that is to be made.

At step 3, the accountant needs to ensure that the user understands the full impact and financial implications of the accountant’s report taking into account the user’s level of understanding and prior knowledge. This may be overlooked by the accountant, who feels that the task has been completed when the written report has been typed.

It is important to remember in following the model that the accountant is attempting to satisfy the information needs of the individual user rather than those of a ‘user group’. It is tempting to divide users into groups with apparently common information needs, without recognising that a group contains individual users with different information needs. We return to this later in the chapter, but for the moment we continue by studying a situation where the directors of a company are considering a proposed capital investment project.

Let us assume that there are three companies in the retail industry: Retail A Ltd, Retail B Ltd and Retail C Ltd. The directors of each company are considering the purchase of a warehouse. We could assume initially that, because the companies are operating in the same industry and are faced with the same investment decision, they have identical information needs. However, enquiry might establish that the directors of each company have a completely different attitude to, or perception of, the primary business objective.

For example, it might be established that Retail A Ltd is a large company and under the Fisher/Hirshleifer separation theory the directors seek to maximise profits for the benefit of the equity investors; Retail B Ltd is a medium-sized company in which the directors seek to obtain a satisfactory return for the equity shareholders; and Retail C Ltd is a smaller company in which the directors seek to achieve a satisfactory return for a wider range of stakeholders, including, perhaps, the employees as well as the equity shareholders.

The accountant needs to be aware that these differences may have a significant effect on the information required. Let us consider this diagrammatically in the situation where a capital investment decision is to be made, referring particularly to user step 2: ‘Establish with the accountant the information necessary for decision making’.

Figure 1.2 Impact of different user attitudes on the information needed in relation

We can see from Figure 1.2 that the accountant has identified that:

●  the relevant financial data are the same for each of the users, i.e. cash flows; but

●  the appraisal methods selected, i.e. internal rate of return (IRR) and net present value ( NPV), are different; and

●  the appraisal criteria employed by each user, i.e. higher IRR and NPV, are different.

In practice, the user is likely to use more than one appraisal method, as each has advantages and disadvantages. However, we can see that, even when dealing with a single group of apparently homogeneous users, the accountant has first to identify the information needs of the particular user. Only then is the accountant able to identify the relevant financial data and the appropriate report. It is the user’s needs that are predominant.

If the accountant’s view of the appropriate appraisal method or criterion differs from the user’s view, the accountant might decide to report from both views. This approach affords the opportunity to improve the user’s understanding and encourages good practice.

The diagrams can be combined (Figure 1.3) to illustrate the complete process. The user is assumed to be Retail A Ltd, a company that has directors who are profit maximisers.

The accountant is reactive when reporting to an internal user. We observe this characteristic in the Norman example set out in section 1.8. Because the cash flows are identified as relevant to the user, it is these flows that the accountant will record, measure and appraise.

The accountant can also be proactive, by giving the user advice and guidance in areas where the accountant has specific expertise, such as the appraisal method that is most appropriate to the circumstances.

1.7 Agency costs³

The information in Figure 1.2 assumes that the directors have made their investment decision based on the assumed preferences of the shareholders. However, in real life, the directors might also be influenced by how the decision impinges on their own position. If, for example, their remuneration is a fixed salary, they might select not the investment with the highest IRR, but the one that maintains their security of employment. The result might be suboptimal investment and financing decisions based on risk aversion and overretention. To the extent that the potential cash flows have been reduced, there will be an agency cost to the shareholders. This agency cost is an opportunity cost – the amount that was forgone because the decision making was suboptimal – and, as such, it will not be recorded in the books of account and will not appear in the financial statements.

1.8 Illustration of periodic financial statements prepared under the cash flow concept to disclose realised operating cash flows

In the above example of Retail A, B and C, the investment decision for the acquisition of a warehouse was based on an appraisal of cash flows. This raises the question: ‘Why not continue with the cash flow concept and report the financial changes that occur after the investment has been undertaken using that same concept?’

To do this, the company will record the consequent cash flows through a number of subsequent accounting periods; report the cash flows that occur in each financial period; and produce a balance sheet at the end of each of the financial periods. For illustration we follow this procedure in sections 1.8.1 and 1.8.2 for transactions entered into by Mr S. Norman.

1.8.1 Appraisal of the initial investment decision

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.

Our first task has been set out in Figure 1.1 above. It is to establish the information that Mr Norman needs, so that we can decide what data need to be collected and measured. Let us assume that, as a result of a discussion with Mr Norman, it has been ascertained that he is a profit satisficer who is looking to achieve at least a 10% return, which represents the time value of money. This indicates that, as illustrated in Figure 1.2:

●  the relevant data to be measured are cash flows, represented by the outflow of cash invested in the lease and the inflow of cash represented by the realised operating cash flows;

●  the appropriate appraisal method is NPV; and

●  the appraisal criterion is a positive NPV using the discount rate of 10%.

Let us further assume that the 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.

We already know that Mr Norman’s investment criterion is a positive NPV using a discount factor of 10%. A calculation (Figure 1.5) shows that the investment easily satisfies that criterion.

1.8.2 Preparation of periodic financial statements under the cash flow concept

Having predicted the realised operating cash flows for the purpose of making the investment decision, we can assume that the owner of the business will wish to obtain feedback to evaluate the correctness of the investment decision. He does this by reviewing the actual results on a regular timely basis and comparing these with the predicted forecast. Actual results should be reported quarterly, half-yearly or annually in the same format as used when making the decision in Figure 1.4. The actual results provide management with the feedback information required to audit the initial decision; it is a technique for achieving accountability. However, frequently, companies do not provide a report of actual cash flows to compare with the forecast cash flows, and fail to carry out an audit review.

In some cases, the transactions relating to the investment cannot be readily separated from other transactions, and the information necessary for the audit review of the investment cannot be made available. In other cases, the routine accounting procedures fail to collect such cash flow information because the reporting systems have not been designed to provide financial reports on a cash flow basis; rather, they have been designed to produce reports prepared on an accrual basis.

What would financial reports look like if they were prepared on a cash flow basis?

To illustrate cash flow period accounts, we will prepare half-yearly accounts for Mr Norman. To facilitate a comparison with the forecast that underpinned the investment decision, we will redraft the forecast annual statement on a half-yearly basis. The data for the first year given in Figure 1.4 have therefore been redrafted to provide a forecast for the half-year to 30  June, as shown in Figure  1.6.

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

From this statement we can see that the business generated positive cash flows after the end of February. These are, of course, only the cash flows relating to the trading transactions.

The information in the ‘Total’ row of Figure 1.7 can be extracted to provide the financial statement for the six months ended 30 June 20X1, as shown in Figure 1.9.

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.

What are the characteristics of these data that make them relevant?

●  The data are objective. There is no judgement involved in deciding the values to include in the financial statement, as each value or amount represents a verifiable cash transaction with a third party.

●  The data are consistent. The statement incorporates the same cash flows within the periodic financial report of trading as the cash flows that were incorporated within the initial capital investment report. This permits a logical comparison and confirmation that the decision was realistic.

●  The results have a confirmatory value by helping users confirm or correct their past assessments.

●  The results have a predictive value, in that they provide a basis for revising the initial forecasts if necessary.⁴

●  There is no requirement for accounting standards or disclosure of accounting policies that are necessary to regulate accrual accounting practices, e.g. depreciation methods.

1.9 Illustration of preparation of statement of financial position

Although the information set out in Figure 1.10 permits us to compare and evaluate the initial decision, it does not provide a sufficiently sound basis for the following:

●  assessing the stewardship over the total cash funds that have been employed within the business;

●  signalling to management whether its working capital policies are appropriate.

1.9.1 Stewardship

To assess the stewardship over the total cash funds we need to:

(a)    evaluate the effectiveness of the accounting system to make certain that all transactions are recorded;

(b)    extend the cash flow statement to take account of the capital cash flows; and

(c)     prepare a statement of financial position or balance sheet as at 30 June 20X1.

The additional information for (b) and (c) above is set out in Figures 1.11 and 1.12 respectively.

The cash flow statement and statement of financial position, taken together, are a means of assessing stewardship. They identify the movement of all cash and derive a net balance figure. These statements are a normal feature of a sound system of internal control, but they have not been made available to external users.

1.9.2 Working capital policies

By ‘working capital’ we mean the current assets and current liabilities of the business. In addition to providing a means of making management accountable, cash flows are the raw data required by financial managers when making decisions on the management of working capital. One of the decisions would be to set the appropriate terms for credit policy. For example, Figure 1.11 shows that the business will have a £14,350 overdraft at 30 June 20X1.

If this is not acceptable, management will review its working capital by reconsidering the credit given to customers, the credit taken from suppliers, stock-holding levels and the timing of capital cash inflows and outflows.

If, in the example, it were possible to obtain 45 days’ credit from suppliers, then the creditors at 30 June would rise from £37,000 to a new total of £53,500. This increase in trade credit of £16,500 means that half of the May purchases (£33,000/2) would not be paid for until July, which would convert the overdraft of £14,350 into a positive balance of £2,150. As a new business it might not be possible to obtain credit from all of the suppliers. In that case, other steps would be considered, such as phasing the payment for the lease of the warehouse or introducing more capital.

An interesting research report⁵ identified that for small firms survival and stability were the main objectives rather than profit maximisation. This, in turn, meant that cash flow indicators and managing cash flow were seen as crucial to survival. In addition, cash flow information was perceived as important to external bodies such as banks in evaluating performance.

1.10 Treatment of non-current assets in the cash flow model

The statement of financial position in Figure 1.12 does not take into account any unrealised cash flows. Such flows are deemed to occur as a result of any rise or fall in the realisable value of the lease. This could rise if, for example, the annual rent payable under the lease were to be substantially lower than the rate payable under a new lease entered into on 30 June 20X1. It could also fall with the passing of time, with six months having expired by 30 June 20X1. We need to consider this further and examine the possible treatment of non-current assets in the cash flow model.

Using the cash flow approach, we require an independent verification of the realisable value of the lease at 30 June 20X1. If the lease has fallen in value, the difference between the original outlay and the net realisable figure could be treated as a negative unrealised operating cash flow.

For example, if the independent estimate was that the realisable value was £74,000, then the statement of financial position would be prepared as in Figure 1.13. The fall of £6,000 in realisable value is an unrealised cash flow and, while it does not affect the calculation of the net cash balance, it does affect the statement of financial position. Figure 1.13 Statement of financial position as at 30 June 20X1

The additional benefit of the statement of financial position, as revised, is that the owner is able clearly to identify the following:

●  the operating cash inflows of £15,650 that have been realised from the business operations;

●  the operating cash outflow of £6,000 that has not been realised, but has arisen as a result of investing in the lease;

●  the net cash balance of –£14,350;

●  the statement provides a stewardship-orientated report: that is, it is a means of making the management accountable for the cash within its control.

1.11 What are the characteristics of these data that make them reliable?

We have already discussed some characteristics of cash flow reporting which indicate that the data in the financial statements are relevant, e.g. their predictive and confirmatory roles. We now introduce five more characteristics of cash flow statements which indicate that the information is also reliable, i.e. free from bias.⁶ These are prudence, neutrality, completeness, faithful representation and substance over form.

1.11.1 Prudence characteristic

Revenue and profits are included in the cash flow statement only when they are realised. Realisation is deemed to occur when cash is received. In our Norman example, the £172,500 cash received from debtors represents the revenue for the half-year ended 30 June 20X1. This policy is described as prudent because it does not anticipate cash flows: cash flows are recorded only when they actually occur and not when they are reasonably certain to occur. This is one of the factors that distinguishes cash flow from accrual accounting.

1.11.2 Neutrality characteristic

Financial statements are not neutral if, by their selection or presentation of information, they influence the making of a decision in order to achieve a predetermined result or outcome. With cash flow accounting, the information is not subject to management selection criteria.

Cash flow accounting avoids the tension that can arise between prudence and neutrality because, whilst neutrality involves freedom from deliberate or systematic bias, prudence is a potentially biased concept that seeks to ensure that, under conditions of uncertainty, gains and assets are not overstated and losses and liabilities are not understated.⁷

1.11.3 Completeness characteristic

The cash flows can be verified for completeness provided there are adequate internal control procedures in operation. In small and medium-sized enterprises there can be a weakness if one person, typically the owner, has control over the accounting system and is able to under-record cash receipts.

1.11.4 Faithful representation characteristic

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.

1.11.5 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.⁸

1.12 Reports to external users

1.12.1 Stewardship orientation

Cash flow accounting provides objective, consistent and prudent financial information about a business’s transactions. It is stewardship-orientated and offers a means of achieving accountability over cash resources and investment decisions.

1.12.2 Prediction orientation

External users are also interested in the ability of a company to pay dividends. It might be thought that the past and current cash flows are the best indicators of future cash flows and dividends. However, the cash flow might be misleading, in that a declining company might sell non-current assets and have a better net cash position than a growing company that buys non-current assets for future use. There is also no matching of cash inflows and outflows, in the sense that a benefit is matched with the sacrifice made to achieve it.

Consequently, it has been accepted accounting practice to view the income statement prepared on the accrual accounting concept as a better predictor of future cash flows to an investor than the cash flow statements that we have illustrated in this chapter.

However, the operating cash flows arising from trading and the cash flows arising from the introduction of capital and the acquisition of non-current assets can become significant to investors, e.g. they may threaten the company’s ability to survive or may indicate growth.

In the next chapter, we revise the preparation of the same three statements using the accrual accounting model.

1.12.3 Going concern

The Financial Reporting Council suggests in its Consultation Paper Going Concern and Financial Reporting⁹ that directors in assessing whether a company is a going concern may prepare monthly cash flow forecasts and monthly budgets covering, as a minimum, the period up to the next statement of financial position date. The forecasts would also be supported by a detailed list of assumptions which underlie them.

Summary

To review our understanding of this chapter, we should ask ourselves the following questions.

How useful is cash flow accounting for internal decision making?

Forecast cash flows are relevant for the appraisal of proposals for capital investment.

Actual cash flows are relevant for the confirmation of the decision for capital investment.

Cash flows are relevant for the management of working capital. Financial managers might have a variety of mathematical models for the efficient use of working capital, but cash flows are the raw data upon which they work.

How useful is cash flow accounting for making management accountable? The cash flow statement is useful for confirming decisions and, together with the statement of financial position, provides a stewardship report. Lee states that ‘Cash flow accounting appears to satisfy the need to supply owners and others with stewardshiporientated information as well as with decision-orientated information.’10 Lee further states that: By reducing judgements in this type of financial report, management can report factually on its stewardship function, whilst at the same time disclosing data of use in the decision-making process. In other words, cash flow reporting eliminates the somewhat artificial segregation of stewardship and decision-making information.11 This is exactly what we saw in our Norman example – the same realised operating cash flow information was used for both the investment decision and financial reporting. However, for stewardship purposes it was necessary to extend the cash flow to include all cash movements and to extend the statement of financial position to include the unrealised cash flows. How useful is cash flow accounting for reporting to external users? Cash flow information is relevant: ●  as a basis for making internal management decisions in relation to both non-current assets and working capital; ●  for stewardship and accountability; and ●  for assessing whether a business is a going concern. Cash flow information is reliable and a fair representation, being: ●  objective; ●  consistent; ● prudent; and ● neutral. However, professional accounting practice requires reports to external users to be on an accrual accounting basis. This is because the accrual accounting profit figure is a better predictor for investors of the future cash flows likely to arise from the dividends paid to them by the business, and of any capital gain on disposal of their investment. It could also be argued that cash flows may not be a fair representation of the commercial substance of transactions, e.g. if a business allowed a year’s credit to all its customers there would be no income recorded.

REVIEW QUESTIONS

1    Explain why it is the user who should determine the information that the accountant collects, measures and reports, rather than the accountant who is the expert in financial information.

2    ‘Yuji Ijiri rejects decision usefulness as the main purpose of accounting and puts in its place accountability. Ijiri sees the accounting relationship as a tripartite one, involving the accountor, the accountee, and the accountant ... the decision useful approach is heavily biased in favour of the accountee ... with little concern for the accountor ... in the central position Ijiri would put fairness.’¹² Discuss Ijiri’s view in the context of cash flow accounting.

3    Discuss the extent to which you consider that accounts for a small businessperson who is carrying on business as a sole trader should be prepared on a cash flow basis.

4    Explain why your decision in question 3 might be different if the business entity were a mediumsized limited company.

5    ‘Realised operating cash flows are only of use for internal management purposes and are irrelevant to investors.’ Discuss.

6    ‘While accountants may be free from bias in the measurement of economic information, they cannot be unbiased in identifying the economic information that they consider to be relevant.’ Discuss.

7    Explain the effect on the statement of financial position in Figure 1.13 if the non-current asset consisted of expenditure on industry-specific machine tools rather than a lease.

8    ‘It is essential that the information in financial statements has a prudent characteristic if the financial statements are to be objective.’ Discuss.

EXERCISES

An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliottelliott) for exercises marked with an asterisk (*).

Question 1

Jane Parker is going to set up a new business on 1 January 20X1. She estimates that her first six months in business will be as follows:

(i)      She will put £150,000 into a bank account for the firm on 1 January 20X1.

(ii)     On 1 January 20X1 she will buy machinery £30,000, motor vehicles £24,000 and premises £75,000, paying for them immediately.

(iii)    All purchases will be effected on credit. She will buy £30,000 goods on 1 January and will pay for these in February. Other purchases will be: rest of January £48,000; February, March, April, May and June £60,000 each month. Other than the £30,000 worth bought in January, all other purchases will be paid for two months after purchase.

(iv)    Sales (all on credit) will be £60,000 for January and £75,000 for each month after. Customers will pay for the goods in the fourth month after purchase, i.e. £60,000 is received in May.

(v)     She will make drawings of £1,200 per month.

(vi)    Wages and salaries will be £2,250 per month and will be paid on the last day of each month.

(vii)   General expenses will be £750 per month, payable in the month following that in which they are incurred.

(viii)  Rates will be paid as follows: for the three months to 31 March 20X1 by cheque on 28 February 20 X1; for the 12 months ended 31 March 20X2 by cheque on 31 July 20X1. Rates are £ 4,800 per annum.

(ix)    She will introduce new capital of £82,500 on 1 April 20X1.

(x)     Insurance covering the 12 months of 20X1 of £2,100 will be paid for by cheque on 30 June 20 X 1.

(xi)    All receipts and payments will be by cheque.

(xii)   Inventory on 30 June 20X1 will be £30,000.

(xiii)  The net realisable value of the vehicles is £19,200, machinery £27,000 and premises £75,000.

Required: Cash flow accounting

(i)    Draft a cash budget (includes bank) month by month for the period January to June, showing clearly the amount of bank balance or overdraft at the end of each month.

(ii)   Draft an operating cash flow statement for the six-month period.

(iii)  Assuming that Jane Parker sought your advice as to whether she should actually set up in business, state what further information you would require.

* Question 2

Mr Norman set up a new business on 1 January 20X8. He invested £50,000 in the new business on that date. The following information is available.

1    Gross profit was 20% of sales. Monthly sales were as follows:

Month	Sales £	Month	Sales £
January	15,000	May	40,000
February	20,000	June	45,000
March	35,000	July	50,000

April     40,000

2    50 % of sales were for cash. Credit customers (50% of sales) pay in month following sale.

3    The supplier allowed one month’s credit.

4    Monthly payments were made for rent and rates £2,200 and wages £600.

5    On 1 January 20X8 the following payments were made: £80,000 for a five-year lease of business premises and £3,500 for insurances on the premises for the year. The realisable value of the lease was estimated to be £76,000 on 30 June 20X8 and £70,000 on 31 December 20X8.

6    Staff sales commission of 2% of sales was paid in the month following the sale.

Required:

(a)   A purchases budget for each of the first six months.

(b)  A cash flow statement for the first six months.

(c)   A statement of operating cash flows and financial position as at 30 June 20X8.

(d)  Write a brief letter to the bank supporting a request for an overdraft.

Question 3

Fred and Sally own a profitable business that deals in windsurfing equipment. They are the only UK agents to import ‘Dryline’ sails from Germany, and in addition to this they sell a variety of boards and miscellaneous equipment that they buy from other dealers in the UK.

Two years ago they diversified into custom-made boards built to individual customer requirements, each of which was supplied with a ‘Dryline’ sail. In order to build the boards, they have had to take over larger premises, which consist of a shop front with a workshop at the rear, and employ two members of staff to help.

Demand is seasonal and Fred and Sally find that there is insufficient work during the winter months to pay rent for the increased accommodation and also wages to the extra two members of staff. The four of them could spend October to March in Lanzarote as windsurf instructors and close the UK operation down in this period. If they did, however, they would lose the ‘Dryline’ agency, as Dryline insists on a retail outlet in the UK for 12 months of the year. Dryline sails constitute 40% of their turnover and carry a 50% mark-up.

Trading has been static and the pattern is expected to continue as follows for 1 April 20X5 to 31  March 20X 6:

Sales of boards and equipment (non-custom-built) with Dryline agency: 1 April–30 September £120,000; of this 30% was paid by credit card, which involved one month’s delay in receiving cash and 4% deduction at source.

Sixty custom-built boards 1 April–30 September £60,000; of this 15% of the sales price was for the sail (a ‘Dryline’ 6 m² sail costs Fred and Sally £100; the average price for a sail of the same size and quality is £150 (cost to them)).

Purchasers of custom-built boards take an average of two months to pay and none pays by credit card.

Sales 1 October–31 March of boards and equipment (non-custom-built) £12,000, 30% by credit card as above.

Six custom-built boards were sold for a total of £6,000 and customers took an unexplainable average of three months to pay in the winter.

Purchases were made monthly and paid for two months in arrears.

The average mark-up on goods for resale excluding ‘Dryline’ sails was 25%. If they lose the agency, they expect that they will continue to sell the same number of sails, but at their average mark-up of 25%. The variable material cost of each custom-made board (excluding the sail) was £500.

Other costs were:

Wages to employees £6,000 p.a. each (gross including insurance).

Rent for premises £6,000 p.a. (six-monthly renewable lease) payable on the first day of each month.

Other miscellaneous costs: 1 April–30 September         £3,000 1 October–31 March        £900.

Bank balance on 1 April was £100.

Salary earnable over whole period in Lanzarote:

Fred and Sally £1,500 each  living accommodation

Two employees £1,500 each  living accommodation

All costs and income accruing evenly over time.

Required:

(i)   Prepare a cash budget for 1 April 20X5 to 31 March 20X6 assuming that:

(a)   Fred and Sally close the business in the winter months.

(b)  They stay open all year.

(ii)  What additional information would you require before you advised Fred and Sally of the best course of action to take?

References

1    Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, para. 10.

2    Ibid., para. 35.

3    G. Whittred and I. Zimmer, Financial Accounting: Incentive Effects and Economic Consequences, Holt, Rinehart & Winston, 1992, p. 27.

4    IASC, op. cit., para. 27.

5    R. Jarvis, J. Kitching, J. Curran and G. Lightfoot, The Financial Management of Small Firms: An Alternative Perspective, ACCA Research Report No. 49, 1996.

6    IASC, op. cit., para. 31.

7    Ibid., para. 36. 8   Ibid., para. 35.

9       Going Concern and Financial Reporting – Proposals V. Revise the Guidance for Directors of Listed Companies. FRC, 2008, para. 29.

10    T.A. Lee, Income and Value Measurement: Theory and Practice (3 rd edition), Van Nostrand Reinhold ( UK), 1985, p.  173.

11    Ibid.

12    D. Solomons, Making Accounting Policy, Oxford University Press, 1986, p. 79.