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.
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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.
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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 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.
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 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.
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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.
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.
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.
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.
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