Patrik Siljelund Cash flow statements The difference between IAS 7 and other cash flow statements Date: 20/10-2009 Supervisor: Berndt Andersson Patrik Siljelund 800104 Karlstads universitet 651 88 Karlstad Tfn 054-700 10 00 Fax 054-700 14 60 Information@kau.se www.kau.se 1
Abstract The focus essay is to show the cash flow statements by the IASC (international Accounting Standard Committee) and compare it with the standard boards of various countries, such as the UK and Sweden. There have been some lively debates on whether or not the cash flow statements have made an improvement on the statements of various companies who choose to implement its standards, ever since they have been established in 1994. Models of cash flow are the backbone of financial theory. Cash flows offer more credibility to valuation because they are more tangible than accrued earnings. Historical cash flow information is an indicator of the relationship between profitability cash-generating ability, and therefore an indicator of the quality of the profit earned. The question is if the IASC has made these standards more different then they were for each country before and if this has made it more difficult to understand the contents of the cash flow statement. 2
Contents Abstract...2 Cash flow statement differences...4 An introduction to financial accounting...4 The balance sheet...4 The Income statement...4 Cash flow statement -...4 Statement of shareholders equity -...4 Cash flow according to the IASC standards IAS 7...4 Categorizing cash flows in the statement...6 Cash flow formats...6 Dividends and interest...8 Foreign exchange...9 Non-cash transactions...9 Cash flow statements in the UK...10 Cash flow statements in Sweden...11 Conclusions...12 Reference...14 3
Cash flow statement differences An introduction to financial accounting Ever since the first enterprises were formed, there has been a need for a company to present certain information about the financial activities going on. During the course of history, every country has had their own methods of analyzing and presenting their financial reports. In the pioneer era of private businesses, a company would only present financial reports about the activities for its own sake. As time went by, authorities and the private sector have demanded that financial reports are made to present information to those outside the company sphere. There are different kinds of accounting reports depending on who the information is intended to. The Management board of accompany may need different kind of information than the owners/stockholders, stakeholders or even employees of the company itself. In this case, the only significant group of people are the ones outside the company, like the shareholders, the stakeholders etc. The contents of a financial report usually consist of four parts: 1 The balance sheet - Balance sheets show what a company owns and what it owes at a fixed point in time, the assets, which consist of the equity and liability. The Income statement - Income statements show how much money a company made and spent over a period of time. Cash flow statement - Cash flow statements show the exchange of money between a company and the outside world also over a period of time. Statement of shareholders equity - shows changes in the interests of the company s shareholders over time. Cash flow according to the IASC standards IAS 7 The part that will be discussed here is the difference in the cash flow statement for small or medium sized entities (SME) in various countries. The detailed contents of the cash flow statement according to IAS 7 are presented in the table below 2. The definition of an SME varies depending on what country the entity is located at. In the UK, a small company is that which has 50 or less employees and a turnover of no more than 6.5 million, while a medium sized company is that which has 250 employees or less and a turnover of no more than 25.9 million. In the EU, a small company has less than 50 employees or no more than 10 million. A medium sized company has 250 or less employees and a turnover of no more than 50 million. In the USA, the definition is somewhat different from that of the UK and the EU. Instead of classifying the companies by the size of the employees and the annual turnover, the companies are size classified depending on what industry it belongs to. Manufacturing or 1 http://www.sec.gov/investor/pubs/begfinstmtguide.htm 2 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 4
mining companies, whole sale trade industries, retail and services industries, etc. They all have all different size classifications 3. Operating activities Investing activities Financing activities Cash receipts from sale goods Cash payments to acquire Cash proceeds from issue of shares and rendering services fixed assets and pther equity instruments Cash flow receipts from royalties, Cash receipts from sale of Cash payments to owners to acquire fees, commissions and other fixed assets or redeem the entity's shares revenue Cash payments to acquire Cash payments to suppliers for goods and services equity or debt instruments of other entities and interests in joint ventures specificallyidentified with parties financing or investing activities Cash payments for futures, forward Cash recepits and payments contracts, options and swaps from except when the contracts are held contracts held for dealing or for dealing or trading purposes or trading purposes the payments are classified as financing activites Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other shortor longterm borrowings Cash payments to and on behalf Cash advances and loans made to of employees other parties Cash repayments of amounts borrowed Cash payments or refunds of Cash receipts from the repayment of income taxes unless they can be advances and loans made to other Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease Cash receipts and cash payments for an insurance entity for premiums and claims, annuities and other policy benefits The above stated posts will result in a net change (either positive or negative) in cash flows. It is suggested that cash is derived from internal and external sources. The internal cash resources come from the operating activities, while the external resources come from 3 http://www.lib.strath.ac.uk/busweb/guides/smedefine.htm 5
financing activities. All three activities seem to be accepted by the IASC and most national accounting authorities, even though the details may be different for each one depending on the needs for the companies in every country. Cash flow is not necessarily only measured in the actual cash in hand or in the bank account, it can also include so called cash-equivalents. These are short-term, highly liquid investments that are readily convertible to known amount of cash and which are subject to an insignificant risk of changes in value. 4 There is no mention of how to determine the significance to changes in that value. Earlier, cash was referred to as cash on hand and deposits with bank That term was later changed to cash in hand or in the bank account. It was changed for reasons such that it explained too much and too little at the same time. Too much in such sense that not all bank deposits are short-term ready to sell for conversion to cash on hand. Too little because cash can be deposited or invested in institution other than bank, both financial, and non-financial. This situation involving cash equivalents has caused somewhat of a peculiarity, since there are no clear guidelines of how to measure the definition of readily convertible to known amounts of cash according to the IASC financial standard boards. 5 Categorizing cash flows in the statement The three categories, operations/financing/investing, are not mutually exclusive. A transaction may contain two or even all three categories of the cash flow statement (operating-, investingand financing activities). An example of such a case is a finance lease payment where the principal payment will be disclosed as a cash flow under financing and the interest payment will be disclosed under operating or financing. The interest however does not necessarily have to be categorized under operating activities. It can, depending on the situation, be named under financing or investing activities. The UK ASB categorized the interest, dividends or other transactions under posts that are separate from operating, financing or investing activities. This variety in classification is an uncommon procedure which is only allowed under special circumstances, and could prove to be an advantage for multi-product, multioperational companies. Indeed, IASB, UK USA and Sweden have accepted the use of three or more categorizations of cash flows and use it as a favored method of cash flow statement. The reason is that it is much more informative to know the details of the inflow of cash to the company. Cash outflow is merely the usage of cash and cash equivalents. 6 Cash flow formats The cash flow of a company is not the same as the net working capital. Inventory can be purchased by using either cash or bank savings, and since both are current assets, neither one of them will affect net working capital of the balance sheet. This procedure does however increase the inventory stock and decreases the cash of the company, hence decreasing the cash flow. 7 There are two different methods of measuring cash flow from operating activities: The direct method and the indirect method. 8 4 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 5 (IASC). 1992. International Accounting Standard: Cash Flow Statements, London. 6 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 7 Ross, Westerfield, Jaffe; Corporate Finance; 2005, New York 8 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London. 6
The direct method is determined from cash receipts and payments. Cash receipts are printed documents that are registered by a business each time cash is received for a good or service. Basically, this means that it measures how much cash and cash equivalents comes in from customers and other sources of cash in-flow, and how much cash out-flows go to employers, suppliers, creditors etc. The indirect method comes from adjusting net profit for non-cash receipts and payments. It is a way of calculating by avoiding the operational or trading moments and working backwards from net income. According to IAS 7, there are two different formats of presenting each method, which is only allowed by the IASB, but not the other standard boards. The two methods however are allowed to be practiced by all countries. 9 The direct method requires the change of accounting systems for the gross receipts and payments to be obtained from cash flow operations. The alternative direct method, which is recommended by the IASC, does not require it, which allows the use of the old accrual accounting system. The difference is that the numbers are converted by adjusting them for changes that occur in inventories, payments and operating receivables, different non-cash items and other effects on cash that associate to investing and financing activities. 10 The way to report cash flows from operating activities with the indirect method is by changing the net loss or profit for alterations in non-cash transactions, payments/cash receipts that are not related to the reporting year and other elements with financing/investing activities in the profit or loss. There is another way of calculating the cash flow through the indirect method, and that is to get the expenses and revenues from the income statement, and alter those numbers for changes that occur during the year in operating receivables and payables and inventories. The indirect method seems to be the preferred one by the IASC and other national accounting standard boards. The reason is that it provides more information that could be used to predict future cash flow. The UK ASB (Accounting Standards Board) claims that the costs of using the direct method do not outweigh the benefits. It is true that the direct method requires the recording and analysis of cash flows in relation to each transaction, thus calculating two accounting systems. Such a way of working is both time consuming and expensive. 11 It is rather interesting to see how the standard regulating authorities in different countries have chosen to present cash flows from operating activities. The two methods are included with options in which to do with or without reconciliation, which means the reconciliation of net operating cash and cash equivalents to the operating net after tax as reported in the income statement. There are three ways to choose from: 1. The use of the direct method only, with the option to use reconciliation of net cash flows 2. Either the direct or indirect method, with or without reconciliation. 3. The indirect method with direct method proof of operating cash flow For countries like the UK and USA it is optional to choose between the three ways, except for the direct method without reconciliation, which is not allowed in either of the two. The choice between the direct and indirect method is depended on how much effort someone is willing to give for certain amount and type of information. The direct is the method that basically shows all the essential cash flow information according to some. It is claimed that the indirect method only shows computational net income which isn t really a cash flow 9 IASC. 1992. International Accounting Standard:Cash Flow Statements, London. 10 (IASC). 1992. International Accounting Standard: Cash Flow Statements, London. 11 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 7
statement. However, the indirect method does not allow preparers of the cash flow to alter the numbers of the results, thus minimizing the temptation of management to present false information. Also, the choice to include reconciliation of cash flow does have its disadvantages of being costly time consuming in order to extract the desired information. In the end, it all comes down to what kind of information about cash flow is wanted and how this information is to be presented. In some cases both might even be preferable. The direct method with reconciliation is considered by many to be troublesome, in a sense that it requires the assembling of both direct and indirect statements. It is also the reason why this method of approach is not preferable by IASC. There was a survey on which method was preferred by each nation. The results are based on the choices of several banking and financial institutions in each country. The UK, while still showing a majority of voters for the direct method, did show many supporters for the indirect method as well (1/4 of those questioned), and many who liked to choose between the methods (1/3 of those questioned). In the USA, more than half of the institutions chose the direct method, 1/4 chose indirect and 1/5 chose the options to choose 12. This survey shows us that the direct method is indeed the preferred one. The UK and the USA did however have those who strongly support the indirect method or both. 13 It is important to emphasize that the direct method of approach is preferred by regulating authorities in each country, but not by most companies that are established. Surveys have revealed that if companies chose between the two methods, most of them would not pick the direct method because it requires companies to reveal certain vulnerable and detailed information about their cash flow. Depending on who is the end user of such cash flows, if they are only concerned with seeing positive and large numbers of net cash flow, thinking that bigger is better then low, negative numbers might at first strike to them as something negative. Still, it is suggested that companies will not present cash flow that seems positive for end users, if it is more cost- and time consuming for the company itself. In the end, a company s ability to generate cash is essential to make it last. The use of cash flow statements in an annual financial report is a rather new addition to an entity s accounting. It wasn t until a few decades ago it became mandatory for entities to present cash flow as a statement. IAS for example made it a requirement in 1977. Before the establishment of the new IFRS directives, most countries in the EU didn t have it mandatory for companies to present cash flows. The presentation of the balance sheet and the income statement was usually enough information for an outsider to have a clear view of the activities of an entity. The balance sheet gave the reader information about changes in the assets, while the income statement showed if the entity had a positive or negative net value throughout the year, and thus showing if it gained any profits. Nevertheless, not only has the usage of cashflow increased, there are also written principles and details written down for every entity to follow. The Requirements according to the International Accounting Standards are presented in IAS 7, as stated earlier in the table. 14 Dividends and interest When it comes to payments and cash receipts of dividends and interest, the IASC classifies the posts consistently and to separate each post in either operating financial or investing activities. As for the USA, it categorizes all interest and dividends posts as operative 12 (IASC). 1992. International Accounting Standard: Cash Flow Statements, London 13 http://www.allbusiness.com/government/business-regulations/543477-1.html 14 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 8
activities, except for dividends paid, which are put in financing activities. The reason for this is that there are no generally accepted rules of classifying these posts. Only five countries have standards regarding this subject and of them, only the UK requires that dividends and interest are classified into groups that are different from operating, financing or investing activities. Dividends and interests are categorized depending on the reporting company itself and how the operating activities are defined. If operating activities are associated to production or delivery of goods and services or other activities that relate to the company s main operations, then operating activities are clearly distinct from financing and investing activities. If income in the form of investment that comes from dividends and interest is an addition to contributing goods and services, then it should not be a part of cash flow from operating activities 15. Foreign exchange Foreign exchange has an effect on cash flow in three different ways: 1. Transaction in foreign currency by national firms. 2. Translating cash flows from foreign subsidiary companies. 3. Alterations in foreign currency exchange rates and the impact it has on cash balance in foreign currency. Impact of exchange rate alterations on cash in foreign currencies should be noted as a divided item in reconciling the opening and closing balance of cash and cash equivalents. Alteration of foreign currency exchange rates causing unrealized changes in items other than cash must not be treated as cash flows. The UK, as well as the IASC respond to these situations in similar ways. In the first point, all countries may choose if they wish to use historic rates method (rates that occur on the date of the cash flow, and not the date of the transaction) or weighted average rate method. The second point is similar to the first, where IASC and most countries permit the choice between the historic rate method and the weighted average rate method. The last point regarding effects of changes in foreign exchange rates describes two situations in which cash flows are affected. IASC and the majority of the countries did accept both methods as a response to effects in cash flow 16. Non-cash transactions There are a few ways of obtaining assets or other companies without cash. Some of them include the acquisition of companies with non-cash means, bond issue or equity, or simply just an exchange of assets. This affects the future cash flows in a way that they are still a part of the financing and investing activities of an entity. Nevertheless, these transactions are to be excluded from the cash flow statement, and are to be disclosed somewhere else in the financial statement so that it brings out all the important information about the financing and investing activities involving the transaction. In the UK, disclosing such transactions do not 15 (IASC). 1992. International Accounting Standard: Cash Flow Statements, London 16 (IASC). 1992. International Accounting Standard: Cash Flow Statements, London 9
only relate to those of financing and investing activities, but all material non-cash transactions. 17 Cash flow statements in the UK Every entity needs to present a cash flow statement based on aspects like culture, environment but also depending on what group of people the statement turns to and what information they seek. The equivalent of the cash flow statement in the UK is presented in the UK standard FRS 1. In essence, the UK FRS 1 has more posts in their statement and different names for some of the definitions. The table below shows comparison between the FRS 1 and IAS 7 and the equivalent of a post in each statement. This shows that while IAS 7 has three posts to assign different transactions, the FRS 1 has eight. 18 FRS 1 IAS 7 Operating Dividends from joint ventures and associates Returns on investments and servicing of finance Taxation Capital expenditure and financial investment Acquisition and disposals Equity dividends paid Operating Operating or investing Operating or financing for interest paid, investing for interest and dividends received Operating Investing Investing Financing or operating Management of liquid resources Investing or cash equivalent Financing Financing The FRS1 was created by the UK ASB in 1991 and revised in 1996 and it s been told that the creation of FRS 1 was influenced by the IAS 7. In general, there are many similar aspects between FRS 1 and IAS 7 but the main difference between these two statements is that FRS 1 only defines cash flow as cash on hand, whereas IAS 7 goes a little bit further by defining both cash and cash equivalents as cash flow. FRS 1 sees deposits as repayable on demand less overdrafts. In FRS 1, cash equivalents are written apart under the post management of liquid resources. This shows that by putting together and parting the cash equivalents, FRS 1 are 17 http://www.ifrs-portal.com/dokumente/ifrs%20ias%20eu%20english.pdf (IAS 7, nr. 43) 18 Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London 10
more traditional in it statements than the IAS 7. As a consequence, investors who aren t familiar with the differences in the posts might see more cash flow in the IAS 7 rather than its UK counterpart, when comparing the two statements. This makes the IAS 7 more appealing even though the true cash flows are the same in the entity. IAS 7 also shows higher liquidity ratios, and will also have a bigger impact using cash like net debt to equity ratio. This could mean completely different financial statement analysis results for two entities that have the same elements use two different statements 19. When it comes to legal aspects, the FRS 1 gives smaller companies some dispensations which allow them to exclude cash flow statements if they choose so. This is not the case in IAS 7. Smaller companies who choose IAS statements must include cash flow in their statements. Cash flows under FRS 1 from foreign subsidiary companies are to be interpreted at the same rate as profit and loss posts, and approximation of actual rates should be used for transactions within groups. However, IAS 7 implies that cash flows from foreign subsidiaries should be interpreted at the exchange rates commencing at the date of the cash flow. This lack of actual exchange rate in each transaction leaves the foreign cash flows somewhat unbalanced for the IAS 7 statement. To compensate, it is allowed to calculate a weighted average exchange rate to the actual exchange rate. The IAS standards allow the reporting of net cash flow coming in from cash receipts and payments if they are activities from customers but not from the reporting company. Such reports are not allowed by FRS 1. The disadvantage of reporting net figures may be that it hides important information about a company for potential investors. Any changes in debt must be reported by the company according to FRS 1. The IAS 7 does not have such requirement. The handling of debt issues is an important subject in any company and it is a positive attribute to report any changes in a company s debt. The reconciliation of debt by the use of cash is very valuable information to future investors who wish to see how the company is handling its debt and how resources are being distributed. Similar to debt reconciliation, FRS 1 allows the reporting of liquid resources under the post named as management of liquid resources. This increases the level of details which investors might find useful 20. Cash flow statements in Sweden The Swedish equivalent of the IASC is Redovisningsrådet or RR. IAS 7 states that the direct method is the recommended method to be used when reporting cash flow from operating activities. There is no directive implemented in the Swedish RR 7, the choice between the direct and the indirect method is optional. 21 Other than that, there are no significant differences involving the two methods between the regulations of the IAS 7 and RR 7. According to RR, both methods have advantages over the other which makes it difficult to choose which method should be preferred. The direct method has the advantage of being thorough and detailed when dealing with cash flows. On the other hand, the indirect method is easier to understand and easier to obtain the relevant information. Just as in IAS 7, RR 7 states that cash flow is to be divided in to three categories: operating, financing and investing activities and each transaction can also be related to more than one of these three categories. 22 The statement of operating activities can differ between the direct and indirect method, according to RR 7. It states that the direct method can be applied in two different ways: 19 Accounting Standards Board (UK ASB). 1991. Financial Reporting Standard (FRS) I: Cash Flow Statements 20 Accounting Standards Board (UK ASB). 1991. Financial Reporting Standard (FRS) I: Cash Flow Statements 21 http://www.lib.strath.ac.uk/busweb/guides/smedefine.htm 22 Redovisningsrådet, RR 7, redovisning av kassaflöden (cash flow statement) 11
Cash receipts and payments are collected from the accounts without adjustments Cash receipts and payments are obtained from sales, the cost of sold assets, and other posts in the income statement are adjusted for assets and liabilities, among other posts. The indirect method, which is the most widely used by Swedish companies, is calculated by adjusting the net cash flow by changes in inventory, cash receipts and other posts belonging to financing and investing activities. As far as financing and investing activities, only the most important ones are to be disclosed separately in the cash flow statement. 23 Interest and dividends are to be disclosed as separate posts in the cash flow statement, either as operating, financing or investing activities, just like the IAS 7 recommendations. If these posts occur in a financial company, then they can be classified into operating activities. For other companies they are treated as financing or investing activities. The same procedure applies to extraordinary costs and revenues. 24 RR does not favor any method (direct or indirect) to be used, the choice is made by each company. As stated before, this could lead to misinterpretation of the statements if two companies with the same results use the two methods. The end result will be the same, but the statements will look differently. Conclusions The cash flow statement is important since it represents a company s ability to produce means of dividends and even function as a mean for investors to forecast future cash flows. It is also important for a company to have means with which to quickly pay off short term debts in case of a situation where an entity has encountered an unexpected acquisition. According to IAS 7, all companies, no matter what size or business venture, are in need of liquid assets to pay off debts, employees salaries and to give investors a yield on invested capital. 25 The fact that many companies did not have a policy to present annual cash flow statements is a peculiarity, since CF-statements contain rather vital information about a company s generated cash during a period of time. It is intriguing that the UK ASB prefers the indirect method of cash flow determination from operating activities, due to the fact that they can t see any advantages of it. The IAS does seem to find it useful, and this is a perfect example of the differences in cash flow statements. The reasons for such differences can be speculated to cultural differences. Maybe the users of cash flow statements have other demand criteria for the contents of the statements and feel that the direct method is unnecessary for them and have other ways interpret useful information. The differences between the Swedish RR and IASC cash flow statements aren t many. The only big difference is that IASC encourages companies to use the direct method due to its great level of detail and to estimate future cash flows. Problems that could arise in both statements are classification problem. The uncertainty to classify dividends as financing or operating activities may arise. The maintenance of machinery is another example, which can be classified as investing or operating activities. Which of these transactions belongs to the right activity can cause classification problems. 23 Redovisningsrådet, RR 7, redovisning av kassaflöden (cash flow statement) 24 Redovisningsrådet, RR 7, redovisning av kassaflöden (cash flow statement) 25 Nilsson, Sundgren, Nilsson; Internationell Redovisning, teori och praxis, 2009, Lund 12
The UK FRS 1 and the IAS 7 is a perfect example of how two different statements of an entity show different detailed information in cash flow, even though they present the same net result. The big issue here is what an investor would prefer to read, and what details are preferred when examining a statement. One might think that more detailed specifications might be better, but that might not be the case for someone who prefers simplicity over details. It s a matter of perspective, as long as the end result is the same, then the choice of statement presentation should be a matter of personal choice, in my opinion. The choice of travelling to a city by car, plane or boat should not make any matter as long as you arrive at the designated city. The only thing that matters is what choice of travel is considered to be more comfortable by each traveler. 13
Reference Accounting Standards Board (UK ASB). 1991. Financial Reporting Standard (FRS) I: Cash Flow Statements. Financial Accounting Standards Board (US FASB). 1987. Statement of Financial Accounting Standards (SFAS) 95: Statement of Cash Flows. (November): Stamford, CT: FASB International Accounting Standards Committee (IASC). 1992. International Accounting Standard: Cash Flow Statements. : London. Redovisningsrådet, RR 7, redovisning av kassaflöden (cash flow statement) Alexander Britton and Jorrisen, International Financial Accounting and analysis, 2007, London Ross, Westerfield, Jaffe, Corporate Finance, 2005, New York. Nilsson, Sundgren, Nilsson; Internationell Redovisning, teori och praxis, 2009, Lund http://www.sec.gov/investor/pubs/begfinstmtguide.htm http://www.lib.strath.ac.uk/busweb/guides/smedefine.htm http://www.allbusiness.com/government/business-regulations/543477-1.html http://www.ifrs-portal.com/dokumente/ifrs%20ias%20eu%20english.pdf 14