Introduction
All firms that prepare financial statements are required to prepare and present a statement of cash flow in conformity with IFRs. The statement of cash flow is prepared based on two years’ published financial statements. It is used as a management tool in decision-making. Firms could prepare a report of cash flow from direct cash entries of any account involving cash transactions to operating, financing, or investing activities. However, as the level of transactions increases, classifying transactions becomes cumbersome to handle. Therefore, firms usually prepare accounting statements starting with the income statement to the statement of financial position. Information from the two financial statements is then transformed into a statement of cash flow.
Purpose of the statement of cash flow
Stakeholders are interested in knowing how the firm is generating and using money regardless of the nature of the entity. Moreover, stakeholders expect a firm to define clearly ways in which cash and cash equivalent are generated and used in spite of whether money is perceived as a product or a service. Organizations require money to pay their obligations such as creditors and suppliers. Cash is also needed to finance the normal operations of a business irrespective of the differences in primary cash-generating activities.
A cash flow in conjunction with other financial statements enables organizations to evaluate changes in net assets and financial structure. This also includes assessing the financial liquidity of a company. Users of financial statements can then be able to develop models for evaluating and comparing the present value of future cash flows of an enterprise. Moreover, preparing a cash flow report improves the compatibility of financial statement reporting by eliminating the effect of the application of different accounting treatments on a transaction.
Purpose and objective of International Accounting Standard 7(IAS)
An international accounting standard is a set of rules that regulate accounting reporting in order to enhance consistency in the financial statement. The primary objective of developing accounting standard 7 is to ensure international acceptable high-quality accounting standards. It also issues the principles-based standards that remove alternative ways of presenting the statement of cash flow to ensure that firms adhere to, and better reflect economic conditions. Limiting accounts presentation denies management an opportunity to alter financial information at their discretion. According to Lee (111) a statement of cash flow that adheres to international standards enables investors and other stakeholders to make a sound investment decision by reflecting the true financial condition of a firm. Moreover, it increases accounting quality by ensuring that all businesses present a statement of cash flow using similar principles. International accounting standard 7 defines cash and cash equivalent together with a distinctive definition of what investors should look for in financial statements.
Cash and cash equivalent
The end product of the statement of cash flow is the increase or decrease in cash and cash equivalent. According to IAS 7 Cash and cash equivalent can be defined as those assets in a firm that can be converted into cash within a short period without losing value. A company holds cash and cash equivalent to meet its short-term financial obligations. Other items such as equity are excluded from cash equivalent unless they are in substance cash. For instance, preference shares acquired with a short maturity period and with a specified maturity date qualify as cash and cash equivalent (Albrecht 614). Following this logic, these preference shares must be realized within a very short time without loss of value. The major conditions that must be met before an item qualify as cash and cash equivalent are; short-term maturity and insignificant risk to changes in value.
In some countries, bank borrowings are considered as cash and cash equivalent. However, according to international accounting standard 7, bank loans are generally considered as financing activities. Firms in these countries must, therefore, present bank borrowing as a component of cash and cash equivalent. However, putting this into perspective, it means that bank balances usually fluctuate from positive to negative (Megginson et al. 89). Typically, a cash flow does not include changes to items that constitute cash and cash equivalent because they are part of a firm’s cash management. In fact, these items represent excess investments of cash and cash equivalents. The items must be convertible to known amounts which implies that the market should be available, and their market value should not be subject to major changes in value (Greuning and Koen 132).
Classifying cash flow as operating investing and financing activities
International accounting standards require businesses to prepare cash flows in a manner that is most appropriate to their operations. Statements of cash flow must be prevented from operating, investing, and financing activities (Alexander and Britton 651-653).
Operating activities
Cash flows from operating activities arise from the primary revenue-generating operations of an enterprise. Cash from operating activities shows how efficiently a firm has generated enough cash to repay its loans, pay dividends and make an external investment without depending on external financing. Two-year historical information is used to generate cash flows in conjunction with other information to forecast future cash flows. In simple terms, operation activities result from transactions that determine the net profit of an enterprise. For instance, transactions involving cash receipts from sales of goods or cash payments to suppliers. Some transactions that are included in the determination of net profit do not qualify as operating activities. For example, a transaction involving a sale of an item of plant is included in determining net profit; however, this transaction relates to investing activities. Interest paid and dividends received are classified as operating activities. Nonetheless, there is no harmony in the classification of such items in the statement of cash flow. A firm may hold securities for trading purposes in which case they act like inventory with an aim of resale. Therefore, cash flows from such transactions are treated as operating activities.
Investing activities
Investing activities include all expenditures made to purchase resources intended to generate future cash flows. The separate disclosure of such expenditures is crucial in assessing the ability of a firm to make long-term investment decisions that are likely to generate future cash flows. An example of a cash expenditure arising from investment activities is a cash payment to purchase property plant and equipment. It also includes a cash payment to acquire debt and equity instruments. Similarly, cash receipts from forwarding contracts, swaps contracts, and futures contracts are classified as investing activities unless they are held for trading purposes (Grier 55).
Financing activities
Financing activities refer to activities that result in changes in the value of equity and loans. The separate disclosure of such activities is critical when determining claims from providers of the capital of a firm. They involve cash transactions involving proceeds from issuing stocks and other equity instruments. Similarly, it also includes cash transactions from issuing debentures, notes, and short-term borrowings. From this logic, the dividend paid can be classified as financing activities since it is a cost of obtaining resources to finance future cash flows. Alternatively, it can be classified as operating activities to determine the ability of a company to pay dividends out of operating cash flows.
Evaluating the purpose of a cash flow
A cash flow statement explains how a firm’s cash was generated within the reporting duration and how that cash was used (Albrecht 615). A cash flow reports items and transactions in terms of their impact on cash. The purpose of this statement is to explain how an organization has generated and used the money over the reporting period. The statement of cash flow is intended to provide stakeholders with information that will enable them to assess the firm’s viability, liquidity, and financial flexibility. If an organization where the balance sheet indicates poor liquidity (high bank overdraft) the same should be reflected in the cash flow. A cash flow should, in this case, explain what has been happening to the cash position of the firm. If liquidity is high, the cash flow should indicate how the firm has generated excess cash may be from the sale of an asset. A cash flow assesses a company’s viability in terms of its ability to generate cash to survive. Profitable businesses have had to sell part of their businesses because they did not have enough cash to run their day-to-day activities. A cash flow assesses whether a company is generating sufficient cash from normal activity to remain viable or whether it might go into liquidation (Coyle 82). The cash flow statement also indicates the financial flexibility of a firm in terms of its ability to spend money when it wants and on what investment. Coyle also noted that a company with a large positive cash flow shows the firm has surplus cash to invest in purchasing assets or acquiring new ventures whenever an opportunity arises (p. 83).
Benefits that accrue to Thorne Ltd by preparing the statement of cash flow
Preparing a cash flow statement will enable Thorne Ltd to assess effectively its future viability in terms of its ability to generate cash for normal operations. A cash flow statement will help managers to assess what has happened in the past and provide an impressive opportunity to predict what will happen in the future. Thorne management will be able to predict whether the company will face financial difficulties based on what has happened in the past. It will also allow managers to rethink their investment portfolio before making any investment. For instance, Thorne Ltd has a positive cash flow which indicates the firm can invest in alternative sources of revenue like purchasing new assets to generate future cash flow.
Conclusion
The main objective of a statement of cash flow is to establish the ability of a firm to generate money for normal operations. Moreover, it assesses the ability of the company to stay viable in the future by disclosing its cash-generating items. A statement of cash flow is presented according to international accounting standards to ensure consistency in reporting. It also ensures high-standard reporting by eliminating management action that could jeopardize accountability.
Works Cited
Albrecht, W. S. Accounting concepts and applications. Mason, Ohio: Thomson/South- Western, 2008. Print.
Alexander, David, and Anne Britton. Financial reporting. London: Thomson Learning, 2004. Print.
Coyle, Brian. Cash flow control. Chicago (Ill.) Chicago London: Glenlake Publ. Fitzroy Dearborn Publ, 2000. Print.
Greuning, Hennie V., and Marius Koen. International accounting standards : a practical guide. Washington, DC: World Bank, 2011. Print.
Grier, Waymond A. Credit analysis of financial institutions. London: Euromoney, 2007. Print.
Lee, T. A. Financial reporting and corporate governance. Chichester, England Hoboken, NJ: John Wiley & Sons, 2006. Print.
Megginson, William L., Scott B. Smart, and Brian M. Lucey. Introduction to Corporate finance. London: Cengage Learning EMEA, 2008. Print.