Cashing in

Every businessman, from those running mom-and-pop stores at the corner of the street to the shareholders of big corporations with offices in the central business districts, would want to cash in on their investments.

Shareholders, management and stakeholders normally focus on the balance sheet and income statement when preparing and reading financial reports. However, business folks should also pay attention to cash and the cash flow statements as there’s more to them than meet the eye.

Based on my experience auditing companies of various sizes, cash flow statements are often prepared late in the financial reporting process and thus, there is a risk that management and other stakeholders may miss out on the stories that the cash flow statements may tell about the operating, financing and investing activities of the company.

This adds to the fact that regulators the world over continue to challenge and find recurring errors in the cash flow statements, providing reason why companies should start paying attention to the cash flow statements and ensure that their preparation is in compliance with accounting standards.

I remember having a discussion with a friend who was running a trading business. He said that when it came to preparing the financial reports, particularly the cash flow statement, his concern would always be whether his company was presenting too much, too little or just the right information, and whether he had adequate and real understanding of what was being presented in the statement.

These are some of the questions that I’ll answer as we revisit the financial reporting requirements for cash.

The statement of cash flows or cash flow statement is the main tool used in reporting about cash. It is one of the primary statements (along with the statement of total comprehensive income, the statement of financial position and the statement of changes in equity) in a financial statement. It provides users with a basis to assess a company’s ability to generate and use cash. In our country, the accounting and financial reporting requirements for cash are stated in Philippine Accounting Standards No. 7, Statement of Cash Flows or PAS 7. It says all companies reporting under Philippine Financial Reporting Standards must include a cash flow statement as part of their financial statements. There are no exemptions available from this requirement. Under PAS 7, the cash flow statement should provide a reporting of movements of cash and cash equivalents, classified as arising from three main activities (or shall we say classifications) over a specific period of time: operating, investing and financing. The standard does not set out a sequence to be followed, but instead, allows cash flows to be reported in the manner most appropriate to a company. In practice, the significant majority of companies keep to the order of operating, investing and financing activities.

Operating cash flows

Operating cash flows comprise all cash flows during the period that do not qualify as either investing cash flows or financing cash flows. Operating cash flows may be prepared from a company’s accounting records under the “direct method,” which shows the gross cash receipts/payments from operations. Alternatively, a company can calculate the cash flows indirectly by adjusting net profit or loss for non-operating and non-cash transactions; and for changes in working capital. Where the “indirect method” is used, reconciliation between profit or loss and the net cash flow from operating activities is effectively being presented.

For example, in a retail business, changes in typical working capital components such as accounts receivable, inventories and accounts payable under the indirect method reflect how effectively management is running the business. An increase in accounts receivable and inventories because of sales growth during the period may not necessarily mean that resources are being utilized efficiently. It may also indicate a decline in the speed in which the company is able to collect from customers and sell its goods.

While companies are encouraged to report cash flows from operating activities using the direct method because the information provided is more useful, most companies are using the indirect method.

Investing cash flows

Investing activities include cash payments to acquire property, plant and equipment and other long-term assets, unless these are part of a company’s operating activities. PAS 7 clarifies that cash payments to manufacture or acquire assets held for rental to others and subsequently held for sale (which applies to assets that are held for rental and routinely sold) are cash flows from operating activities. The cash receipts from rent and subsequent sales of such assets are also cash flows from operating activities.

Investing activities also include cash payments and cash receipts relating to acquisitions and disposals of debt and equity interests in other companies (including obtaining or losing control of subsidiaries) and interests in associates and joint ventures (except for these relating to dealing or trading activity). Loans or advances made to other parties, as well as their repayments, are classified as investing activities, other than those loans or advances made by a financial institution.

Only expenditures that result in a recognized asset in the balance sheet are eligible for classification as cash flows from investing activities. This may impact the classification of expenditure such as that on exploration activities or internal research activities where this cannot be capitalized as an intangible asset.

Financing cash flows

Financing cash flows include cash flows relating to obtaining, servicing and redeeming sources of finance. Those sources of finance can include loans, debentures and share capital.

The three activities altogether

To put it simply, operating activities are a company’s revenue-producing activities. Investing activities are the acquisition and disposal of long-term assets (including business combinations) and investments that are not cash equivalents. Financing activities are changes in equity and borrowings. The classification of an item as an operating, financing or investing activity can require significant judgment on the part of management.

Cash flows from investing and financing activities are reported separately at gross (that is,
gross cash receipts and gross cash payments) except when:
Cash receipts and payments are made on behalf of a customer and, therefore, represent the customer’s transactions and not the reporting company’s; or

Cash receipts and payments are in respect of items for which the turnover is quick, the amounts are large and the maturities are short.

The cash flows arising from dividends and interest receipts and payments are classified on a consistent basis and are separately disclosed under the activity appropriate to their nature. PAS 7 does not dictate how dividends and interest cash flows should be classified, but rather allows a company to determine the classification appropriate to its business. It is generally accepted that dividends received and interest paid or received in respect of the cash flows of a financial institution will be classified as operating activities. For other types of companies, interest and dividends received may be classified in either operating or investing activities. Interest and dividends paid are normally classified as either operating or financing activities.

Cash flows relating to taxation on income are classified and separately disclosed under operating activities, unless they can be specifically attributed to investing or financing activities. It is imperative that the correct amounts of taxes are presented in the cash flow statement.

Cash and cash equivalents and required disclosures

The total that summarizes the effect of the operating, investing and financing cash flows is the movement in the balance of cash and cash equivalents from the start of the period to the end. If the total for cash and cash equivalents presented cannot be traced directly to the balance sheet, reconciliation is presented in the notes to the financial statements disclosing the components of cash and cash equivalents used for the cash flow statement and how these reconcile back to the balance sheet.

A company is required to disclose the accounting policy it adopts for determining the composition of cash and cash equivalents. Cash equivalents are defined in PAS 7 as “short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.” Short-term is viewed by PAS 7 as normally meaning investments with an original maturity of three months or less.

A bank overdraft may be used as part of a company’s day-to-day cash management tools rather than as financing arrangements. Normally, such overdraft accounts will regularly fluctuate between a positive and a negative balance. The overdraft balance should be included in the balance of cash and cash equivalents where overdrafts are used for such cash management purposes. In all other circumstances, an overdraft balance is treated as part of a company’s financing.

Separate disclosure is made of significant non-cash transactions (such as the issue of equity for the acquisition of a subsidiary or the acquisition of an asset through a finance lease). Non-cash transactions include impairment losses/reversals; depreciation; amortization; fair value gains/losses; and income statement charges for provisions. In presenting the amounts of these transactions, it is extremely important that their related tax treatments are correct.

Restricted cash balances should be disclosed in a note to the cash flow statement, including a narrative explanation of any restriction. Moreover, companies are encouraged to disclose additional information that is relevant to users in understanding a company’s financial position and liquidity. This may include the amount of undrawn borrowing facilities (an off-balance sheet item) and any restrictions thereon, the aggregate amount of cash flows representing increases in operating capacity separate from those maintaining capacity.

Parting words

The success, growth and survival of every business depend on its ability to generate or otherwise obtain cash. It is the lifeblood of a business. Cash flow is a concept that everyone understands and with which they can identify. Reported profit is important to users of financial statements, but so, too, is the cash flow-generating potential of a business. What enables a business to survive is the tangible resource of cash, not profit, which is merely one indicator of financial performance. Thus, various stakeholders look to cash in on the business – owners look for dividends, suppliers and lenders expect payments and repayments, employees receive wages for their services, and the tax authorities are legally entitled to tax revenues due. Hence, a cash flow statement is a crucial part of business reporting and should be given close attention.