Financial Accounting

Rationale for Preparing Cash Flow Statement

Cash Flow Statement

In order to understand the rationale for cash flow statements in company reporting, it is important to appreciate what the cash flow statement is trying to achieve and how it is different from the profit and loss account.

cash flow statement

IAS 7 states that ‘information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows.’ This highlights a crucial difference between the profit and loss account and the cash flow statement.

Purpose of Preparing Cash Flow Statement

The purpose of the cash flow statement is to show how the business has generated cash (for instance by trading and raising finance) and how it has used those cash flows (for instance to purchase fixed assets or pay dividends to shareholders). 

Remember that the profit and loss account provides limited information about fixed assets (only to show how they are depreciating over time). Also, the profit and loss account does not provide information about how the company has increased sources of finance (such as ordinary shares and loans).

Numerous reasons have been advanced in favour of cash flow reporting. One of the greatest justifications is that because cash is such a critical aspect in evaluating a firm’s survival chances, cash flow information is required. Firms can collapse due to a cash constraint, not a lack of ‘accounting profitability.’

Historic cost accounting can often give an over-optimistic view of a firm’s performance, especially during a period of rising prices.

Thus, cash flow reporting may cause a corporation to be more circumspect, for example, regarding its dividend payout strategy. For instance, a business whose earnings are mostly reflected by rises in its stock and debts may choose to consider paying a high dividend. Large dividend payments to shareholders may require the company to increase its overdraft, which may not be the best course of action.

Another argument in favour of cash flow reporting is that the allocation of revenues and expenses to distinct time periods is avoided. Cash flow accounting does not involve the subjective assumptions which are associated with the profit and loss account and its reliance on accruals accounting conventions. In that sense, cash flow accounting is more objective.

Cash flow reports cannot be distorted by certain types of accounting manipulation (for instance, changing the depreciation policy, or changing the basis on which provisions for doubtful debts are calculated). Moreover, cash flow statements are simpler and should be easier to understand, especially by readers of accounts who do not have a strong background in accounting.

Cash flow accounting, on the other hand, avoids time period allocation. On the other hand, the reader of a cash flow statement is left to interpret the information contained inside. Consider the example of a business that modifies its clients’ credit conditions in a given year, requiring them to pay their bills sooner than they previously did.

Conclusion

A profit and loss account would show no increase in sales revenue. But a cash flow statement would show an increase in cash received from customers, which is, of course, a benefit in terms of improved liquidity, but this could just be a ‘one-off’ benefit that could not be repeated in future years. So a cash flow statement could give the misleading impression that the business had benefited from a ‘permanent improvement in its financial performance.

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