% The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory

(07 !7"# Cash Flo$ %eporting

Introduction

In previous lectures the system of replacement cost accounting (RCA) introduced the concept of valuing all balance sheet assets and liabilities at replacement cost (or entry value), i.e., the cash outflow required to replace an asset. owever, it is also possible, as an alternative, to value all assets at net realisable value (or e!it value), i.e., the cash flow generated by selling an asset. "aluing all balance sheet assets and liabilities in this manner is referred to as net realisable value accounting (#R"A) and the system is considered useful because it provides current data on potential cash flows, i.e., the cash the firm will generate if it were to sell all its assets (fi!ed and current).

owever, although the #R"A system provides data on potential cash flows, it gives no information on actual cash flows. ence, it is not uncommon to find (e.g., $ee,

%&'() that its use is combined with a system of cash flow accounting (C)A) which, in effect, abandons the accruals concept and substitutes the cash flow statement for the income statement as the primary source of financial data on the firm*s operational performance. +he combination of the #R"A and C)A systems is called cash flow

. reporting (C)R) and it is this combined system that is introduced here. +he C)R system is designed to provide data on both realised and realisable cash flows.

Cash flow reporting (C)R)

+he concept that is fundamental to C)R is that of realisability. +he C)R system focuses upon cash flows but distinguishes between those that have been realised (i.e. which already e!ist in the form of cash as a result of past cash flow transactions) and those which are unrealised (i.e. those which are e!pressed in terms of net realisable values or selling prices). owever, in order to apply this concept of realisability in

practice, a fundamental change is needed in asset and liability classifications contained in the traditional balance sheet. Although it can be argued that the order in which assets are listed in the traditional balance sheet is based upon the notion of (reverse) liquidity, the distinction between fi!ed and current assets depends upon the sub,ective and changeable intentions of entity management as opposed to the ob,ectivity of the mar-et place. )or e!ample, consider a manufacturing firm*s transport assets, such as motor vehicles. +raditionally classified as fi!ed in the balance sheet, these assets may in fact be more realisable (i.e. can be converted into cash more quic-ly) than the firm*s stoc- and wor- in progress, even though the latter are classified as current assets in the balance sheet.

In C)R, therefore, assets are classified according to their mar-etability or realisability and not the realisation intentions of entity management. +he classification assumes an orderly liquidation, i.e. as if the entity was adapting sensibly to a changing

4 environment. In simplified form, the assets in a balance sheet would be classified as follows/

Balance sheet category Realised Readily realisable #ot readily realisable #ot realisable +otal assets

&'amples Cash and ban- balances Investments, motor cars, land and buildings 1or- in progress, plant and machinery #on2mar-etable brands

( 0 0 0 0 0

$iabilities are classified according to their payability, as determined by legally enforceable contracts (and hence their classification among short, medium and long term would not differ materially from current practice).

A -ey element of the C)R approach is the availability of factual sales prices in identifiable mar-ets, even if limited. If a sale price does not e!ist, then the asset concerned has a 3ero cash equivalent. +he sale prices used in the balance sheet reflect potential not e!pected cash flows. +he intention is to provide useful information on adaptability and command over resources, not liquidation proceeds. +he use of sale prices should not be interpreted as an implied statement that the assets are to be liquidated immediately.

( +he C)R system requires the production of four separate financial statements, as follows ($ee, %&'(/5.256)/

CF% system %. 7tatement of realised cash flow .. 7tatement of realisable earnings 4. 7tatement of financial position

()CA e*uivalent# (Cash flow statement) (Income statement) (8alance sheet)

(. 7tatement of changes in financial (7tatement of changes in equity) position

9ach of the above statements is illustrated below.

Statement of realised cash flo$

Detail Cash inflo$s :perating cash flow Additional borrowing +otal cash inflows Cash outflo$s Capital e!penditure +a!ation paid ;ividends paid +otal cash outflows +et cash flo$s for period

! ! !

(!) (!) (!) (!) !<(!)

Statement of realisa,le earnings Detail %ealised earnings :perating cash flow Unrealised earnings =otential cash flows from/ Readily realisable net assets #ot readily realisable net assets Total realisa,le earnings +a!ation provided +otal realisable earnings after ta!ation ;ividends provided Total realisa,le earnings retained for the financial year Retained earnings of prior periods Retained earnings carried forward ! ! ! ( (

! ! (!) ! (!) ! ! !

Statement of financial position Detail %ealised assets %eadily realisa,le assets $ess/ short2term liabilities #et realised and readily realisable assets +ot readily realisa,le assets +ot realisa,le assets Total assets $ess/ long2term liabilities ( ! (!) ( ! ! ! ! ! ! (!)

> Total net assets 7hare capital Retained earnings Total e*uity ! ! ! !

Statement of changes in financial position Detail %ealised cash inflo$ Increase in realised assets %eadily realisa,le inflo$ Increase in readily realisable assets $ess/ increase in short2term liabilities +ot readily realisa,le inflo$ Increase in not readily realisable assets .ong/term cash outflo$ Increase in long2term liabilities 0ndefinite cash outflo$ Retained earnings of period ! (!) !

! ! ! ! ! !

6 The University of Birmingham The Birmingham Business School Accounting and Finance Su,1ect 2roup Accounting Theory (07 3 4!5# Cash Flo$ %eporting &'ample 6 CF% .td

C)R $td had the following balance sheet as at % ?anuary .@0% which is presented in conventional historical cost form e!cept that all assets are valued at their selling (net realisable) values/ Balance sheet as at 3 7anuary 083 A@@@ A@@@ A@@@ )i!ed assets =roperty =lant and machinery Botor vehicles Current assets 7toc- of finished goods 1or- in progress +rade debtors Cash at banCreditors due within one year +rade creditors +a!ation ;ividend payable Creditors due after one year $oan Capital and reserves :rdinary share capital Retained profit & %4 %@ %@ & %% 5 45 %. & %@ 4%

4.

4 4( %@ .( %@ %( .(

' ;uring the financial year to 4% ;ecember .@0%, the following transactions tooplace/ +o9 % . 4 ( 5 > 6 ' & %@ %% %. %4 Transaction +otal sales on credit =urchases of materials, wages and overheads 1or- in progress transferred to finished goods stocCost of finished goods sold Cash received from trade debtors Cash paid to trade creditors Interest paid +a! paid ;ividend paid =urchase of property for cash Receipt of cash from additional long term loan +a! provision for .@0% ;ividend proposed (000 %&( %44 %.5 %%& %'6 %.( . %4 %@ 6 ' .@ %.

As at 4% ;ecember .@0%, the following information was relevant/ +o9 % . 4 ( 5 > 6 ' Detail #et realisable value of property #et realisable value of plant and machinery #et realisable value of motor vehicles #et realisable value of stoc- of finished goods #et realisable value of wor- in progress #et realisable value of trade debtors +rade creditors Cash at ban(000 .@ > ( %' .( %' %' ((

%e*uired: In accordance with the principles of cash flow reporting (C)R), prepare for C)R $td for the financial year ending 4% ;ecember .@0% the following financial statements, as far as the given information allows/ statement of realised cash flowC statement of realisable earningsC statement of financial position and the statement of changes in financial position.