Cash flow

Statement of cash flow reflects liquidity position (available cash) of an organisation. Cash is vital for continuing daily operation of an organisation and as well for capital investments.

IAS 7 Statement of cash flow requires companies to prepare statement of cash flow. Statement of cash flow shows how the cash movement took place (i.e. the net changes in cash position = difference in current and previous period cash balance). There are two methods for preparation of cash flow. The “direct method” and the “indirect method”. Companies are free to adopt one of the alternatives. Whichever method is used, statement of cash flow must be presented using standard headings. They are:

Cash flows from operating activities:

Ø  Cash earned from operations: Direct method vs Indirect method

Direct method use ledger balance (i.e. cash sales and cash received from debtors less cash purchase and cash paid to supplier along with other general cash expenses)

Indirect method use information from income statement and financial position (i.e. begins with profit before tax and interest, adds back depreciation and adjust for change in working capital)

Ø  Cash from operating activities: includes interest paid, dividend paid and income tax paid.

Change in working capital – subtract increase in value of current assets (receivable and inventory), add increase in value of current liabilities (payable) and vice versa. The change is the difference in current and previous balance in the statement of financial position.

Cash flows from investing activities: Includes payment made for purchase of property, plant and equipment, proceed received from sales of equipment, interest earned and dividends received.

Cash flows from financing activities: Includes proceeds from issues of shares and debentures and repayment of debentures.

Proforma  for adjustment required for cash flow:

Value of Account in Income Statement accrual acc..ting	E.g. Tax expense  (Non cash flow)	(***)
Add decrease in Asset Account in SOFP and vice versa	E.g. Decrease in tax assets	***
Add increase in Liability Account in SOFP and vice versa	E.g. Increase in current tax payable	***
Cash received +ve, Cash paid –ve balance	Cash flow	**/(**)

Statement of Financial Position

Balance sheet (Statement of financial position) perspective of accounting starts with stating balance equation (Assets = Liabilities + Equities/”Net Assets”). This always does not means change in balance in one side (i.e. Assets) always affect other side (i.e. Liabilities or Equity). A very simple example to justify the statement is cash purchase of machine. Here, both elements of double entry transaction are covered under assets heading where, decrease in cash results in increase in value of machinery.

As the name suggest the statement discloses the financial position of an institution on the date as at mentioned in the statement of financial position. Financial position preceding and succeeding the date addressed on statement varies. Most statements we work after reflect the past position of an institution. It tells how successful an institution was and its position for particular time period in history. Analyzing the trend for a range of period prediction on future periods can be made. Statement of financial can be forecasted for some upcoming periods (1-3 years) or can be projected for unforeseen future (5-many years). There is no certainty that forecasted or projected financial statements do reflect true future position. However, while preparing forecast statements are prepared considering information available which reflect all possible economic changes for the period forecast is drawn.

A statement of financial position is prepared form “trial balance after year end adjustment”. The statement has two parts. Assets and Liabilities + Equity. Assets reflects company’s holding of all short and long term investments in machinery, land, building, bond and equity of other institution valued at cost or market price. Short term investments are called current assets which includes inventories, receivables and cash at bank. Liabilities show how much a company owes at the particular point of time. Long term liabilities includes debts that are repayable in more than 1 year time period, where loan are payable within a year they are included in current liabilities. Current liabilities includes other accounts like payables, GST payable, income tax payable, employees’ benefit payable, overdraft etc. The residual of assets over liabilities is called Equity (the owner’s interest).

Cash Vs Accrual

Understanding Cash and accrual basis of accounting is very important to know overall implication of financial accounting on financing and investing decision. Preparation of cash flow statement requires total understanding of cash vs. accrual system of accounting. Cash flow is the starting point to analyse the viability of the project/organisation. International financial standard requires transactions to record in accrual basis of accounting. i.e. IAS 1 requires that an entity prepare its financial statements, except for cash flow information, using the accrual basis of accounting.

Under cash basis a transaction is complete and is only recorded when cash is received or paid. Open transaction is not recorded until it is closed by the delivery of cash and cash equivalent. Eg. a prepaid expense (recognised as assets on accrual basis) will be recorded as expense on the date the cash is paid. Likewise, checks are written when funds are available to pay bills, and the expense is recorded as of the check date - regardless of when the expense was incurred.

Accrual basis accounting matches revenues and expenses to the time-period in which they are earned and incurred. It captures true picture of all transactions that takes place within given time-period. Example; vendor record shows all bills paid, credits, and payments for that vendor and A/P Aging Summary and A/P Aging Detail reports show outstanding (unpaid) bills. This is a good report to use to prioritize payments and manage cash flow. The Profit and Loss report will show all bills — whether the bill has been paid or not — on the accrual basis, and only paid bills on the cash basis. The balance sheet will show the vendor liabilities (unpaid bills) in the accounts payable account.

The same is with most of expenses and revenue items. Eg. Accounts like wage, tax and purchase can take form of assets if paid in advance, a form of liability until it is paid and is expensed when paid. Accounts like interest income and sale can take form of assets until received and a form of liability if received in advance and is recognised as revenue when amount is received.  Understanding this nature is vital for the preparation of cash flow statement using indirect method.

Alternatively, by straightforward recording of transaction on cash basis we can prepare cash flow by using direct method.

http://office.microsoft.com/en-us/support/understanding-cash-and-accrual-basis-accounting-HA010164612.aspx

Interpolation and Extrapolation

Interpolation and extrapolation both are used to estimate hypothetical value for variables based on observation. Interpolation estimates value within the parameter of observation whereas extrapolation estimates value which is outside the parameter of observation.

In finance and management interpolation/extrapolation is mostly used to predict rate of return. Commonly used examples include IRR (Internal Rate of Return), Cost of irredeemable debt (to company or to investor).

Here we see how interpolation/extrapolation is used to calculate IRR manually.

Ø  Calculate Net Present Value (NPV) using a discount rate that gives a whole number.

Ø  Calculate a second NPV using another discount rate. If the first NPV was positive, use the rate that is higher than the first rate; if it was negative , use a rate that is lower than the first rate.

Note,

 where both first and second NPV are positive or negative then you use extrapolation and

 where NPV are in set of positive and negative whole numbers we use interpolation.

Basically same formula works for interpolation and extrapolation.

Ø  Use the two NPVS to calculate the IRR. The formula to apply is:

REQUIRED RATE OF RETURN (Where in this case is IRR)

IRR = a +((NPVa/(NPVa-NPVb))(b-a))%

Where, 

a	the lower of the two rates of return used
b	The higher of the two rates of return used
NPVa	The NPV obtained using rate a
NPVb	The NPV obtained using rate b

Between interpolation and extrapolation, interpolation is preferred. This is because using interpolation increases the likelihood of obtaining valid estimate. Using extrapolation means making assumption that are outside the range of observed trend.

However, for exam purpose without looking for exact two sets of positive and negative NPV it will be easier and time saving to tackle from two selected rates of return as the same formula works for interpolation and extrapolation.

Statement of profit or loss

Preview on Conceptual Framework for Financial Reporting 2010

The elements directly related to the measurement of performance in the income statement are income and expenses.

4.24 Profit is frequently used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share. The elements directly related to the measurement of profit are income and expenses. The recognition and measurement of income and expenses, and hence profit, depends in part on the concepts of capital and capital maintenance used by the entity in preparing its financial statements. These concepts are discussed in paragraphs 4.57 -4.65.

4.27 Income and expenses may be presented in the income statement in different ways so as to provide information that is relevant for economic decision making. For example, it is common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the entity and those that do not. This distinction is made on the basis that the source of an item is relevant in evaluating the ability of the entity to generate cash and cash equivalents in the future; for example, incidental activities such as the disposal of a long term investment are unlikely to recur on a regular basis. When distinguishing between items in this way consideration needs to be given to the nature of the entity and its operations. Items that arise from the ordinary activities of one entity may be unusual in respect of another.

4.28 Distinguishing between items of income and expense and combining them in different ways also permits several measures of entity performance to be displayed. These have differing degrees of inclusiveness. For example, the income statement could display gross margin, profit or loss from ordinary activities before taxation, profit or loss from ordinary activities after taxation, and profit or loss.

For more on Income and Expenses check Conceptual FW 2010 4.29-1.35 – Page 32.

Conceptual Framework for Financial Reporting 2010