Accounting Essays - Financial Accounting Measurement

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Select a financial accounting measurement or disclosure issue regulated by an FRS and an IFRS

The recent spurt in big accounting standards like Enron and WorldCom has once again brought cash into focus. Internet boom saw investors focusing on potential earnings with little reference to cash flows. The demise of larger companies and scale of manipulation in earnings has once again turned the tide in favour of cash flows.

Discounted cash flows models are the cornerstone of financial theory. Cash flows offer more credibility to valuation as they are more tangible than accrued earnings. 'Historical cash flow information gives an indication of the relationship between profitability and cash-generating ability, and thus of the quality of the profit earned' (Accounting Standards, 2004).

This paper compares and contrasts FRS 1 and IAS 7, the cash flow statement standards of UK'S ASB and International Accounting Standards respectively. A cash flow statement is required due to difference between the profit and loss statement and cash. It is useful in assessing the current liquidity and sources of funding of a business.

UK's Accounting Standards Board (ASB) first promulgated FRS 1 in 1991 and subsequently revised it in 1996. The equivalent international accounting standard is IAS 7. There are many similarities between FRS 1 and IAS 7 and it is generally believed that IAS 7 influenced the formulation and subsequent revision of FRS 1. Both FRS 1 and IAS 7 are similar in the content of information they provide. They show the cash flow generated and utilised during the year.

Even though FRS 1 is similar to IAS 7, there are still some differences between them. These are mainly due to classification of cash and reporting formats.

Definition of cash

The main difference between FRS 1 and IAS 7 is in the definition of cash flows. ASB's FRS defines cash flows to include movements in cash only. Cash is defined as cash in hand and deposits repayable on demand less overdrafts. IAS definition of cash flows is broader than that of FRS and IAS defines cash flows as movement in both cash and cash equivalents. Cash equivalents are short-term highly liquid investments that are easy to convert into cash and carry an insignificant risk of loss in value.

Under FRS 1, cash equivalents are included separately in the 'management of liquid resources'. By clubbing together and showing separately the not so liquid cash equivalents, FRS cash flows standard is more conservative than IAS standards. If investors want a more conservative approach, they can quickly take out 'management of liquid resources' from cash flow statement.

On IAS 7 compliant cash flows statements, we would see more 'cash' than in FRS 1 compliant cash flow statements. Lets imagine a scenario where two companies have same cash and cash equivalents. When comparing just cash amounts, IAS 7 format company will show higher number than the company using FRS 1.

Also the company using IAS 7 will report higher liquidity ratios such as cash to liability ratio or quick ratio. IAS 7 will also impact other ratios using cash like net debt to equity ratio. So two companies with exactly same components will show different financial statement analysis results.

Legal exemption

FRS 1 gives certain companies exemption and they are not legally liable to include cash flow statements into their annual accounts. This exemption is available to small companies and certain open-ended investment funds among others.

All entities of a company using IAS 7 would also have to report cash flow statement. This will allow more in depth financial statement analysis of subsidiaries also.

Foreign exchange movements

Under FRS 1, cash flows of a foreign subsidiary should be translated at the same rate as the profit and loss account. FRS 1 also states that actual or approximation of actual rates should be used for intra group transactions. IAS 7 on the other hand states that cash flows of a foreign subsidiary should be translated at the exchange rates prevailing at the dates of the cash flows. In absence of actual exchange rate for each transaction, IAS 7 allows companies to use a weighted average exchange rate that approximates to the actual rate. This weighted average exchange rate will give same answer as obtained by using actual exchange rate for each transaction.

By using the exchange rates as on the date of actual cash flow transfer, cash flows generated under IAS 7 are more close to the real transfers. If there is a big movement between an actual transfer date and date of profit and loss preparation, cash flows under FRS 1 could be significantly different from actual cash flows. This means that we may encounter different financial statement analysis results under FRS 1 and IAS 7.

Net reporting

IAS 7 allows companies to report net of cash receipts and payments when such cash flows represent the activities of customers and not that of the reporting entity. This aspect is important for companies in the outsourcing services sector. Some companies collect and distribute huge amount of cash on behalf of their customers, many a times government authorities. Reporting a net figure obscures one additional layer of information from investors. It may happen that two companies reporting same net cash flows have very different magnitude of cash receipts and payments. If investors can see the exact magnitude of cash receipts and payments, they can judge which of the companies is better in cash flow management.

FRS 1 doesn't permit netting of customer's cash flows. Customers' cash flow can be an important source of funding for many businesses and hence separate reporting of cash receipts and payments may show investors how the reporting company is utilising customers' cash for its own benefit.

Format

Cash flow statements under IAS 7 format have three sub categories – 'cash flow from operating activities', 'cash flows from investing activities' and 'cash flow from financing activities'. FRS 1 on the other hand has eight headings.

Though FRS 1 has more number of headings than IAS, the format of IAS cash flow statement is better suited for financial analysis purposes. Analysts and investors can clearly see in IAS 7 how much cash is generated through operations, investment and financial arrangements.

Cash flow from operations is the most important thing that investors look for valuing a company. It shows what is the maximum level of cash that can be withdrawn from the business and hence defines the upper limit of valuation.

But a company also needs investment to replace and upgrade machinery and technology. Investors can look at the net cash flow after investing to see whether overall activities yield a positive cash flow or not.

Lastly by looking at cash flow under financing, investors can see how a company's activities have been funded. Cash flow from financing activities clearly shows whether company has utilised external sources of funding to finance its activities in that year or it has used internal cash generation to repay loans. It is also useful in predicting claims on future cash flows by providers of capital.

By clearing demarcating three categories, IAS 7 format makes it much easier for investors to analyse the financial statements of the company. Under FRS 1, though there are eight categories but an investor would have to add them to get a clear picture.

Reconciliation to net debt

FRS 1 requires companies to have a cash flow statement reconciliation showing movement in cash flows to the movement in net debt. This is shown as a note after the main cash flow statement. IAS 7 doesn't have any provisions for such thing.

This is a helpful feature for investors as they can see where cash is coming from to reduce debt or from what external sources of cash are being used in increasing debt levels. Investors look at net debt levels to see signs of financial distress. Presenting a concise statement showing movement in net debt is a useful tool in investors hand for analysing companies.

Management of liquid resources

FRS 1 requires cash flow statements to contain a separate heading on management of liquid resources. Cash flows relating to short term deposits and other similar cash equivalents are now reported under 'management of liquid resources'. Now investors can make a clear distinction between cash flows arising from liquid resources from those of other investing activities. This segregation reflects better the way a company manages its cash flows.

Conclusion

FRS 1 and IAS 7 both describe the content and format of cash flows. IAS 7 and FRS 1 standards differ in the definition of cash and translation methods of foreign exchange. This would result in different cash flow comparisons and different financial ratios. IAS 7 format is better suited for financial analysis. On the other hand FRS 1 has advantages in terms of more conservative in definition of cash and contains more categories and layers of information. FRS 1 also includes additional notes on net reconciliation.

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