November 2024
Tom Clendon explains how you can sort the ‘useful’ information from the chaff.
The question
Do cash flow statements provide useful
information to the users of the accounts?
Tom’s answer
This is a big question. It needs breaking down.
What is meant by useful information?
‘Useful’ is a key word in the conceptual framework for financial reporting. Information will only be useful if it is both relevant and faithfully represented. These two characteristics are fundamental to information being useful.
If information is not relevant or not faithfully represented then it is useless.
Information is relevant if it is capable of making a difference to the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive or confirmatory value.
Faithful representation means that information must faithfully represent the substance of what it purports to represent. A faithful representation is complete, neutral and free from error.
There are also four attributes that enhance the usefulness of information but are not fundamental. These are the characteristics of understandability; comparability; verifiability; and timeliness.
As you read the rest of the article look out for key words, particularly those associated with the two fundamental characteristics of relevant and faithful representation.
Who are the users of the accounts?
The primary users of the financial statements are the providers of capital – i.e. shareholders and lenders, both current and prospective. These users are looking at the financial statements in order to make decisions. Buy or sell the shares.
Sack the board or vote to reappointment them.
Make a further advance or call in the existing loan.
Additional information
Cash flow statements provide additional information that is not found in the income statement. Only the cash flow statement shows how the business has generated and used cash in the accounting period. This means that users have a more complete understanding of the business’ performance.
For example, the Profit & Loss account may show profits even if the company is suffering severe cash flow problems. Whereas a cash flow statement enables users of the financial statements to assess the liquidity, solvency and financial adaptability of a business. This is relevant as users will be interested in the going concern of the business.
In addition, cash flow statements can give an indication of the relationship between profitability and cash generating ability, and thus of the quality of the profit earned. A business that year on year reports a profit but never generates cash is said to have low quality profits – i.e. reported profits may have been generated through the manipulation of estimates and policies.
No estimates
The Profit & Loss account measures profit.
This involves making a series of judgments and estimates to match costs and benefits. For example, the depreciation charge depends on an estimate of the useful life of the asset.
In contrast cash flow statements have no obvious judgments or estimates. Cash has either been received and paid or it has not. This is simple and therefore understandable. Cash flow statements are reliable and verifiable in a way that income statements are not.
No accounting policies
When preparing the Profit & Loss account, a series of accounting policy decisions are made. For example, whether inventory should be accounted for on a first in first out basis or average cost basis.
But to prepare a cash flow statement does not involve formulating any accounting policies.
This makes cash flow statements simpler and therefore understandable.
No measurement issues
Assets and liabilities are sometimes measured at cost and other times at value. These decisions have a direct impact on the measurement of profit, e.g. if property, plant, and equipment is revalued then there will be more depreciation charged as it will be based on the revalued amount.
However, in a cash flow statement there are no arguments over whether to use cost or value. $100 cash is $100 cash. There is no way to revalue cash! This absence of measurement issues means that cash flow statements are still comparable between businesses even if they measure assets and liabilities differently or have different accounting policies.
Business valuation
Investors are interested in the capital value of their investments. They try to use the financial statements to assess their value. They often develop models to assess the future cash flow of entities which they then discount back to a present value. Using cash flow statements to value businesses is predictive.
Dividends and interest payments
Investors are also interested in the ability of the business to pay dividends and interest.
These represent the return on the investments.
Dividends and interest are paid by the reporting entity in cash. The cash flow statement therefore provides relevant information for these users to predict the likelihood that such payments will be made in the future.
Conclusion
he purpose of financial statements is to provide financial information that is useful to users in making decisions relating to providing resources to the entity. I hope that you now understand that cash flow statements are very useful to users because they represent a faithful representation of the cash inflows and outflows and that is relevant.
- Tom Clendon is an online ACCA SBR lecturer and podcaster. He loves WhatsApp – 07725 350793. Or go to www.tomclendon.co.uk
