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.
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.
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).
There are a number of arguments which have been put forward in favour of cash flow reporting. One of the strongest arguments is that cash is such an important factor in determining a firm’s prospects for survival that cash flow information is essential. Firms can fail, not through a lack of ‘accounting profits’ but from a shortage of cash.
Historic cost accounting can often give an over-optimistic view of a firm’s performance, especially during a period of rising prices.
So cash flow reporting might make a company more cautious, for instance with respect to its dividend distribution policy. For example, a firm whose profits are largely represented by increases in stocks and debtors might want to think seriously about paying a large dividend. Large dividend payment to shareholders might have to be financed by increasing its overdraft, which might not be a prudent decision.
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.
It is true that cash flow accounting avoids time period allocation. On the other hand, it is left to the reader to interpret the information contained in a cash flow statement. Consider the case of a firm which changes the credit terms of its customers in a particular year, so that they are required to settle their debts earlier than before.
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.