Chapter III Theoretical Background -...

Chapter III: Theoretical Background

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Chapter III

Theoretical Background

3.1

3.2

3.3

3.4

3.5

3.6

3.7

3.8

3.9

Introduction

Financial Management

History and Concept of Cash Flow Management

Limitations of Financial Statement

Background of Accrual Accounting

Methods of Cash Flow Statement

Background of the Research

Rationale of the Research

Conclusion


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CHAPTER III

THEORETICAL BACKGROUND

3.1 Introduction

Wealth maximization is the main objective of financial management and

growth is essential for increasing the wealth of equity shareholders. The growth can

be achieved through expanding its existing markets or entering in new markets.

A company can expand/diversify its business internally or externally. It can

also be known as internal growth and external growth. Internal growth requires that

the company increase its operating facilities i.e. marketing, human resources,

manufacturing, research, IT etc. which requires huge amount of funds. Besides a huge

amount of funds, internal growth also requires time. Thus, lack of financial resources

or time needed constrains a company’s space of growth. The company can avoid these

two problems by acquiring production facilities as well as other resources from

outside through mergers and acquisitions.

The previous chapter was related to review of literature and this chapter is

about theoretical background. It constitutes of financial management, history and

concept of cash flow management, limitations of financial statement, background of

accrual accounting and methods of cash flow statements.

3.2 Financial Management

Business concern needs finance to meet their requirements in the economic

world. Any kind of business activity depends on the finance. Hence, it is called as

lifeblood of business organization. Whether the business concerns are big or small,

they need finance to fulfill their business activities.

In the modern world, all the activities are concerned with the economic

activities and very particular to earning profit through any venture or activities. The

entire business activities are directly related with making profit.

According to the economics concept of factors of production, (rent given to

landlord, wage given to labor, interest given to capital and profit given to shareholders

or proprietors), a business concern needs finance to meet all the requirements. Hence,


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finance may be called as capital, investment, fund etc. but each term is having

different meanings and unique characters. Increasing the profit is the main aim of any

kind of economic activity.

Finance may be defined as the art and science of managing money. It includes

financial service and financial instruments. Finance also is referred as the provision of

money at the time when it is needed. Finance function is the procurement of funds and

their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. Each

word is having unique meaning. Studying and understanding the concept of finance

become an important part of the business concern.1

There are three key elements to the process of financial management. 2

(1) Financial Planning

Management need to ensure that enough funding is available at the right time

to meet the needs of the business. In short term, funding may be needed to invest in

equipment and stocks, pay employees and fund sales made on credit.

In the medium and long term, funding may be required for significant

additions to the productive capacity of the business or to make acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure

that the business is meeting its objectives. Financial control addresses questions such

as:

Are assets being used efficiently?

Are the businesses assets secure?

Does management act in the best interest of shareholders and in accordance

with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing

and dividends:


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Investments must be financed in some way, however, there are always

financing alternatives that can be considered. For example, it is possible to

raise finance from selling new shares, borrowing from banks or taking credit

from suppliers?

A key financing decision is whether profits earned by the business should be

retained rather than distributed to shareholders via dividends. If dividends are

too high, the business may be starved of funding to reinvest in growing

revenues and profits further.

Every organization has its core competence which is guarded by its finance

team. Hence, finance person is a goal keeper of an organization.

Financial management is a process to have knowledge of balance sheets,

analyzing cost center and expenses of an organization. This program helps the

candidate to understand the role of the Finance Manager about how to minimize cost

and maximize profit.

It is a program which should be done by candidate who wants to pursue their

career in financial services and financial backup of an organization.

3.2.1 Objectives of Financial Management

The financial management is generally concerned with procurement,

allocation and control of financial resources of a concern. The objectives can be such

as:3

To ensure regular and adequate supply of funds to the concern.

To ensure adequate returns to the shareholders which will depend upon the

earning capacity, market price of the share, expectations of the shareholders

To ensure optimum funds utilization. Once the funds are procured, they should

be utilized in maximum possible way at the least cost.

To ensure safety on investment, i.e, funds should be invested in safe ventures

so that adequate rate of return can be achieved.

To plan a sound capital structure-There should be sound and fair composition

of capital so that a balance is maintained between debt and equity capital.


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3.2.2 Functions of Financial Management

1. Estimation of Capital Requirements

A finance manager has to make estimation with regards to capital

requirements of the company. This will depend upon expected costs and

profits and future programmers’ and policies of a concern. Estimations have to

be made in an adequate manner which increases earning capacity of enterprise.

2. Determination of Capital Composition

Once the estimation has been made, the capital structure have to be decided.

This involves short- term and long- term debt equity analysis. This will

depend upon the proportion of equity capital a company is possessing and

additional funds which have to be raised from outside parties.

3. Choice of Sources of Funds

For additional funds to be procured, a company has many choices like-

a. Issue of shares and debentures;

b. Loans to be taken from banks and financial institutions;

c. Public deposits to be drawn like in the form of bonds.

Choice of factor will depend on relative merits and demerits of each source

and period of financing.

4. Investment of Funds

The finance manager has to decide to allocate funds into profitable ventures

so that there is safety on investment and regular returns are possible.

5. Disposal of Surplus

The net profits decisions have to be made by the finance manager. This can be

done in two ways:

a. Dividend declaration-it includes identifying the rate of dividends and

other benefits like bonus.

b. Retained profits- the volumes have to be decided which will depend

upon expansion, innovational, diversification plans of the company.


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6. Management of Cash

Finance manager has to make decisions with regards to cash management.

Cash is required for many purposes like payment of wages and salaries,

payment of electricity and water bills, payment to creditors, meeting current

liabilities, maintenances of enough stock, purchase of raw materials, etc.

7. Financial Controls

The finance manager has not only to plan, procure and utilize the funds but he

also has to exercise control over finances. This can be done through many

techniques like ratio analysis, financial forecasting, cost and profit control etc.

3.3 History and Concept of Cash Flow Management

The balance sheet and income statement have been the required statements for

fears but the cash flow statement has been formally required in the United States only

since 1988.

However, cash flow statements, in some form or another, have a long history

in the United States. In 1883, Northern Central Railroad issued a summary of its

financial transactions that included an outline of its cash receipts and disbursement for

the year.

Because current assets can be thought of as those assets that are close to

becoming cash and current liabilities, as those liabilities that are close to being paid in

cash, an alternative to focusing on cash flow is to examine the net change in working

capital.

(Current Assets -Current Liabilities)

In some sense, working capital is equal to cash plus net short-term potential

cash. In 1902, United States Steel Corporation produced a report that listed the major

causes of the change in fund during the year, with funds being defined as current

assets minus accounts payable. A working capital funds statement started to become

increasingly popular after 1920.

In 1971, the Accounting Broad Principle ABP issued opinion No.19 officially

requiring that a funds statement be included as one of three primary financial

statements in annual reports to shareholders and that should be according to the

auditor’s report. Opinion No. 19 did not specify a single definition or concept of funds


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or a required format for the statement. This statement was called the statement of

changes in financial position. During the 1970, the statement of changes in financial

position (or fund statement) was not given emphasis and was usually not even

discussed in introducing financial accounting courses.

During the early 1980, the Financial Executives Institute (FEI) encouraged its

members to adopt a cash emphasis in their statements of changes in financial position.

In 1980, only 10% of the fortune500 companies used a cash focus, the other 90%

reported net changes in working capital. By 1985, 70%used a cash focus. During this

same period, the FASB4 issued statement of Financial Accounting Concepts No. 5,

which suggested that conceptually; a cash flow statement should be a part of the full

set of financial statement.

In late 1987, the FASB issued statement No.95, which superseded APB

opinion No19, instead of moving various definitions of funds, such as cash or

working capital and a variety of formats. The FASB called for a statement of cash

flow to replace the more general statement of changes in financial position because

the required cash flow statement is relatively young (remember, double entry

accounting is 500 years old).It sometimes does not get the emphasis it deserves as one

of the three primary financial statements.

Many accounting textbooks still delay coverage of cash flow statements until

the end of the book. In addition, most of the age old tools of financial statements

analysis do not incorporate use of cash flow data. In fact, because the traditional

analysis models were developed in an age when cash flow data were not available,

analysis will go to great lengths to approximate cash flow numbers. Seemingly

unaware that since 1988 the actual numbers have been easily available in the cash

flow statement. For example, a number often used in evaluating a company heath is

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

When pressed about the reason for using this number, an analyst will say this

as EBITDA approximates operating cash flow. Why do analysts not use the real cash

flow numbers? Because information from the cash flow statements is not ingrained in

the analytical tradition. But it will be, in fact, one way to impress others that you are

a modern, well trained, future- looking professional is to become proficient in

preparing and analyzing cash flow statement.


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3.3.1 Concept of Cash Flow Management

Cash flow management is the process of monitoring, analyzing, and adjusting

ones business' cash flows. For small businesses, the most important aspect of cash

flow management is avoiding extended cash shortages, caused by having too great

gap between cash inflows and outflows. One won't be able to stay in business if one

can't pay ones bills for any extended length of time!

Therefore, one needs to perform a cash flow analysis on a regular basis, and

use cash flow forecasting so one can take the steps necessary to head off cash flow

problems. Many software accounting programs have built-in reporting features that

make cash flow analysis easy. This is the first step of cash flow management.

The second step of cash flow management is to develop and use strategies that

will maintain an adequate cash flow for your business. One of the most useful

strategies for small businesses is to shorten your cash flow conversion period so that

your business can bring in money faster.

Business analysts report that poor management is the main reason for business

failure. Poor cash management is probably the most frequent stumbling block for

entrepreneurs. Understanding the basic concepts of cash flow will help one plan for

the unforeseen eventualities that nearly every business faces.

Cash is ready money in the bank or in the business. It is not inventory, it is not

accounts receivable (what you are owed), and it is not property. These can potentially

be converted to cash, but can't be used to pay suppliers, rent, or employees.

Profit growth does not necessarily mean more cash on hand. Profit is the

amount of money one expects to make over a given period of time, while cash is what

one must have on hand to keep your business running. Over time, a company's profits

are of little value if they are not accompanied by positive net cash flow. One can't

spend profit; one can only spend cash.

Cash flow refers to the movement of cash into and out of a business. Watching

the cash inflows and outflows is one of the most pressing management tasks for any

business. The outflow of cash includes those checks one writes each month to pay

salaries, suppliers, and creditors. The inflow includes the cash one receives from

customers, lenders, and investors.


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Positive Cash Flow, if its cash inflow exceeds the outflow, a company has a

positive cash flow. A positive cash flow is a good sign of financial health, but is by no

means the only one.

Negative Cash Flow, if its cash outflow exceeds the inflow, a company has a

negative cash flow. Reasons for negative cash flow include too much or obsolete

inventory and poor collections on accounts receivable (what ones customers owe

one). If the company can't borrow additional cash at this point, it may be in serious

trouble.5

One can use Cash Flow Management to predefine an opening balance for a

forecast, based on a single cash management transaction or a specific General Ledger

account balance. One also can base a forecast on one or more checkbook balances

with or without work/adjust transactions, such as deposits, payments and

reconciliation adjustments that are not part of the checkbook balance.

One also can use Cash Flow Management to complete the following tasks:

Create an unlimited number of cash flow forecast definitions;

Forecast cash flows in different ways;

Create scenarios without actually recording transactions;

Summarize daily inflows and outflows of cash in the calendar window;

View the summary of any given day’s cash inflow and outflow;

Obtain weekly detailed or summary and monthly calendar reports. 6

3.3.1.1 Definition of Cash Flow

A revenue or expense stream that changes a cash account over given period

cash inflow usually arise from one of the three activities (i.e.) financing, operations or

investing- although this also accurse as a result of donations or gifts in the case of

personal finance. Cash out flow results are due to the expenses or investments. This is

common for both business and personal finance.

An accounting statement called as the statement of cash flow shows the

amount of cash generated and used by a company in a given period. It is calculated by

adding noncash charges (such as depreciation) to net income after taxes. Cash flow


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can be attributed to a specific project, or to a business as a whole. Cash flow can be

used as an indication of a company’s financial strength.

According to Investopedia explains cash flow7

there are some explanations

of cash flow pointed as the following:

1) In business as in personal finance, cash flow is essential to solvency. They can

be presented as a record of something that has happened in the past such as the

sale of a particular product or forecasted into the future representing what a

business or a person expects to take in and to spend. Cash flow is crucial to an

entity survival. Having ample cash on hand will ensure that creditors,

employers, and other can be paid on time. If a business or person does not

have enough cash to support its/ his operations, it’s said to be insolvent and a

likely candidate for bankruptcy if the insolvency continues.

2) The statement of a business cash flow is often used by analysts to gauge

financial performance. Companies with ample cash on hand are able to invest

the cash back into the business in order to generate more cash and profit.

3.3.1.2 Background of FASB Statement No. 95

The FASB cash flow pronouncement, statement No.95, illustrates that the

setting of accounting standards is not a science but is a balancing act with the

differing opinions of users and prepares being weighed against one another and the

consideration of cost of implementation being weighed against the potential benefits.

Because standard setting is a balance act, not all interested parties’ outcome with the

acceptance on the final. In fact, three of the seven FASB members dissented to the

final version of statement No.95. One area of disagreement involved the

categorization of interest and divided cash flow.

Three of Board members believed that interest and dividend paid are a cost of

obtaining financing and each should be classified as cash out flow from financing

activities. In statement No.95, however, dividend payments are included in the

financing activities section while interest payments are classified as cash out flow

from operating activities .Similarly, the three Board members believed that interest

and dividends’ received are returns on investments and therefore should be classified

as cash inflows from investment activities. Statement No. 95 includes both items in

the operating activities section. A more significant disagreement related to the


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permissibility of both the indirect and the direct methods of reporting cash flow from

operation.

Before issuing the statements a majority of the outside comment to the Board

advocated the required use of the direct method. Most of those comments from

commercial lenders who indicated that detailed cash flow information by category

would help them to better assess a firm’s ability to repay the borrowing. Those

opposed to this direct method requirement and who instead advocate permissibility of

both methods were mainly preparers and providers of financial statement. They

argued that requiring the use of the direct method would impose excessive

implementation costs on some firms.

They also argued that the indirect method provides more meaningful

information because it is more similar to what has been used in the past. Statement

No.95 allows both methods but does encourage the use of direct method. The

statement also describes major change in financial reporting as an evolutionary

process. Conceptual purity is balanced against feasibility and cost of implementation

while, it is likely that the standards of cash flow reporting will be further improved in

the future.

Statement No. 95 represents a significant incremental improvement over prior

practice. Every big and small firm performs cash transactions. Cash transaction refers

to cash inflows and outflows. Cash inflows and outflows help to review success,

failure of a firm and its ability to meet maturing debts. Such review and evaluation are

possible if the statement of cash flow is prepared. Accounting standard Board, ASB at

international level in 1996 suggested every firm to publish the statement of cash flow

along with the final accounts. Since then the statement of cash flow is getting more

recognition than funds flow statement.

The statement that shows cash inflows and outflows of a firm for a specified

period is called the cash flow statement. Cash flow statement demonstrates where the

cash has come during the period and what the firm has done with the available cash.

Therefore, cash flow statement shows a picture of cash movement occurred in and out

from a firm during a year in a summarized form. Cash flow statement gives a picture

of sources and applications of cash of a firm for a year.


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The cash flow statement is not a cash book because it demonstrates inflows

and outflows of cash and near to cash items. Cash and near to cash cover entire items

of current assets and current liabilities. The cash flow statement reports increase and

decrease in cash by listing in meaningful categories in terms of operating, investing

and financing activities.

3.4 Limitations of Financial Statements

We know that financial statements is a written report which quantitatively

describes the financial condition of a firm or company, financial statements report

includes the balance sheet, income statement, statement of changes in net worth and

statement of cash flow. A financial management system is the creation of financial

statements. To manage proactively, one should plan to generate financial statements

on a monthly basis.8

Although analysis of financial statement is essential to obtain relevant

information for making several decisions and formulating corporate plans and

policies, it should be carefully performed as it suffers from a number of the following

limitations such as: 9

1. Mislead the User

The accuracy of financial information largely depends on how accurately

financial statements are prepared. If their preparation is wrong, the information

obtained from their analysis will also be wrong which may mislead the user in making

decisions.

2. Not Useful for Planning

Since financial statements are prepared by using historical financial data, the

information derived from such statements may not be effective in corporate planning,

if the previous situation does not prevail.

3. Qualitative Aspects

Financial statement analysis provides only quantitative information about the

company's financial affairs. However, it fails to provide qualitative information such

as management labor relation, customer's satisfaction, and management’s skills and so

on which are also equally important for decision making.


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4. Comparison not Possible

The financial statements are based on historical data. Therefore comparative

analysis of financial statements of different years cannot be done as inflation distorts

the view presented by the statements of different years.

5. Wrong Judgment

The skills used in the analysis without adequate knowledge of the subject

matter may lead to negative direction. Similarly, biased attitude of the analyst may

also lead to wrong judgment and conclusion.

Therefore, the limitations mentioned above about financial statement analysis

make it clear that the analysis is a means to an end and not an end to itself. The users

and analysts misunderstand the limitations before analyzing the financial statements

of the company.

3.5 Background Accrual Accounting

An accounting method of that measures the performance position of a

company by recognizing economic events regardless of when cash transaction is

occurred.10

The general idea is that economic events are recognized by matching revenues

to expenses (the matching principle) at the time in which the transaction occurs rather

than when payment is made (or received).

This method allows the current cash inflow and out flow to be comparing with

the future expected cash inflow out flow to give a more accurate picture of a

company’s current financial condition.

3.5.1 History of Accrual Accounting

Luca Pacioli an Italian Triar, is known as “Father of Accounting”. His system

uses debits and credits to represent the numbers found in financial business

transaction. Pacioli’s book on double entry accounting was published in 1494.

Pacioli’s accounting system uses a system of general ledgers and journals to maintain

and preserve financial information. Pacioli describes the use of the years and journal

entries and trial balance to reconcile financial information, which is indicative of

accrual accounting.


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The use of accrual accounting is still unusual for most Governments.11

Very

few Governments have yet to adopt it, certainly at the national level. This has first

occurred in Chile in the mid 1970s in the Pinochet regime.

New Zealand followed the same in 1990 and the US federal Government

moved to accrual based accounting in 1997, but US state and local Governments are

now making the change. By the year 2000, only three other Central Governments had

adopted the accrual basis for their annual financial accounts. Eight of the 30 most

developed countries members of the Organization for Economic Co-operation and

Development (OECD) –) had not adopted accrual based accounting for any aspect of

their public sectors by 2000. The UK Government moved to accrual based accounting

in 2001–2002 and Canada did in the following year as well. By the middle of 2003

only half the OECD countries had adopted accrual based accounting for their central

Government accounts.

In 2000, Malaysia and Tanzania were the only non-OECD countries that were

planning to adopt the accrual basis for their central Government accounts (according

to an IFAC Public Sector Committee Publication, Study Government Financial

Reporting, Accounting Issues and Practices. This is not now considered a priority for

Tanzania and the change is unlikely to take place there in the near future. South

Africa is actively following programmers to change the basis of its public sector

accounting to the accruals over the next few years and this basis has already been

adopted in Mongolia.

Several of the Governments of the largest economies in the world have yet to

introduce such changes. The French National Assembly had agreed definite plans to

make the change by 2005, but in Germany and Italy there are no such plans. Late last

year the Dutch Government dropped its plans to move the accounts of its national

ministries to the accrual basis because of the costs involved. Japan has decided not to

introduce this reform.

3.5.2 Definition of Accrual Accounting

Accrual accounting is considered to be the standard accounting practice for

most companies, with the exception of very small operation. This method provides a

more accurate picture of the company’s current condition. Its relative complexity


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makes it more expensive to implement, this is the opposite of cash accounting, which

recognizes transaction only when there is an exchange of cash.

The need for this method arose out of the increasing complexity of business

transactions and a desire for more accrual financial information. Selling on credit and

projects that provide revenue streams over a long period of time affect the company’s

financial condition at the point of the transaction. Therefore, it makes sense that such

events should also be reflected on the financial statements during the same reporting

period that these transactions occur.

Accrual accounting, however, says that the cash method is not accurate

because it is likely, if not certain, that company will receive the cash at some point in

the future because the sale has been made.

3.6. Methods of Cash Flow Statement

In financial accounting a cash flow statement,12

also known as statement of

cash flows, is a financial statement that shows how changes in balance sheet accounts

and income affect cash and cash equivalents and breaks the analysis down to

operating, investing, and financing activities. Essentially, the cash flow statement is

concerned with the flow of cash in and out of the business.

The statement captures both the current operating results and the

accompanying changes in the balance sheet. 13

As an analytical tool, the statement of

cash flows is useful in determining the short-term viability of a company, particularly

its ability to pay bills. International Accounting Standard 7, IAS 7 is the International

Accounting Standard that deals with cash flow statements.

The cash flow statement was previously known as the Flow of Cash Statement

as the cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot

of a firm's financial resources and obligations at a single point in time, and the income

statement summarizes a firm's financial transactions over an interval of time.

These two financial statements reflect the Accrual Basis Accounting used by

firms to match revenues with the expenses associated with generating those revenues.

The cash flow statement includes only inflows and outflows of cash and cash

equivalents; it excludes transactions that do not directly affect cash receipts and

payments.


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These non-cash transactions include depreciation or write-offs on bad debts or

credit losses to name a few. The cash flow statement is a Cash Basis Report on three

types of financial activities: operating activities, investing activities and financing

activities. Non-cash activities are usually reported in footnotes.

The cash flow statement has been adopted as a standard financial statement

because it eliminates allocations, 14

which might be derived from different accounting

methods, such as various timeframes for depreciating fixed assets.

The cash flow statement is intended to: 15

1. provide information on a firm's liquidity and solvency and its ability to change

cash flow in future circumstances;

2. provide additional information for evaluating changes in assets, liabilities and

equity;

3. Improve the comparability of different firms' operating performance by

eliminating the effects of different accounting methods;

4. indicate the amount, timing and probability of future cash flows;

The below table shows us the process and Cash Flow Statements Clearly:

Figer 3.1

The Process of Cash Flow Statements

(Source: Designed by Researcher)

Figure 3.1 shows cash flow statement items come from income statement and

the balance sheet statement. That means cash flow statement constitutes of income


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statement and balance sheet statement. It is a very important tool for financial

mangers for taking decisions about the future of Company’s Cash Flow.

IAS 716

Statement of Cash Flows requires an entity to present a statement of

cash flows as an integral part of its primary financial statements. Cash flows are

classified and presented into operating activities (either using the 'direct' or 'indirect'

method), investing activities or financing activities, with the latter two categories

generally presented on a gross basis. IAS 7 was reissued in December 1992, revised in

September 2007, and is operative for financial statements in which the covering

periods beginning on or after 1 January 1994.

The objective of IAS 7 is to require the presentation of information about the

historical changes in cash and cash equivalents of an entity by means of a statement of

cash flows, which classifies cash flows during the period according to operating,

investing and financing activities.

All entities that prepare financial statements in conformity with IFRSs are

required to present a statement of cash flows. [IAS 7.1]

The statement of cash flows analysis the changes in cash and cash equivalents

during a period. Cash and cash equivalents comprise cash on hand and demand

deposits, together with short-term, highly liquid investments that are readily

convertible to a known amount of cash and that are subject to an insignificant risk of

changes in value. Guidance notes indicate that an investment normally meets the

definition of a cash equivalent when it has a maturity of three months or less from the

date of acquisition.

Equity investments are normally excluded, unless they are in substance of a

cash equivalent (e.g. preferred shares acquired within three months of their specified

redemption date). Bank overdrafts which are repayable on demand and which form an

integral part of an entity's cash management are also included as a component of cash

and cash equivalents [IAS 7.7-8].

Cash flows must be analyzed between operating, investing and financing

activities [IAS7.10]. Key principles specified by IAS 7 for the preparation of a

statement of cash flows are as follows:


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Operating activities are the main revenue-producing activities of the entity

that are not investing or financing activities, so operating cash flows include cash

received from customers and cash paid to suppliers and employees [IAS 7.14].

Investing activities are the acquisition and disposal of long-term assets and

other investments that are not considered to be as the cash equivalents [IAS

7.6].

Financing activities are activities that alter the equity capital and borrowing

structure of the entity [IAS 7.6].

Interest and dividends received and paid may be classified as operating,

investing or financing cash flows, provided that they are classified

consistently from period to period [IAS 7.31].

Cash flows arising from taxes on income are normally classified as

operating, unless they can be specifically identified with financing or

investing activities [IAS 7.35].

For operating cash flows, the direct method of presentation is encouraged,

but the indirect method is also acceptable [IAS 7.18].

3.6.1 Reporting Cash Flows from Operating Activities

An enterprise should report cash flows from operating activities using either:

The direct method, whereby major classes of gross cash receipts and gross

cash payments are disclosed; or

The indirect method, whereby net profit or loss is adjusted for the effects of

transactions of a non-cash nature, any deferrals or accruals of past or future

operating cash receipts or payments, and items of income or expense

associated with investing or financing cash flows.

3.6.1.1 The Direct Method

The direct method provides information which may be useful in estimating

future cash flows and which is not available under the indirect method.

Therefore, it is considered more appropriate than the indirect method. Under

the direct method, information about major classes of gross cash receipts and gross

cash payments may be obtained either:

From the accounting records of the enterprise; or


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By adjusting sales, cost of sales (interest and similar income and interest

expense and similar charges for a financial enterprise) and other items in the

statement of profit and loss for:

Changes during the period in inventories and operating receivables and

payables;

Other non-cash items; and

Other items for which the cash effects are investing or financing cash flows.

This shows each major class of gross cash receipts and gross cash payments.

The operating cash flows section of the statement of cash flows under the direct

method would appear something like this:

Table 3.1

Direct Method of Cash Flow Statement

Direct Method Cash Flow Statement: (Rs. ’000) 1996

Cash flows from operating activities

Cash receipts from customers 30,150

Cash paid to suppliers and employees (27,600)

Cash generated from operations 2,550

Income taxes paid (860)

Cash flow before extraordinary item 1,690

Proceeds from earthquake disaster settlement 180

Net cash from operating activities 1,870

Cash flows from investing activities:

Purchase of fixed assets (350)

Proceeds from sale of equipment 20


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Interest received 200

Dividends received 160

Net cash from investing activities 30

Cash flows from financing activities

Proceeds from issuance of share capital 250

Proceeds from long-term borrowings 250

Repayment of long-term borrowings (180)

Interest paid (270)

Dividends paid (1,200)

Net cash used in financing activities (1,150)

Net increase in cash and cash equivalents 750

Cash and cash equivalents at beginning of period 160

Cash and cash equivalents at end of period 910

(Source: Accounting Standard No.3www.mca.gov.in/Ministry/notification)

3.6.1.2 The Indirect Method

Under the indirect method, the net cash flow from operating activities is

determined by adjusting net profit or loss for the effects of:

(a) Changes during the period in inventories and operating receivables and

payables;

(b) Non-cash items such as depreciation, provisions, deferred taxes and unrealized

foreign exchange gains and losses; and

(c) All other items for which the cash effects are investing or financing cash

flows.


108

Alternatively, the net cash flow from operating activities may be presented

under the indirect method by showing the operating revenues and expenses excluding

non-cash items disclosed in the statement of profit and loss and the changes during the

period in inventories and operating receivables and payables. The researcher use

indirect method for this study.

Table No 3.2

Indirect Method of Cash Flow Statement

Indirect Method Cash Flow Statement (Rs. ’000) 1996

Cash flows from operating activities

Net profit before taxation, and extraordinary item 3,350

Adjustments for:

Depreciation 450

Foreign exchange loss 40

Interest income (300)

Dividend income (200)

Interest expense 400

Operating profit before working capital changes 3,740

Increase in sundry debtors (500)

Decrease in inventories 1,050

Decrease in sundry creditors (1,740)

Cash generated from operations 2,550

Income taxes paid (860)

Cash flow before extraordinary item 1,690


109

Proceeds from earthquake disaster settlement 180

Net cash from operating activities 1,870

Cash flows from investing activities

Purchase of fixed assets (350)

Proceeds from sale of equipment 20

Interest received 200

Dividends received 160

Net cash from investing activities 30

Cash flows from financing activities

Proceeds from issuance of share capital 250

Proceeds from long-term borrowings 250

Repayment of long-term borrowings (180)

Interest paid (270)

Dividends paid (1,200)

Net cash used in financing activities (1,150)

Net increase in cash and cash equivalents 750

Cash and cash equivalents at beginning of period 160

Cash and cash equivalents at end of period 910

(Source: Accounting Standard No.3www.mca.gov.in/Ministry/notification)17

The exchange rate used for translation of transactions denominated in a

foreign currency should be the rate in effect at the date of the cash flows

[IAS 7.25];


110

Cash flows of foreign subsidiaries should be transacted the exchange

rates prevailing when the cash flows took place [IAS 7.26];

Regarding the cash flows of associates and joint ventures, where the

equity method is used, the statement of cash flows should report only cash

flows between the investor and the investee; where proportionate

consolidation is used, the cash flow statement should include the venture’s

share of the cash flows of the investee [IAS 7.37-38];

Aggregate cash flows relating to acquisitions and disposals of subsidiaries

and other business units should be presented separately and classified as

investing activities, with specified additional disclosures. [IAS 7.39] The

aggregate cash paid or received as consideration should be reported net of

cash and cash equivalents acquired or disposed of [IAS 7.42];

Cash flows from investing and financing activities should be reported

gross by major class of cash receipts and major class of cash payments

except for the following cases, which may be reported on a net basis: [IAS

7.22-24].

Cash receipts and payments on behalf of customers (for example, receipt and

repayment of demand deposits by banks, and receipts collected on behalf of and paid

over to the owner of a property) cash receipts and payments for items in which the

turnover is quick, the amounts are large, and the maturities are short, generally less

than three months (for example, charges and collections from credit card customers,

and purchase and sale of investments) cash receipts and payments relating to deposits

by financial institutions cash advances and loans made to customers and repayments

thereof investing and financing transactions which do not require the use of cash

should be excluded from the statement of cash flows, but they should be separately

disclosed elsewhere in the financial statements [IAS 7.43]. The components of cash

and cash equivalents should be disclosed, and a reconciliation presented to amounts

reported in the statement of financial position [IAS 7.45]. The amount of cash and

cash equivalents held by the entity that is not available for use by the group should be

disclosed, together with a commentary by management [IAS 7.48].


111

3.7 Background of the Research

Cash flow prediction is an essential obligation. It is evolved in different

economic decisions, investors, for example have much information about future cash

flow. The capability of a company to generate cash flow is reflected in the value of its

share.

Research done in Thailand suggested that cash flow has value relevance to

stock prices in the Thailand Stock Market. 18

Thus, predicting future cash flow

permits investors to predict stock prices. In addition, the financial accounting standard

Board (FASB) suggested that financial reporting can help users assess future cash

flow FASB1978 and the cash flow has an important role in all these issues.

More researchers have tried to discover the predictive ability of occurring

under an accrual accounting basis and cash flow, in prediction future cash flow,

butFASB stated that earning is a better prediction of future cash flow than cash flows

themselves. However, previous research findings have not shown any confirmed

result. Some researchers have made a decision that the predictive capability of earning

outperforms that of cash flow in predicting future cash flow.

For example, the studies of Greenberg Johnson and Ramesh (1986), 19

and

Dehow, Kothari and Watts (1998), 20

in opposite, some studies showed the

disagreement and the result in which cash flows are the better prediction of future

cash flow. For example the studies of Finger (1994), (21)

Bowen Burgstahler and

Daley (1986), (22)

Percy and Stokes (1992), (23)

However, the study by McBeth (1993),

(24) rejected both results and asserted that no cash flow and no earning are not a good

predictor of future cash flow.

In addition to single variable testing, some researchers have focused on

multiple variables. Such as the components of earning including cash flow and

accrual accounting data ( Barth, Cram and Nelson 2001), (25)

used a simple time series

model to test relationship between accrual component of earning and future cash flow.

They find that each accrual components reflected different information relating future

cash flow.

Replicated Barth, Cram and Nelsons study and both these studies provided

evidence that models based on cash flows and total accrual obtained a superior

predictor of future cash flow over models based solely on earnings.


112

3.8 Rationale of Research

Cash flow prediction is an important object for reporting financial situation as

suggested by the FASB. 1976. However, cash flow has included some economic

decisions such as liquidity, solvency evaluation, performance evaluation monitoring

evaluation and prediction function. For example (Narktabtee 2000), the work in

Thailand suggested that the cash flow has a value relevance to stock price in Thailand

Stock Market. Therefore, it is very important for investors to find out who can predict

future cash flow of a company; they can predict share prices of that company too.

Many researchers have investigated the ability of cash flow and accrual

accounting data to prediction future cash flow but their researches were incompatible

and so many researchers have been undertaken in the United States, there has not

been any published research article which is undertaken in India.

The researcher has presented the history and profile of pharmaceutical

industry in the next chapter.

3.9 Conclusion

Cash flow statements and accrual accounting statements play an important role

for any company’s financial manager for making future and present decision of that

company. Then, company’s financial managers take into consideration about the cash

flow statements and accrual accounting statements from the past time and analyze

them for taking the best alternative for the present and future of their company with

an open vision.

An accounting statement is called as the statement of cash flow which shows

the amounts of cash generated and used by a company in a given period. Having

ample cash on hand will ensure that creditors, employers and other can be paid on

time. But accrual accounting is the opposite of cash accounting, which recognizes

transaction only when there is an exchange of cash. The need for this method arose

out of the increasing complexity of business transactions and a desire for more accrual

financial information. Selling on credit and projects that provide revenue streams over

a long period of time affect the company’s financial condition at the point of the

transaction.


113

An enterprise should report cash flows from operating activities using either:

the direct method, whereby major classes of gross cash receipts and gross cash

payments are disclosed; or

the indirect method, whereby net profit or loss is adjusted for the effects of

transactions of a non-cash nature, any deferrals or accruals of past or future

operating cash receipts or payments and items of income or expense

associated with investing or financing cash flows.


114

References:

1) C. Paramasi vanand T. Subramanian, Financial Management Text Book,

Faculty of Commerce, Vivekananda College, pp 1-2

2) Jim Riley September,2012 http://www.tutor2u.net Retrieved on17/5/2014

3) 30/14, Floor 1, Old Rajinder Nagar New Delhi - 110060, India Email

id: [email protected] Phone No: +91 9871636504. Retrieved

on17/5/2014

4) Financial Accounting Standard Board (FASB) of India

5) www.reuters.com. Retrieved on19/5/2014

6) Microsoft Dynamics™ GP Cash Flow Management 2007. 19/5/2014

7) www. investopedia.com Retrieved on21/5/2014

8) Mohammad Wahi Abdullah Khan on July 18, 2013TheLimitations of

Financial Statement Analysis. Financial journal

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10) Academic. Cengage.com Retrieved on25/5/2014

11) Andy Wynne Head of Public Sector Technical Issues ACCA 2004, Is the

Move to Accrual Based Accounting a Real Priority for Public Sector

Accounting? p. 4

12) Bloom, R. and Naciri, M. A. ‘Accounting Standard Setting and Culture: A

Comparative Analysis of United States, Canada, England, West Germany,

Australia, New Zealand, Sweden, Japan and Switzerland, International Journal

of Accounting Education and Research’. Vol. 24, 1989

13) Erich A. (2001). "The Nature of Financial Statements: The Cash Flow

Statement". Financial Analysis - Tools and Techniques - A Guide for

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1.^ Epstein, pp.90-9

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http://en.wikipedia.org/wiki/International_Standard_Book_Number

http://en.wikipedia.org/wiki/Special:BookSources/0-07-251077-3

http://en.wikipedia.org/wiki/John_Wiley_%26_Sons

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http://en.wikipedia.org/wiki/Cash_flow_statement#cite_ref-4


115

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Capital Market, PhD thesis, University of Arkansas.

19) Greenberg, R, R, and Johnson, G. L. & Ramesh, K.( 1986) ‘Earnings Versus

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Accounting of Auditing and Finance, Vol.1 (4), pp. 266-77

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Relationship Between Earnings and Various Measures of Cash Flow; The

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