By Steve Collings Financial accounting and reporting FRS 102: cash flow statements 10 Jan 2017 FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with the preparation and presentation of the cash flow statement in Section 7 Statement of Cash Flows. Preparers of financial statements under FRS 102 can expect the presentation of an FRS 102-style cash flow statement to be markedly different than the cash flow statement prepared under FRS 1 Cash flow statements (revised 1996). The purpose of the cash flow statement is to enable users of an entity’s financial statements to understand how the entity has generated cash and what it has done with that cash. Section 7 also recognises the concept of ‘cash equivalents’ which are short-term, highly liquid investments which the entity can convert into known amounts of cash and which must also be subject to an insignificant risk of change in value. Entities that are classified as small under the Companies Act 2006 do not have to prepare a cash flow statement as part of their statutory financial statements; however, that does not mean to say that they are precluded from preparing such a statement, if the directors so wish. Where the entity voluntarily chooses to prepare a cash flow statement, it must apply the provisions in Section 7. Medium-sized and large companies reporting under FRS 102 must prepare a cash flow statement as part of their general purpose FRS 102 financial statements. Classification of cash flows A notable difference between FRS 1 and FRS 102 is the number of cash flow classifications. FRS 1 contained nine different cash flow classifications as follows: Operating activities Dividends from joint ventures and associates Returns on investments and servicing of finance Taxation Capital expenditure and financial investments Acquisitions and disposals Equity dividends paid Management of liquid resources Financing Under FRS 102, there are only three types of cash flow classification: Operating activities Investing activities Financing activities Operating activities Operating activities are the day-to-day revenue-producing activities of the entity. The operating activities classification is the ‘default’ classification and hence any cash flows which are not investing or financing cash flows will be operating cash flows. A common scenario which presents itself to entities reporting under FRS 102 for the first time is where to classify interest income/expense and taxation cash flows. Under FRS 1 such cash flows would have been presented under returns on investment and servicing of finance and taxation respectively. However, as there are no such cash flow classifications under FRS 102, such cash flows will be classed as operating activities. Paragraph 7.4(e) of FRS 102 says that cash payments or refunds of tax are operating activities unless they can specifically identified with financing and investing activities. In practice, it is expected that the majority of interest and tax cash flows will be treated as operating cash flows. Investing activities Investing activities are cash flows which deal with the acquisition and disposal of long-term assets, such as: the acquisition and disposal of fixed assets payments the entity may make to acquire equity or debt instruments of other entities or interests in joint ventures receipts from the disposal of equity or debt instruments loans made to third parties (where the entity is not a financial institution) payments for derivative instruments, such as forward contracts, option contracts and swap contracts (the exception is where such contracts are held for dealing or trading or the payments are classified as financing activities) receipts from derivative instruments, such as forward contracts, option contracts and swap contracts (again, the exception would be where such contracts are held for dealing or trading or the payments are classified as financing activities) Financing activities Financing activities are those cash flows which change the borrowing and equity composition of the entity’s balance sheet. Such cash flows would include: proceeds from a share issue payments made to owners to redeem their shares proceeds from loans, notes, bonds, mortgages and debentures repayments of capital elements of amounts borrowed cash payments in respect of the capital element of a finance lease Preparation of the cash flow statement Paragraph 7.7 of FRS 102 allows a reporting entity to prepare a cash flow statement using two permissible methods: the indirect method, or the direct method Indirect method Under the indirect method, net cash flow from operating activities is arrived by adjusting profit or loss for the effects of non-cash items included in profit or loss. In addition, fluctuations in inventory, debtors and creditors are also taken into account as well as the effects of any other items that relate specifically to investing or financing activities as these will be reallocated to investing and financing cash flows. An example of how this works in practice is shown below: Direct method Under the direct method, the reporting entity will disclose information about the major classes of gross cash receipts and gross cash payments. While accounting standards prefer this method, in practice its use is less common than the indirect method, mainly because the direct method is inherently more complex. An example of this method is shown below: Non-cash transactions By its nature, the cash flow statement is prepared on a cash basis so as to demonstrate how the entity has generated and spent cash during the accounting period. For this reason, FRS 102 requires an entity preparing a cash flow statement to exclude investing and financing cash flows that do not require the use of cash or cash equivalents. Instead, reporting entities are required to disclose such transactions elsewhere within the financial statements in such a way that it will provide all the relevant information about such investing and financing activities. Example – Disclosure of non-cash transactions Madeira Co Ltd has a year-end of 30 November 2016. On 17 June 2016 the company issued 200,000 new shares to convertible loan note holders in settlement of £150,000 worth of capital and interest that was outstanding on the loans. The remaining capital and interest liabilities owed to the loan note holders were satisfied by a rights issue: £18,000 was raised in cash with the remainder being an exchange of shares. Such transactions would ordinarily be disclosed as a footnote to the cash flow statement so as to draw attention to the non-cash transactions that have been entered into, especially as such transactions are likely to be material to the financial statements. Reporting on a net basis The standard allows certain cash flows arising from operating, investing and financing activities to be reported in the cash flow statement on a net basis as follows: (a) cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity (b) cash receipts and payments for items in which the turnover is quick, the amounts are large and the maturities are short Cash flows in foreign currencies Cash flows in a foreign currency are translated into the entity’s functional currency (e.g. Sterling) by applying the exchange rate prevailing at the date of the cash flow. The entity may also use an exchange rate which approximates the actual rate, such as a weighted-average exchange rate for the period. If the reporting entity has a foreign subsidiary, the subsidiary’s cash flows are translated at the exchange rate between the reporting entity’s functional currency and the foreign currency at the date of the cash flow. An exchange rate which approximates actual rate (such as a weighted-average exchange rate for the period) can also be used. The standard recognises that unrealised gains and losses arising from changes in foreign currency exchange rates are not cash flows. To allow an entity to reconcile the cash and cash equivalents at both the beginning and end of the accounting period, the effect of exchange rate changes on cash and cash equivalents that are held, or due, in a foreign currency have to be presented within the cash flow statement. As a result, the reporting entity must remeasure cash and cash equivalents held during the accounting period at the exchange rate prevailing at the reporting date. The resulting unrealised gain or loss is to be presented separately from cash flows from operating, investing and financing activities. Example – Disclosure of effect of exchange rate fluctuations on cash held (extract) Components of cash and cash equivalents Paragraph 7.20 of FRS 102 requires an entity to present the components of cash and cash equivalents together with a reconciliation of the amounts presented in the cash flow statement to the equivalents items in the balance sheet. This reconciliation is not required if the amount of cash and cash equivalents presented in the cash flow statement is the same as the amount(s) in the balance sheet. Other disclosure requirements If the reporting entity holds significant cash and cash equivalents which are not available for use by the entity, paragraph 7.21 of FRS 102 requires disclosure of such balances together with management commentary. The paragraph provides two examples of situations when a reporting entity might hold significant cash and cash equivalents which relate to foreign exchange controls or legal restrictions. Whilst not all entities under the scope of FRS 102 will prepare a cash flow statement, it is important to understand the presentational differences under FRS 102 because it may be that the accountant is required to interpret a cash flow statement to non-financially-orientated individuals. Fewer cash flow classifications may mean that certain cash flows will have to be reallocated under FRS 102, such as interest and tax. Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.