Accounting and reporting on cash flow and accrual bases

Solutions

Review Questions Ch 01

  1. The user should know what type of information he needs to be able to make useful decisions in his business enterprise. However, the accountant will normally have more expert knowledge of what information can be collected and how it should be collected.

Therefore, both the user and the accountant should work together to decide what is the most useful information and how it should be collected measured and reported.

  1. Industry-specific tools will have a limited re-sale market. Therefore there would probably be unrealised cash flows as their value is written down (depreciation) over their useful life
  1. Prudence requires reporters to be fair in their assessment if values to be reported are to be useful. Overly optimistic (or pessimistic) values remove objectivity from the financial statements. In cash flow accounting, only those cash flows that have occurred should be reported.
  1. Investors need to be able to make reasonable predictions of what may happen in the future. Therefore, as realised cash flows only report what has already happened, investors may have difficulty in being able to predict what their future dividends and returns might be.
  1. Small business owners need to be able to make decisions that will affect the future of the business. Therefore, they need more information than can be obtained from cash basis accounting – they need to know what their future cash flows are likely to be.
  1. Unrealised operating cash flows are very important to the investor – he needs to know whether or not the business will continue as a going concern. Unrealised cash flows help indicate the future needs for when cash will be required to meet future liabilities
  1. A role of the accountant is to gather and report information that is required for the business to succeed. Therefore they need to have a bias towards this purpose. An unbiased approach could lead to gathering information that is not useful, or more importantly, not gathering important information that could result in the business failing.

Problems.

1.Solution Cash Receipts

April / May / June / July / August
Sales / $ 65,000 / $ 60,000 / $ 70,000 / $100,000 / $100,000
Cash sales (50%) / $ 32,500 / $ 30,000 / $ 35,000 / $ 50,000 / $ 50,000
Collections:
Lag 1 month (25%) / 16,250 / 15,000 / 17,500 / 25,000
Lag 2 months (25%) / 16,250 / 15,000 / 17,500
Total cash receipts / $ 66,250 / $ 82,500 / $ 92,500

2. SolutionCash Budget–Basic Zhengzhou Enterprises

March / April / May / June / July
Sales / $50,000 / $60,000 / $70,000 / $80,000 / $100,000
Cash sales (.20) / $10,000 / $12,000 / $14,000 / $16,000 / $ 20,000
Lag 1 month (.60) / 36,000 / 42,000 / 48,000
Lag 2 months (.20) / 10,000 / 12,000 / 14,000
Other income / 2,000 / 2,000 / 2,000
Total cash receipts / $62,000 / $72,000 / $ 84,000
Disbursements
Purchases / $50,000 / $70,000 / $80,000
Rent / 3,000 / 3,000 / 3,000
Wages & salaries / 6,000 / 7,000 / 8,000
Dividends / 3,000
Principal & interest / 4,000
Purchase of new equipment / 6,000
Taxes due / 6,000
Total cash disbursements / $59,000 / $93,000 / $97,000
Total cash receipts / $62,000 / $72,000 / $84,000
Total cash disbursements / 59,000 / 93,000 / 97,000
Net cash flow / $ 3,000 / ($21,000) / ($13,000)
Add: Beginning cash / 5,000 / 8,000 / ( 13,000)
Ending cash / $ 8,000 / ($13,000) / ($26,000)
Minimum cash / 5,000 / 5,000 / 5,000
Required total financing (Notes Payable) / 0- / $18,000 / $31,000
Excess cash balance
(Marketable Securities) / $ 3,000 / -0- / -0-

The firm should establish a credit line of at least $31,000.

3. SolutionCh 01 Question 1 – Jane Parker

4. SolutionCh 01 Question 2 – Mr Norman

Notes:

  • The cash flow statement with summary attached is effectively a 6-month cash budgetshowing the cash received, cash paid each month and the resulting month-end balances.
  • It is necessary to separate sales and purchase transactions into cash and on-credit, and to identify clearly the month of receipt and payment.
  • Commission is paid in the month after the sale is made, and all other cash flows are clearly indicated and allocated to specific months.
  • Note that the format of the cash flow statement brings out key figures – for management decision and control. For example:
  • month-end balances – assist in the control of liquidity;
  • cash deficiencies – identify how much must be financed;
  • early warning – allows management to approach appropriate sources;
  • cash surpluses – identify amounts to be invested on the best terms.

Notes:

  • This statement shows net assets of £75,200.
  • Make up: premises £76,000 less the negative cash balance £800.
  • The negative cash balance indicates the need for overdraft arrangements.
  • The statement is based on cash flow concept:
  • It ignores accrual-based figures (£36,900 less £25,250).
  • Accruals are not regarded as real assets and liabilities.
  • Critics of the cash flow concept would maintain that its utility has therefore beenseriously diminished.

(iv) Letter to the bank requesting an overdraft facility

  • The maximum overdraft facility of £28,800,
  • will be required at the end of January.
  • will be eliminated by July.
  • Overdraft will fall progressively as per the cash budget.
  • It might be practical to request a limit of £30,000,
  • for the full 6-month period.
  • reducing it to £15,000 thereafter to allow for contingencies. The facility is only to becalled on as required.
  • Refer to the cash budget to support the request and
  • confirm that it is based on the most likely scenario.
  • agree to a repayment schedule.
  • Specify that collateral security is available in the form of premises if it should be required.
  • If not an existing customer
  • give outline details of business background.
  • explain future plans.

Ch 02 Questions

  1. Cash flow accounting shows whether the firm is generating enough cash from operations in the long term to be able to meet all of its investing and financing activities as well as its day-to-day operations.

Accrual accounting shows the past transactions involving receipt and payment of cash as well as the future obligations to pay cash and the resources that represent cash receipts in the future.

Therefore information provided by both forms of accounting is required by potential investors.

  1. Accrual accounting shows the past transactions involving receipt and payment of cash as well as the future obligations to pay cash and the resources that represent cash receipts in the future. It therefore shows the type of information about past transactions and other events that is most useful in making economic decisions.
  1. Accrual accounting requires subjective judgements. The information is based on the matching principle which requires subjective assessments of when sales are recognised and when expenses are incurred.
  1. Both types of statement are important to all users. However, the cash based statements would be choice of priority for employees, suppliers and trade creditors as these users are interested in the short-term ability of the firm to pay its liabilities as they fall due.

The other users are more concerned with the log-term stability of the firm, so accrual statements would be most useful to them.

5.The users of financial information include:

a owners

b managers

c creditors

d investors

e employees

f government

g the general public.

The needs of these users are:

Owners: Because these people provide the initial funds, or capital, they are interested in thereturn earned on their funds, and in the financial stability of the business. Therefore, theyneed information that tells them how much the company has earned (has it increased itswealth?), and whether it can pay its bills as they fall due.

Managers: These people fall into different categories (top, middle and lower), and theinformation needs of each kind of manager depends on their level in the organisation.

Top managers want information that

a shows how their policy decisions have affected the performance of the company, and

b enables them to make policy decisions for the future activities of the company.

Middle management wants information about the performance of their departments such ashow efficient end effective they have been in carrying out the policy decisions of topmanagement.

Lower management wants information that tells them how well their sections haveperformed.

Creditors: These people provide goods and services (such as raw materials), to thecompany. They are concerned with the financial stability of the company and whether or notit will pay its bills as they fall due. Thus they are mainly concerned with the company’sliquidity, and with the security it offers to cover any advances made to it.

Investors: We have already covered the owners. Here, we are mainly concerned withprospective investors. These are people who are contemplating buying a share in thecompany. They are concerned with financial stability and with return on investment. Thus,profitability and measures of management performance are important to them. They will usethis information to predict future performance, and thus aid their decision on whether tobuy the shares.

Employees: The workers are also concerned about the performance of the company, and itsfuture prospects. They want information about these items to assess their future job securityand to ensure they receive a fair wage for the work they do. The information will alsoindicate whether they should stay with this employer, or seek employment elsewhere.

Government: The information wanted by this user includes profit figures to assess the taxliability of the company, and to assess the need for price controls, tariff restraints, and so on.

Several government departments collect information about sales levels, profits, investments,inventories, liquidity, dividend levels, proportion of profits absorbed by taxation, and so on.

This information is very important in setting policies for managing the economy, and it isproduced by the accounting system of organisations.

The general public: As customers, the general public wants to know the quality of thegoods and services it is offered, the fairness of the pricing policies (such as the relativeproportion unit price which consists of costs, profits and taxes), and the prices of thecompany and its competitors.With the increased interest in conservation and other social effects of business, the generalpublic also wants to know how well business is using the resources it has available and whatit is doing to maintain the ‘quality of life’ in regard to such matters as pollution control,recycling and replacement of resources.

Problems

1. Ch 02 Question 1 – Jane Parker

Note:

No entries will be made for the 20X0/X1 local taxes that are paid in Feb 20X2 – this situation arose because Jane Parker had assumed that the business would only pay the taxes from the start of the tax year, e.g. 1.4.20X1.

However, there will be an entry in the profit and loss account and the statement of financial position.

(iii) Possible action to deal with exceeding agreed overdraft limit

  • Approach the bank to re-negotiate the overdraft or arrange a loan facility for an agreed term.
  • The amount and the period for which additional facilities are required depend on preparing a projected cash flow statement for a longer period taking into account future plans, e.g. owner’s drawings requirement, any additional capital expenditure etc.
  • In particular, consider alternatives such as the following:
  • leasing vehicles and/or machinery;
  • mortgaging the property;
  • getting debts in quicker manner;
  • introducing more capital;
  • obtaining or providing loan capital.

2. Ch 02 Question 2 – Mr Norman

(iv) Investment of surplus funds

• Acid test ratio

  • At the end of the first 6 months trading, Norman’s statement of financial position shows that the acid test ratio is 1.28:1 (266.22/208.55) – this is higher than the basic 1:1 ratio but it should be compared with the ratio of similar businesses in the same industry in order to establish a norm. It would appear, however, that the business has surplus funds to invest.

• Amount to invest

  • A projected cash flow statement is required, taking into account future plans regarding the owner’s drawing requirements, future capital commitments and working capital criteria, e.g. debtor collection and creditor payment terms.

• Period to invest

  • The projected cash flow will give an indication of the period of the investment, e.g. it could range from overnight on the money market to term investments.

The important aspect is that the owner should be aware of the projected cash flows, so that return on surplus funds can be maximised.