FRS 102: The cash flow statement
FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with the cash flow statement (or ‘statement of cash flows’ as it is referred to in FRS 102) in Section 7 Statement of Cash Flows.
The cash flow statement has been the subject of a thematic review by the Financial Reporting Council (FRC) in 2020 which noted some basic errors creeping into the statement. Conversely, the review also noted some areas of good practice and made suggestion on how companies can improve the cash flow statement. While the thematic review focussed on entities preparing their financial statements under IFRS, the feedback can be taken on board by UK GAAP preparers as the requirements of IAS 7 Statement of Cash Flows is broadly consistent with the requirements of FRS 102.
Discussions with file reviewers have also revealed a common stream of problems where the cash flow statement is concerned and so this article will recap on some of the main issues that preparers may face when it comes to preparing a cash flow statement under the principles of FRS 102.
Small entities are not required to prepare a cash flow statement. Non-small entities will be required to prepare a cash flow statement, unless they can claim exemption through the reduced disclosure framework (FRS 102, paras 1.8 to 1.13) if the entity is a ‘qualifying entity’. The term ‘qualifying entity (for the purposes of this FRS)’ is defined as:
| A member of a group where the parent of that group prepares publicly available consolidated financial statements which are intended to give a true and fair view (of the assets, liabilities, financial position and profit or loss) and that member is included in the consolidation. |
If the subsidiary (or ultimate parent) meets the definition of a qualifying entity, it can claim the exemption from preparing a cash flow statement in FRS 102, para 1.12(b) and para 3.17(d).
Structure of the cash flow statement
FRS 102, Section 7 presents the cash flow statement using three cash flow classifications:
- Operating activities
- Investing activities
- Financing activities
The cash flow statement refers to ‘cash’ and ‘cash equivalents’. ‘Cash’ is defined as:
| Cash on hand and demand deposits. |
‘Cash equivalents’ are defined as:
| Short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of changes in value. |
Operating activities
Operating activities are the day-to-day revenue-producing activities of the business. Effectively, the operating activities classification is the ‘default’ classification. Examples of cash flows from operating activities include receipts from customers and payments to suppliers for goods and services; and payments to employees.
Payments or refunds of tax are also classed as operating activities unless they can be specifically identified with investing or financing cash flows.
Investing activities
Investing cash flows arise from the acquisition and disposal of long-term assets and other investments which are not cash equivalents.
Examples include cash payments to acquire fixed assets and the disposal proceeds from selling fixed assets. Investing activities can also include advances and loans made to third parties as well as the associated receipts from repayment of those advances and loans.
Where the entity acquires equity or debt in another entity, this will also be treated as an investing cash flow (as will the associated proceeds from disposal of equity or debt).
Financing activities
Financing activities are those activities which result in a change in the size and composition of the borrowing and equity structure of the entity. Examples include proceeds from a share issue, payments to owners to acquire or redeem the entity’s shares or cash payments of amounts borrowed.
Pitfalls to avoid
Incorrectly classifying cash flows in the cash flow statement. For example, in one case, the settlement of conditional provisions related to a sale of a business were incorrectly treated as investing cash flows as opposed to operating cash flows. Similarly, acquisition costs were treated as investing rather than operating cash flows.
It is worth noting that an entity cannot treat a transaction as one thing in the profit and loss account/income statement and another in the cash flow statement and this is where a deficiency may be noted during any review of the financial statements.
Reporting cash flows from operating activities
FRS 102, para 7.7 allows two methods to report cash flows from operating activities, being the ‘indirect’ or ‘direct’ method. The indirect method is more common and starts with a measure of profit or loss which is then adjusted for the non-cash effects of transactions reported in profit or loss and increases and decreases in working capital. This reconciliation arrives at net cash flow from operating activities and can either be shown on the face of the cash flow statement or within the notes.
It should be noted that as FRS 102, para 7.7(a) refers to a ‘measure’ of profit or loss disclosed in the statement of comprehensive income (or separate income statement, if presented), any profit figure (including operating profit) can be used as a starting point for this reconciliation provided that profit figure appears as a sub-total in the statement of comprehensive income/income statement. The reconciling items will vary depending on the measure of profit used.
Errors identified by the FRC during the thematic review
The table below shows the errors noted by the FRC in their sample of companies’ cash flow statements that were reviewed during the thematic review in November 2020, together with the impact that the correction would have on the relevant cash flow classification.
| Error |
Correction would impact: |
||
| Operating | Investing | Financing | |
| Deferred purchase consideration for subsidiary undertakings incorrectly classified as an investing rather than operating cash flow |
Decrease |
Increase |
|
| Payment for the acquisition of a business incorrectly classified as an operating cash flow rather than an investing cash flow |
Increase |
Decrease |
|
| Cash outflows on an investment in legal cases and the purchase of a property for resale relating to the cash were presented within investing activities. The cash inflow upon settlement of the cases was presented in operating activities. Both types of cash outflow should have been presented in operating activities on the grounds they arose in the normal activities of the entity |
Decrease |
Increase |
|
| Post-acquisition restructuring costs treated as investing activities rather than operating activities |
Decrease |
Increase |
|
| Cash flows in respect of a joint venture funding treated as financing activities rather than investing activities |
Decrease |
Increase |
|
| Advances to joint ventures treated as operating activities rather than investing activities |
Increase |
Decrease |
|
| Expenses in respect of an acquisition recognised in profit or loss treated as investing activities rather than operating activities |
Decrease |
Increase |
|
| Promissory notes treated as debt, but movements in the balance sheet were treated as operating cash flows rather than financing cash flows |
Increase |
Decrease |
|
| Cash outflow for restructuring treated as investing activities rather than operating activities |
Decrease |
Increase |
|
| Incorrect classification of certain restricted cash balances which were included in financing activities rather than in investing activities |
Decrease |
Increase |
|
Disclosures
FRS 102, para 7.20 requires an entity to present the components of cash and cash equivalents. A reconciliation must be presented if they are different to the cash and cash equivalents per the balance sheet. In some cases this reconciliation has been missed and generally happens when one, or more, bank accounts are overdrawn, and other bank accounts are in hand.
| Illustration
The amounts disclosed on the cash flow statement in respect of cash and cash equivalents are in respect of these balance sheet amounts:
|
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FRS 102, para 7.22 also requires the entity to disclose an analysis of changes in net debt from the beginning to the end of the reporting period. The term ‘net debt’ is defined as follows:
| Net debt consists of the borrowings of an entity, together with any related derivatives and obligations under finance leases, less any cash and cash equivalents. |
| Illustration
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Conclusion
Most automated accounts production software systems can produce the cash flow statement up to a certain point before user input is needed. It is important that preparers have a sound understanding of the definitions of ‘operating activities’, ‘investing activities’ and ‘financing activities’ to ensure that cash flows are correctly classified in the statement. Auditors should also devise audit procedures to ensure that the cash flow statement is accurately presented and that the disclosures presented follow the requirements of FRS 102, Section 7.
Category: Accounting and standards, Audit
