When taking over a forensic accounting engagement, the accountant must be certain he or she knows how to provide information about cash receipts and cash disbursements of an entity during a period. The statement of cash flows is one of the main financial statements. Its link to the other financial statements sheds light to investors, creditors, employees, governmental agencies about the ability of an organization to generate positive future cash flows, to meet its obligations when they become due, to pay dividends, and its need for external financing.
In preparing a statement of cash flows the forensic accountant must identify the major classifications of cash flows, know the difference between net cash flows from operating activities and net income, and be able to identify the contrast between the direct and indirect method of calculating net cash flow from operating activities.
Cash Out Flow (Expense/Spending)
Generally, we pay out money because we want to buy an asset or incur some expense. Regardless of whether you pay for an expense or an asset, it is still a cash out flow.
This is how to differentiate an expense from an asset.
Any payment in exchange for a benefit that you can enjoy now is an expense. Example: Buying a DVD, food, clothes.
Any payment in exchange for a benefit that you can enjoy in the future is an asset. Example: Education fund, retirement fund.
Any payment in exchange for a benefit that you can enjoy now and the future plus you can reasonably sell it in a secondary market is an asset. Example: House, stocks, car, painting.
An exception is your mortgage payment. Mortgage payments are made up of 2 parts. The first part is the interest and the second part is your loan. Paying the interest portion is an expense while the paying the loan portion is building up your asset base
Tax: Remember to include periodic expenses such as property taxes, auto insurance, membership fee and so on. Do not let these expenses catch you off guard. You should examine credit card slips, check butts and bank statements for the past 1 to flag out these expenses.
Energy and Utilities: Look at your bills for the past 1 year and average out the monthly expense. This is because utilities expense is affected by seasonal factors. When the weather is cold, you will turn up your thermostat and rack up your utility bill. The monthly average will provide a more reliable estimate of your expense. Do pay attention to other types of expenses which are seasonal.
This is how to differentiate an expense from an asset.
Any payment in exchange for a benefit that you can enjoy now is an expense. Example: Buying a DVD, food, clothes.
Any payment in exchange for a benefit that you can enjoy in the future is an asset. Example: Education fund, retirement fund.
Any payment in exchange for a benefit that you can enjoy now and the future plus you can reasonably sell it in a secondary market is an asset. Example: House, stocks, car, painting.
An exception is your mortgage payment. Mortgage payments are made up of 2 parts. The first part is the interest and the second part is your loan. Paying the interest portion is an expense while the paying the loan portion is building up your asset base
Tax: Remember to include periodic expenses such as property taxes, auto insurance, membership fee and so on. Do not let these expenses catch you off guard. You should examine credit card slips, check butts and bank statements for the past 1 to flag out these expenses.
Energy and Utilities: Look at your bills for the past 1 year and average out the monthly expense. This is because utilities expense is affected by seasonal factors. When the weather is cold, you will turn up your thermostat and rack up your utility bill. The monthly average will provide a more reliable estimate of your expense. Do pay attention to other types of expenses which are seasonal.
Cash In Flow (Income)
Income is money that comes into your possession and you can rely on this income to continue producing money for you in the future. Examples include weekly or monthly paycheck, rental income and fixed deposit interest.
The following notes are to be read in conjunction with the Cash Flow Example.
Salaries and wages: Use your take-home-pay figure because this is what you actually have at your disposal to plan your budget.
Contract: If you have a contract that expires in 5 months, then you multiply your month contract earnings with 5 months and not 12 months. This applies to all your other income streams if you know they will not last.
Bonus: If you have a contractual bonus stipulated in your contract, then you may add in this amount. If your bonus is based on your performance, or the company’s performance then you should leave this empty.
Rental Income: Even if your tenant is contracted to rent from you for the whole year, it is good practice to assume rental income for less than 12 months. Your tenant might move out early and you might spend 1 or 2 months looking for a new tenant.
In this example, I use 10 months factor. You should use a suitable factor based on your own previous experience in renting out the property.
Dividend: If the dividend has been declared, then fill this field, else leave blank.
The following notes are to be read in conjunction with the Cash Flow Example.
Salaries and wages: Use your take-home-pay figure because this is what you actually have at your disposal to plan your budget.
Contract: If you have a contract that expires in 5 months, then you multiply your month contract earnings with 5 months and not 12 months. This applies to all your other income streams if you know they will not last.
Bonus: If you have a contractual bonus stipulated in your contract, then you may add in this amount. If your bonus is based on your performance, or the company’s performance then you should leave this empty.
Rental Income: Even if your tenant is contracted to rent from you for the whole year, it is good practice to assume rental income for less than 12 months. Your tenant might move out early and you might spend 1 or 2 months looking for a new tenant.
In this example, I use 10 months factor. You should use a suitable factor based on your own previous experience in renting out the property.
Dividend: If the dividend has been declared, then fill this field, else leave blank.
Creative Cash Flow #1: Investments Classified as Trading Securities
Investments in debt and equity securities may be classified as held for trading purposes or as available for sale. In addition, because they have fixed maturity dates, a third classification, held to maturity, can also apply to debt securities. As the title suggests, trading securities are held to take advantage of very short-term price swings. Holding periods are very short, at times possibly even less than a day. Debt securities that are classified as held to maturity are investments for which a firm has the intent and ability to hold until maturity. The plan is to collect the debt instrument’s principal amount at maturity. All other investments are classified as available for sale, a default classification that can include both short-term and long-term investment positions.
The classification of investments as trading, held to maturity, or available for sale directly affects the classification of cash flows associated with their purchase or sale. When investments are classified as held to maturity or available for sale, the use of cash in their purchase or the proceeds generated by their sale are classified as cash flow from investing activities. In contrast, cash used to purchase or cash provided by the sale of investments classified as trading securities is reported as operating cash flow.
Rules for classifying investments as trading, held to maturity, or available for sale are malleable. This flexibility provides an opportunity for companies to alter reported operating cash flow. For example, cash flows associated with investments in short-term debt instruments classified as held to maturity would be reported as investing cash flow.
However, changing their classification to trading would result in the same cash flows being classified as operating cash flow.
Financial institutions—companies such as banks, insurance companies, and brokerage firms—routinely trade financial instruments. It is part of what they do. Cash flows associated with this activity are properly included with operating cash flow. However, when nonfinancial companies classify investments as trading securities, cash used to purchase the investments or cash provided by their sale does not fit the operating designation. At a minimum, such cash flows are not sustainable and will stop when an investment portfolio has been liquidated.
The classification of investments as trading, held to maturity, or available for sale directly affects the classification of cash flows associated with their purchase or sale. When investments are classified as held to maturity or available for sale, the use of cash in their purchase or the proceeds generated by their sale are classified as cash flow from investing activities. In contrast, cash used to purchase or cash provided by the sale of investments classified as trading securities is reported as operating cash flow.
Rules for classifying investments as trading, held to maturity, or available for sale are malleable. This flexibility provides an opportunity for companies to alter reported operating cash flow. For example, cash flows associated with investments in short-term debt instruments classified as held to maturity would be reported as investing cash flow.
However, changing their classification to trading would result in the same cash flows being classified as operating cash flow.
Financial institutions—companies such as banks, insurance companies, and brokerage firms—routinely trade financial instruments. It is part of what they do. Cash flows associated with this activity are properly included with operating cash flow. However, when nonfinancial companies classify investments as trading securities, cash used to purchase the investments or cash provided by their sale does not fit the operating designation. At a minimum, such cash flows are not sustainable and will stop when an investment portfolio has been liquidated.
GAAP Flexibility [Is It Operating or Investing Cash Flow?]
Generally accepted accounting principles are reasonably clear in their definition of operating cash flow. There is, however, considerable flexibility permitted in its calculation. Some firms have demonstrated a willingness to ply this flexibility in an effort to boost amounts reported as operating cash flow. Although such steps raise operating cash flow, they do not increase sustainable cash flow.
Examples of cash flow classified as investing activities include both capital expenditures made to boost future operating cash flows and cash parked in debt and equity securities awaiting future needs. Except for capital expenditures that are included in the calculation of free cash flow, cash provided or used in investing activities is not considered to have the same recurring quality as operating cash flow.
Accordingly, to the extent that creative steps can be taken to boost operating cash inflows by increasing investing cash outflows, an appearance can be communicated of a strengthened cash-generating capability. Two areas for such a cash flow misclassification that are representative of the opportunities afforded by the flexibility found in GAAP are investments classified as trading securities and capitalized operating costs. A third area, acquisitions, can also use investing activities to creatively boost operating cash flow.
Examples of cash flow classified as investing activities include both capital expenditures made to boost future operating cash flows and cash parked in debt and equity securities awaiting future needs. Except for capital expenditures that are included in the calculation of free cash flow, cash provided or used in investing activities is not considered to have the same recurring quality as operating cash flow.
Accordingly, to the extent that creative steps can be taken to boost operating cash inflows by increasing investing cash outflows, an appearance can be communicated of a strengthened cash-generating capability. Two areas for such a cash flow misclassification that are representative of the opportunities afforded by the flexibility found in GAAP are investments classified as trading securities and capitalized operating costs. A third area, acquisitions, can also use investing activities to creatively boost operating cash flow.
Adjustments for Sustainable Cash Flow
All of the factors highlighted in this section can and do lead to misleading operating cash flow amounts. These factors consist of:
Using GAAP flexibility in cash flow classification
Taking actions that extend beyond the boundaries of GAAP
Benefiting from nonrecurring sources of operating cash flow
Reporting taxes related to non-operating items as operating cash flow
Using GAAP flexibility in cash flow classification
Taking actions that extend beyond the boundaries of GAAP
Benefiting from nonrecurring sources of operating cash flow
Reporting taxes related to non-operating items as operating cash flow
Creative Cash Flow Reporting
Creative cash flow reporting refers to any and all steps used to create an altered impression of operating cash flow and, in the process, provide a misleading signal of a firm’s sustainable cash-generating ability. Steps employed to misrepresent a firm’s sustainable cash-generating ability may employ reporting flexibility within the boundaries of GAAP. Alternatively, steps may be taken that extend beyond the boundaries of GAAP. Finally, amounts may be reported properly as operating cash flow but do not have the sustainable qualities normally expected of operating cash flow. Clearly the adjective “creative” is used here in a pejorative sense. This post provides some overview [with examples] of how cash flow reported in a creative manner misrepresents sustainable cash flow.
The Motivation Behind Creative Cash Flow Reporting
Managers are well aware of the importance placed by analysts, investors, and creditors on operating cash flow. Cash flow is the life-blood of any organization. A boost in operating cash flow, even as total cash flow remains unchanged, communicates enhanced financial performance. Consider, for example, the hypothetical cash flow statements presented in below figure:
Statement 1 Statement 2
Cash provided (used) by operating activities = $(14,000) $44,000
Cash (used) by investing activities = (36,000) (66,000)
Cash provided by financing activities = 60,000 32,000
Increase in cash = $ 10,000 $10,000
As reported in both statements, cash on hand increased $10 million.
However:
in Statement 1, the company consumed $14 million in cash from operations. Those operating cash needs together with cash needs for investing activities of $36 million were covered with new financing cash flow in the amount of $60 million.
In Statement 2, the company generated positive operating cash flow of $44 million.
The company invested $66 million in the business and obtained $32 million in new financing to help meet its cash flow needs.
The company represented by Statement 2 is doing a better job of generating what would appear to be sustainable cash flow. That company is apparently investing more heavily and relying less on new financing to support its operating and investing activities.
What we now know, however, is that the company represented by Statement 2 may be no different from the company represented by Statement 1. For example: proceeds from the sale of investments may have been used to boost operating cash flow. Similarly, proceeds from new borrowings may also have been reported as operating cash flow. The net result is the appearance of improved financial performance.
In the absence of careful scrutiny, this apparent improvement in financial performance might have a positive impact on a firm’s share price, its borrowing costs, and the incentive compensation paid its executives:
Share Price Effects - As expectations for sustainable cash flow are increased, so is the present value of that cash flow stream, boosting share-price prospects. Share prices can be influenced to the extent that managers can increase the perception, and not the reality, that their firm is generating more sustainable cash flow. This point was not lost on the executives at companies such as Dynegy, Inc., and Enron Corp. Their managers went to extraordinary lengths to boost operating cash flow in an effort to increase or maintain their share prices. Executives may also have an incentive to report less volatile cash flows, imparting an impression of lower firm risk. The perception of lower risk could move investors to lower their risk-adjusted discount rates. Lower discount rates would boost the present value of future cash flows and potentially raise share prices.
Borrowing Cost Effects - Interest and principal on loans are repaid with cash flow. Increases in operating cash flow may translate into perceived improvements in debt-service capacity. The net effect may translate into higher borrowing capacity, lower interest costs, less onerous loan covenants, fewer guarantees, or, possibly, less loan collateral.
Incentive Compensation Effects - To the extent that steps taken to boost operating cash flow translate into higher share prices, managers compensated with stock options will enjoy increased compensation. Beyond such equity-based arrangements, however, some managers may be paid cash bonuses linked directly to improvements in earnings or in operating cash flow. Consider Tyco International, Ltd., a company that has been accused of artificially boosting operating cash flow. As described below, the company’s bonus plan was based, at least in part, on improvements made in operating cash flow: The cash bonus for the Chief Executive Officer and the Chief Financial Officer has two performance based criteria: (i) increase in earnings before non-recurring items and taxes and (ii) improvement in operating cash flow.
The Motivation Behind Creative Cash Flow Reporting
Managers are well aware of the importance placed by analysts, investors, and creditors on operating cash flow. Cash flow is the life-blood of any organization. A boost in operating cash flow, even as total cash flow remains unchanged, communicates enhanced financial performance. Consider, for example, the hypothetical cash flow statements presented in below figure:
Statement 1 Statement 2
Cash provided (used) by operating activities = $(14,000) $44,000
Cash (used) by investing activities = (36,000) (66,000)
Cash provided by financing activities = 60,000 32,000
Increase in cash = $ 10,000 $10,000
As reported in both statements, cash on hand increased $10 million.
However:
in Statement 1, the company consumed $14 million in cash from operations. Those operating cash needs together with cash needs for investing activities of $36 million were covered with new financing cash flow in the amount of $60 million.
In Statement 2, the company generated positive operating cash flow of $44 million.
The company invested $66 million in the business and obtained $32 million in new financing to help meet its cash flow needs.
The company represented by Statement 2 is doing a better job of generating what would appear to be sustainable cash flow. That company is apparently investing more heavily and relying less on new financing to support its operating and investing activities.
What we now know, however, is that the company represented by Statement 2 may be no different from the company represented by Statement 1. For example: proceeds from the sale of investments may have been used to boost operating cash flow. Similarly, proceeds from new borrowings may also have been reported as operating cash flow. The net result is the appearance of improved financial performance.
In the absence of careful scrutiny, this apparent improvement in financial performance might have a positive impact on a firm’s share price, its borrowing costs, and the incentive compensation paid its executives:
Share Price Effects - As expectations for sustainable cash flow are increased, so is the present value of that cash flow stream, boosting share-price prospects. Share prices can be influenced to the extent that managers can increase the perception, and not the reality, that their firm is generating more sustainable cash flow. This point was not lost on the executives at companies such as Dynegy, Inc., and Enron Corp. Their managers went to extraordinary lengths to boost operating cash flow in an effort to increase or maintain their share prices. Executives may also have an incentive to report less volatile cash flows, imparting an impression of lower firm risk. The perception of lower risk could move investors to lower their risk-adjusted discount rates. Lower discount rates would boost the present value of future cash flows and potentially raise share prices.
Borrowing Cost Effects - Interest and principal on loans are repaid with cash flow. Increases in operating cash flow may translate into perceived improvements in debt-service capacity. The net effect may translate into higher borrowing capacity, lower interest costs, less onerous loan covenants, fewer guarantees, or, possibly, less loan collateral.
Incentive Compensation Effects - To the extent that steps taken to boost operating cash flow translate into higher share prices, managers compensated with stock options will enjoy increased compensation. Beyond such equity-based arrangements, however, some managers may be paid cash bonuses linked directly to improvements in earnings or in operating cash flow. Consider Tyco International, Ltd., a company that has been accused of artificially boosting operating cash flow. As described below, the company’s bonus plan was based, at least in part, on improvements made in operating cash flow: The cash bonus for the Chief Executive Officer and the Chief Financial Officer has two performance based criteria: (i) increase in earnings before non-recurring items and taxes and (ii) improvement in operating cash flow.
Accounting concept of Cash Flow
Profit is an attempt to measure the value added by the activity of the team of people who make up a business. Accountants attempt to measure this by following some established principles; for example, matching income and expenses in the relevant period, ensuring that the expenses incurred in getting the sale and delivering the product or service are recorded in the same period as the sale itself.
Accountants can obviously record all the transactions undertaken in the period; all the cash coming in and out. But in order to do that matching, some adjustments are required for bills or income which we know is coming, but isn't here yet. Or items which don't involve cash, like depreciation. Depreciation is the way in which accountants allocate the cost of a major asset over the period expected to benefit from that asset. For example, if a business buys a car, which is expected to last for three years, the cost of that car can be split in three and allocated in proportion across the three years. There are more complex ways of doing it, but the intention is the same.
So we can then produce a profit and loss account - the measurement of value added - and a balance sheet, which is intended to be a measure of the net worth of a business. But because we've done so many adjustments based on these principles, many people find it hard to understand. They do understand cash going out and coming in, so the cash flow statement is an attempt to reconcile profit with cash flow. You could say to get back to reality. It is an attempt to answer the question about why so many apparently profitable companies can still go bust because they run out of cash.
The cash flow starts with profits and tries to reverse all those clever adjustments to show something close to total cash flows. Many small businesses are of course run on cash flow only - most proprietors know what cash they have, or is coming in or going out, but many have no idea what profit they are making. That seems relevant only at tax time.
It is important to know both. Of course the business will die without positive cash flow, and that needs to be managed on a daily basis. You don't need an accountant for that - and in fact the "accounting concept" of cash flow is of little use here. Just check your statement or go to the ATM. But the profit is important too, because if you do not make profit you will eventually not have the resources to continue in business. If you are not making profit, you are not adding value, and need to either stop or change the method. If this is what's happening, the sooner you find out about it the better.
Advantages of Cash Flow Statement Helps You Run a Successful Business
In financial accounting, a cash flow statement or statement of cash flows is a financial statement that shows a company's incoming and outgoing cash during a time period. All three statements are arranged from the same accounting information, but each statement serves its individual function. The statement of cash flow reports the movement of cash into and out of your business in a given year. Cash is the lifeblood of your company. The cash flow statement reports your business' sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. It also includes the combined total change in cash and cash equivalents from all sources and uses of cash.
Cash flow statements format planning involves forecasting and tabulating all significant cash inflows and analyzing the timing of expected payments in detail. We have highly skilled cash flow financing professionals prepare comprehensive periodic cash flow projections that can assist you in tasks such as budgeting, business planning and fund raising.
Advantages of the cash flow statement
Helps the newly formed companies to know their inflow and outflow of cash and thus prevent cash shortage
Helps the investors judge whether the company is financially sound
Cash flow statement records the inflow and outflow of cash over a period of time
We provides Cash Flow statements on monthly, quarterly, six monthly or yearly bases
Helps the company to know whether it will be able to cover payroll and other immediate expenses
These statements will be highly helpful for planning and management of future financial commitments
This helps them have an accurate analysis of the firm's ability to meet its current liabilities. Our Accounting Firms possessing years of experience and expertise catering to the diverse requirements of global clients can help prepare periodic cash flow statements format - historical or projective. We deliver integrated Cash Flow financing management solutions that go beyond recommendations and reports.
These statements will be extremely helpful for planning and management of future financial commitments. Availing Cash Flow financing statements Format preparation support from us will act as a very useful money management tool that provides warnings in advance of periods of high expenditure and low sales. This is also a very important component in the application process for additional funding.
Cash Flow Accounting
A control technique (q.v.) that aims to keep the amount of cash immediately available to an organisation within desired limits.
Explanation:
If a company is unexpectedly short of cash the result can be anything from mildly annoying to disastrous. For example, the company may have to seek an immediate alteration in the overdraft limit, or it may unable to pay salaries. If it has an unexpected surplus, again money is likely to be lost since insufficient time is available to plan the most profitable way to dispose of it. Consequently it is important to be able to forecast the cashflows of the company reasonably accurately in the short, medium and long term.
The technique consists of two component parts.
there are the various methods of cash forecasting; this is of crucial importance (e.g. the Balance Sheet Projection Method);
there is the daily, weekly and monthly cycle of activity needed to invest surpluses, to borrow to meet shortages and to mobilise cash from investments.
Illustration:
A cash-only grocer has a much simpler problem than an international manufacturing company. It is not just a matter of scale but of complexity. The latter has to make dividend payments, allow for devaluations, finance debtors, have cash available for capital expenditure and so on. In a large company the cash sums handled may be so large that it becomes necessary to appoint full-time specialists to prepare forecasts and co-ordinate day to day and month to month action on investments and cash mobilisation.
Explanation:
If a company is unexpectedly short of cash the result can be anything from mildly annoying to disastrous. For example, the company may have to seek an immediate alteration in the overdraft limit, or it may unable to pay salaries. If it has an unexpected surplus, again money is likely to be lost since insufficient time is available to plan the most profitable way to dispose of it. Consequently it is important to be able to forecast the cashflows of the company reasonably accurately in the short, medium and long term.
The technique consists of two component parts.
there are the various methods of cash forecasting; this is of crucial importance (e.g. the Balance Sheet Projection Method);
there is the daily, weekly and monthly cycle of activity needed to invest surpluses, to borrow to meet shortages and to mobilise cash from investments.
Illustration:
A cash-only grocer has a much simpler problem than an international manufacturing company. It is not just a matter of scale but of complexity. The latter has to make dividend payments, allow for devaluations, finance debtors, have cash available for capital expenditure and so on. In a large company the cash sums handled may be so large that it becomes necessary to appoint full-time specialists to prepare forecasts and co-ordinate day to day and month to month action on investments and cash mobilisation.
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