accrual and cash basis

The requirement to prepare a statement of cash flows is a (relatively) recent requirement – within the last 50 years – and it’s an acknowledgement that accruals based financial statements are fine and serve their purpose but a statement of cash flows can tell a different story than those traditional financial statements

Rolls Royce in 1971 published financial statements that showed wonderful profits and a strong statement of financial position.

They were in liquidation 6 months later.

They had capitalised millions of pounds of development expenditure that they had incurred on the development of the RB-211 engine which was close to final launch so it was an asset on the statement of financial position

But in their final testing, when firing frozen chickens at the engines as they were being tested, it was discovered that the material used in those engines could not withstand the force of a frozen chicken and the project was abandoned

In one fell swoop, the asset of development expenditure became an expense of huge proportions and RR went into liquidation

A statement of cash flows would have shown the ways and places where cash had been spent and could have raised concern in the minds of the readers of those financial statements but in 1971 no such statement was required

You can’t pay wages and salaries by saying to your work-force “We have no cash left but you can take some of our capitalised development expenditure home with you this week”

The statement of cash flows starts with profit before interest and tax and then step by step provides us with an explanation of how that profit before interest and tax results, through receipts and payments of cash, in an increase or decrease in cash and cash equivalents

It in effect reconciles accruals based results with the movement in cash since the beginning of the accounting period

Better?