Identify the Differences Between a Cash Flow Statement and a Profit and Loss Account Essay Example for Free

Identify the Differences Between a Cash Flow Statement and a salary and Loss Account EssayThere is undoubtedly, a clear dissentence between what is termed hard currency and what avail is and by extension a bills run away statement and a scratch and departure statements. Notwithstanding these differences, each statement saltations a different yet important view of disposalal performance.Cash check to Holmes et al 2005166 is cash in hand and deposits repayable on demand less(prenominal) oerdrafts repayable on demand i.e. they can be withdrawn at all time with verboten penalty. Cash takes cash and deposits denominated in foreign currency. Once, posters were comprised of just the balance sheet and the make headway and bolshie statements. However in the late 1960s, a design characterised as a high inflationary period, it was felt that historical belling convention which is indicative of the profit and damage account, provided information that was outdated and as such (prenominal) provided little insight on the menstruation market note value of companies and by extensions their profits. Therefore, on that point became a need for an additional statement- the cash precipitate statement.A cash hang up statement is a statement produced either for management or external report purposes showing, by broad categories cash receipts and payments in a period (Leicester, 2001. 10.3), and is intended to supplement the profit and red ink account and the balance sheet. The cash shine statement therefore, assists creditors, investors and generally all stakeholders in evaluating the silver-tonguedity and solvency of a craft or rather, shows changes in cash be it negative or positive i.e. cash out fertilises and cash in decreases.The Cash flow statement is divided into triad main sections1.Core operations (operating activities) 2.Investing 3.FinancingA typical cash flow statement can be seen in Appendix B.Cash flows from operating activities generally i nclude transactions that be associated with the calculation of income. It excessively includes items which are involved in the production or purchase of merchandise, the sale of good and/or services to the organisations customers and expenditure relating to the general administration of a championship.Under the broad heading of investing activities, are found important element relating to cash flow in an organisation. These transactions involve making and collecting repayments on loans, purchasing and snitching of plant assets and other productive assets. All other investment activities are generally classified on a lower floor this heading.Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are cash in when chief city is raised theyre cash out when dividends are paid. Thus if a ships company issues a bond to the public, the company receives cash financing. However, when interest is paid to bondholders, the company is reducing its cash. (Heakal, 2004)It is straight important that the issue of profit and the profit and release account be examined. Profit by definition is the excess of revenue everywhere expenditure. Revenues are increases in the companys assets from its profit-driven activities, resulting in positive cash flows (inflows). Conversely, expenses are decreases in the companys assets from its profit-driven activities, which results in negative cash flows (outflows). brighten income/profit is therefore, the difference between the two. According to Williams et al 200254 if a companys expenditure exceeds income then the difference is a lettuce loss, suggesting that the enterprisingness has suffered a loss. Alternatively if the companys income exceeds its expenditure the difference is a net profit.The profit and loss account is a financial statement which shows the profit (loss) made by a business during a defined period of time (normally one year). The account also shows the uses to which the profit has been put (or how losses were financed). (Jewel 1998327) sometimes referred to as the revenue account, the profit and loss statement is divided into four parts1.How the profit (loss) was take in 2.The expenditure for the period under review 3.How a good deal was taken by taxation 4.What happened to the profit (or loss) that was left after taxationAppendix A shows a typical profit and loss account.It is a adage that a business must make a profit in order to be successful. This is imperative since profits are needed to pay out dividends to shareholders in the case of a company and to reward partners of proprietors in the case of a sole trader or a partnership. Irrespective of the form of business organisation, some profits are retained within the business as reserves or as proprietors funds, to finance the development and process of the business (Leicester 2001, 3.45). Consequently, although a business can experience occasional losses, it is imperative that it be profitable in the long run.A loss signifies that the value of resources use up in a period to generate sales/revenue is more than the sales/revenue generated in that period. These lose as a result, origin a reduction in the overall value of a business and can eventually lead to the collapse/liquidation of the organisation. When an organisation publishes its profit and loss accounts and a profit is shown, users of the statements whitethorn think that the business has cash and in turn expect different benefits. The Shareholders for example, might believe that if the company makes a profit after tax of say $200,000 then the company is in a position to pay out dividends. Similarly, employees might believe that the company can turn over an increase in wages in the subsequent year. The fact is profit does not always give a useful or meaningful go out of a companys operations. Readers of a companys financial statements might even be misled by a report profit bet (ACCA, paper 1.1 St udy school text June 2003, 360).The fact is that profit does not necessarily mean an increase in cash. For example, an oil company on presenting its final accounts may show a large profit figure primarily because of large summations of stock which it holds. Although the company may be profitable, it may be experiencing serious cash flow problems. Too much stock therefore according to many another(prenominal) writers is tied-up cash and should be avoided as much as possible.Cash therefore according to Larson and Miller 1992726 is the lifeblood of a business enterprise. In a sense, cash is the fuel that keeps a business alive. With cash, employees and suppliers can be paid, loans can be repaid and owners receive dividends. Without cash, none of these things can happen. In simple terms, a business must have adequate amounts of cash to operate. Hence, profits/losses shown by the profit and loss account and net cash inflow/outflow shown by the cash flow statement do not represent the same thing.Therefore, when businesses are profitable, which is a long expectment it must pay in cash, its goods and services, capital equipment, the workforce and for that matter, all expenses incurred in the line of the business operation. If cash is not available to pay these expenses when the conciliate due, the business go out slowly lose its goodwill, employees, suppliers and it will be forced into liquidation as was previously suggested.1.If a non-current asset is purchased an outflow of the full amount is shown under Investing Activities in the cash flow statement for that period moreover only disparagement, which is part of the live of that asset, is shown in the profit and loss account. This depreciation amount is not shown in the cash flow statement since it is not an actual movement of cash. The profit and loss statement therefore, attempts to spread the cost of the assets over its estimated useful life by a depreciation charge every year until it is expensed. By so doing the cost of the asset is not absorbed in the accounts in one year as is done by the cash flow statement, but over a period of time.2.When shares are issued and cash is genuine from the sale, the cash flow statement will show this as a source of cash i.e. a cash flow under Financing Activities but this transaction does not have any effect on the profit and loss account. Similarly, if a loan is obtained, this is reflected as a cash inflow under financing activities but has no effect on the profit and loss account until subsequent interest charges have been made then it is shown. The same is also applicable for businesses which enjoy the overdraft facilities accorded to them by commercial banks.3.After the sale of a non-current asset the profit or loss which is the difference between the sale price and the net book value of the asset is recorded in the profit and loss account while the entire proceeds is recorded in the cash flow statement as an increase in cash inflow under in vesting activities. Thus, while the cash flow statement shows inflow of cash, the profit and loss account may show a loss on disposal of the non-current asset merely because the asset was sold less than the net book value consequently representing a loss which the company has made.4.The profit and loss account reports the total value of sale in a year less the cost of sales (the costs directly associated with making or acquiring your products. Costs include material purchased from outside suppliers used in the manufacture of your product, as good as any internal expenses directly expended in the manufacturing process.BusinessTown.com 2003) which is profit. Operational cash flow is the difference between cash received and cash paid from trading.If there are credit sales (receivables), cash received will differ form the value of the sales and conversely cash paid will differ from the cost of sales if there are credit purchases (payables). The difference therefore, between sales and cash received is because of changes in the amount of debtors and the difference in cost of sales and cash is because of changes in the amount of creditors.It is worthy to note that operational cash flow in the cash flow statement differs from profit in the profit and loss account. Because business accounts are put upd on an accruals basis and not on a cash basis, a sale or purchase is accounted for in the year in which it was made even if cash is exchanged in subsequent years. This practice is exercised in most businesses who, if they do not sell on credit may purchase on credit and if cash business descent is used, the accounts would not represent a trustworthy and fair picture of the business activity in a given period. The accounting convention when used is an application of the accrual concept. Therefore there is recognition that while the profit and loss account is affected by the accrual concept, the cash flow statement is not as was previously stated.It should be noted al so, that profit, which is shown in the profit and loss account (Net profit before taxesAppendix A) is really a reflection of future cash for the company because the entries recorded are from transactions done ground on the accruals concept. This can be illustrated by means of a cash flow statement done using the indirect manner. Using the indirect method of preparing a cash flow statement, net profit or loss is adjusted for the effects of transactions of a non-cash nature e.g. depreciation, any deferrals or accruals of bypast or future operating cash receipts or payments and of income or expense associated with investing or financing cash flows (ACCA, paper 1.1 Study text June 2003, 365).Appendix A con fuddleds that the net profit of $ 3,390 million reported in the profit and loss account after adjustments became $ 410 million, the same cash amount reported in the balance sheet in Appendix C, extract under current assets. Users of the profit and loss account therefore as was esta blished precedent may be missed by the profit figure reported. However, cash reported in the cash flow statement is certain and represents the actual liquid position of a business organisation as at the balance sheet date.There have been frequent arguments that profit does not give an authentic view of the organisations performance as has been established thus far. Since the making of a profit will not necessarily result in an increased cash balance, one can conclude that a companys performance and prospects depends not so much on profits earned in the period but more realistically on cash flow or rather the companys liquidity. Bearing this in mind, many investors now find the profit figure reported in the profit/loss account less reliable than the cash balance reported in the cash flow statement because it is felt that the profit figure can be manipulated to reflect the producers bias.This notion is supported by Joseph Bernardino origin chief executive of Anderson quoted in The Economist. Bernardino argued that our financial reporting system is broken with many investors now believing that companies can manipulate their accounts more or less at will, with the aim of producing profits that increase steadily over time. Provisions are bumped up in goods years and later released or the value of an attainment is slashed there are plenty tricks. The solution in the meantime may be to hear at the cash, which is harder to disguise or invent.The cash flow statement is therefore, unambiguous and provides information which is additional to that already provided in the other final accounts. Additionally the cash flow statement provides information based on activity instead of by balance sheet classifications and shows changes in actual cash, thus, providing additional information over the balance sheet and profit and loss accounts. The predicament as a result becomes fairly simple there is cash or there is no cash. For this reason, the cash flow statement has sever al advantages which give shareholders and investors an idea as to how the funds of a company are being managed. These advantages include1.Cash flows allow for intermit comparisons and an understanding of various companies financial performance as it reports on how the cash was earned and spent as well as the reason for the difference between reported profit and related cash flows.2.It allows for easier formulation of cash flow forecasts which is more useful than profit forecasts.3.Cash flow reporting satisfies the needs of its users. It provides the information that enables management to make well informed decisions. It also assists shareholders with stewardship accounting while better serving the information needs of employees and creditors on the companys liquidity status.4.Cash flow is easily understood than profit which is based on accounting conventions and concepts such as accruals convention or the matching concept and therefore, is easier for the layman to understand.5.Cre ditors are more interested in a businesss ability to repay their debts than its profitability. Profits may indicate that cash may be available at later date, while cash flow suggests a direct view of the businesss cash situation i.e. how much money is readily available.6.Cash flow accounting directs managements focus on the optimum use of company assets in order to generate positive cash flows bearing in mind that cash is essential for the survival of an enterprise.In any organisation, a strong financial position is one which shows that a business has relatively little debt and large amounts of liquid assets in comparison to its current liabilities. Additionally, a strong cash balance generating with ease and efficiency from its operating activities further indicate financial strength. Large companies are therefore, mandated by law to prepare financial statements and it is in these that their performance is assessed.The users of financial statements are interested in solvency, the a bility to pay debts and profitability, which creates equity. Management is also interested in these statements as it will assist them in improving the areas where performance is weak.Despite the argument presented thus far, it must be noted that no man is an island. This suggests that in isolation, a true understanding of a business performance cannot be attained by an examination of only the cash flow statement. When used in conjunction with the profit and loss account and the balance sheet, the cash flow statement gives shareholders and the other users of the financial statements the required information on viability, solvency, liquidity and the financial flexibility of a company at a specific time, essentially at the balance sheet date. Furthermore, the conjunctive use of the cash flow statements give an indication of the relationship between profitability and a companys ability to generate cash, consequently, defining the quality of the profits reflected in the profit and loss a ccount.Should one therefore, require an overall well calculated view of an organisation, no statement, be it profit and loss account, balance sheet or cash flow statement should be looked at in isolation. For example, in St.Lucia a new shopping plaza is on the verge of opening. Needless to say that Blue Sky Limited is now investing heavily in the refurbishment of the building in which it is to be housed. A close examination of Blue Sky Limiteds accounts would break up large outflows with little inflows. It therefore becomes necessary to examine Blue Sky Limiteds cash flow accounts in conjunction with the profit and loss account and the balance sheet so that a more wholesome picture can be obtained. Simply put, the cash flow statement is simply a part of the puzzle. Analysing it with the other statements can give you a more overall look at a companys financial wellness (Investopedia.com 2005).This notion is supported by Aharony et al 2003 in their study who posits that in order to u nderstand which statement gives a better view of organisational performance, it becomes imperative to look at the life cycle status (LCS) of the of the business in question. Aharony et al therefore arguePrevious researchers identify four LCSs Start-up, maturity and surrender or stagnation. At the start-up stage there are normally only a few assets in place. Growth opportunities constitute the major asset of the firm at that stage. Cash flow operation and the earnings are low, and there is a relatively great need for cash to finance the realization of these increment opportunities. At the growth stage there are more assets in place and some income is generated (Black, 1998). Sales and revenue growth rates are high than average in the growth stage and so are investments in production facilities (Anthony and Ramesh, 1992). At the maturity stage firms experience low or no cash and needs are mostly satisfied by internal sources and at the decline or stagnant stage growth opportunities , if any, are likely to be limited, competition intensifies, and the firms financing costs are more expensive.(Aharony et al 2003)The implication of Aharony et als argument is that the cash flow statements may not necessarily be the best statement to look at a particular point in a business LSC because at certain points, liquidity and solvency may be low. At such points, therefore a business performance can be better understood by introspection of the profit and loss statement which relies heavily on accrual accounting or a combination with the balance sheet and cash flow statement. Consequently the stage of a business life cycle plays an important role in the understanding of a business performance.Despite its limitations e.g. its inability to extract opinions whether or not expenditure was necessary of will be profitable, or fail to report on the cause of an increase in the firms receivables due to poor stock control or changes in policy, the cash flow statement remains the most detailed and accurate statement when reporting on a companys liquidity/solvency. Therefore, in comparison to the profit and loss account, the cash flow statement definitely gives a better view of organisational performance, if for example, each statement the cash flow statement and the profit and loss statement, is to be examined in isolation.