The Issue of FRS 1 Cash Flow Statements

The lack of clear guidance provided by SSAP 10, coupled with the vague objectives and poor definition of “funds”, pressurised the ASC for further reforms, resulting in the issue of Exposure Draft (ED) 54: Cash Flow Statements in July 1990. After receiving the comments on ED 54, the newly formed Accounting Standards Board (ASB) issued

Financial Reporting Standard (FRS) 1 Cash Flow Statements fourteen months later. FRS 1 was clearly influenced by SFAS No. 95, issued in the U.S. around four years prior to its development. From the outset of FRS 1, the ASB made it clear that they had

considered the criticisms levelled against SSAP 10 and there was, accordingly, far less ambiguity regarding the objective of FRS 1, which clearly stated:

“The objective of the FRS is to require reporting entities…to report on a standard basis their cash generation and cash absorption for a period.”

(FRS 1, 1991, paragraph 1)

From this definition, it was apparent the ASB had addressed two notable caveats of SSAP 10. FRS 1 required reporting on a “standard basis”, thereby, eliminating alternative methods of disclosure, which had previously reduced comparability between firms. Moreover, the standard had moved away from reporting “funds” flow and focussed on disclosing the “cash” generated and absorbed during the period.

2.3.2.1 Improved Comparability and Change in Scope

The ASB achieved their objective by mandating a very rigid format for the cash flow statement under five major categories: “operating activities”, “returns on investments and servicing of finance”, “taxation”, “investing activities” and “financing”. Strictly categorising cash flows helped to increase the comparability between enterprises, thereby, resolving one of the major problems of SSAP 10. Further, the scope of the standard changed to exempt a far wider range of entities when compared to the simple £25,000 threshold used by SSAP 10. Changing the scope was largely driven by the argument that the cost of disclosing a cash flow statement would likely outweigh the benefits of reporting cash flow information for certain entities (FRS 1, 1991, paragraph 58).

A clear definition of “cash flow” provided by the ASB, further helped to increase the comparability of cash flow statements between companies. The standard defined “Cash flow” as an increase or decrease in “cash” or “cash equivalents”, with no reference made to “funds” or working capital. Moreover, FRS 1 defined “Cash” as cash in hand and demand deposits while it defined “cash equivalents”, much like SFAS No. 95, as being “short-term highly liquid investments” convertible into cash without notice and maturing within three months from the date of issuance, such as treasury bills. These changes were a vast improvement on the loose definition of “net liquid funds” provided by SSAP 10 as they helped increase the comparability between cash flow statements.

A further change resulting from the move to FRS 1 concerned the disclosure of operating cash flows. FRS 1 allowed operating cash flows to be reported on a net or gross basis on the face of the cash flow statement along with a reconciliation of operating profit to cash flow to be shown as part of the notes to the accounts (FRS 1, 1991, paragraph 16-17). Reading the explanation to the standard makes it is clear that the ASB were not lobbying their constituents to use the direct method as hard as FASB when they presented SFAS No. 95. In fact, the ASB put forward a very balanced debate on the benefits of disclosing operating cash flows using either the direct or indirect method (FRS 1, 1991, paragraphs 69-72). Consequently, FRS 1 noted that the direct method may provide useful information for assessing future cash flows but the indirect method may be useful to assess the quality and persistence of earnings.9Even though four out of six of the illustrative examples in the standard’s appendix made use of the direct method, the ASB only encouraged the use of this approach when the enterprise

9_{The ASB note that the indirect method helps investors assess the quality and persistence of historical}

earnings by providing a detailed breakdown of past accrual adjustments that would be useful when forecasting future earnings or cash flows.

believed the benefits of adopting the direct method would outweigh the associated costs of obtaining the required information. In either case, the ASB were clear that all firms adopting FRS 1 should disclose a reconciliation of operating profit to cash flow as part of the notes to the cash flow statement.

2.3.2.2 The Revision of FRS 1 and Subsequent Issue of FRS 1 (Revised)

With the widespread adoption of FRS 1, the ASB wanted feedback on the standard and, therefore, issued Financial Reporting Exposure Draft (FRED) 10: Revision of FRS 1 Cash Flow Statements for comment (FRS 1, 1996). Based on the responses received to FRED 10, the ASB issued a revised standard on cash flow reporting; FRS 1 (revised 1996): Cash Flow Statements. The first key change to the old standard concerned the definition of “cash flow” since business managers had criticised including “cash equivalents” as part of “cash flow”. They did not consider investments with a maturity of less than three months at the date of inception to be “equivalent” to cash in the running of the enterprise. In view of these comments the ASB revised the definition of “cash flow” to include only “cash”, meanwhile “cash equivalents”, as defined by the original FRS 1, were reported under a newly created category, “management of liquid resources” (FRS 1, 1996, appendix 3.6-3.8).

In addition to this new category, the revised FRS 1 added two more levels of cash flow classification, increasing the total number of standard headings from five to eight. FRS 1 (Revised 1996) now split cash flows from investing activities into “capital expenditure and financial investment” and “acquisitions and disposals”, and created two new categories, “equity dividends paid” and the aforementioned “management of liquid resources”.

Finally, the last significant revision to the standard now required the reconciliation of “net debt” to be disclosed either adjoining the cash flow statement or as a separate note to the accounts. This helped to provide more detailed information regarding the “liquidity, solvency and financial adaptability” of the enterprise (FRS 1, 1996, appendix 3.11).