Summary flow reports

Other financial statements are different from the balance sheet in one important respect: they summarise the significant flows of activities and operations over the period. Accountants prepare two types of summary flow reports for businesses:

• The profit and loss account summarises the inflows of assets from the sale of products and services during the period. The profit and loss account also summarises the outflow of assets for expenses during the period leading down to the well-known bottom line (the final profit or loss) for the period.
• The cash flow statement summarises the business’s cash inflows and outflows during the period. The first part of this financial statement calculates the net increase or decrease in cash during the period from the profit-making activities reported in the profit and loss account.

The balance sheet, profit and loss account, and cash flow statement constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business’s financial affairs. These individuals have invested capital in the business, or the business owes them money and therefore they have a financial interest in how well the business is doing. These three key financial statements are also used by the managers of a business to keep themselves informed about what’s going on and the financial position of the business. They are absolutely essential to helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (Part 3 of this book explains these additional reports.)

The emergence of International Financial Reporting Standards (IFRS)

The accounting professional bodies, with a little prodding from governments, are responsible for ensuring that accounting reports conform to what are known as Generally Accepted Accounting Practices (GAAP). A newish entrant, International Accounting Standards, is challenging that term itself as GAAP rules have been interpreted differently on different continents and indeed largely ignored on others.

The rule book has to be adapted to accommodate changes in the way that business is done. For example, international business across frontiers is now the norm, so rules on handling currency and reporting taxable profits in different countries have to be accommodated within a company’s accounts in a consistent manner.

Although you aren’t usually expected to know all the rules – unless you’re the accountant responsible for preparing your organisation’s figures – try to get up-to-date before any meetings where the subject is likely to come up. You can keep track of changes in company reporting rules on the Institute of Chartered Accountants in England and Wales’ website (www.icaew.com/en/technical/financial-reporting).

In the UK, there’s a large degree of conformity between domestic and international standards, and the Accounting Standards Board (ASB) considers each new international standard carefully before deciding whether or not to include it in the domestic standard. Topics that have been the cause of disagreement in the recent past are the treatment of goodwill, deferred tax and pension costs.

The role of the ASB is to issue accounting standards. The ASB also collaborates with accounting standard-setters from other countries and the International Accounting Standards Board (IASB), both in order to influence the development of international standards and in order to ensure that its standards are developed with due regard to international developments. You can keep up with its work at www.frc.org.uk/asb/.

Why accounting rules are important

Business managers should know the basic features of the accounting rules that apply in their area – though certainly not all the technical details – so that they understand how profit is measured. Managers get paid to make profit, and they should be very clear on how profit is measured and what profit consists of. The amount of profit a business makes depends on how profit is defined and measured.

For example, a business records the purchase of products at cost, which is the amount it paid for the products. Stock is the name given to products being held for sale to customers. Examples include clothes in a department store, fuel in the tanks in a petrol station, food on the shelves in a supermarket, books in a bookstore, and so on. The cost of products is put in the stock asset account and kept there until the products are sold to customers. When the products are eventually sold, the cost of the products is recorded as the cost of goods sold expense, at which time a decrease is recorded in the stock asset account. The cost of products sold is deducted from the sales revenue received from the customers, which gives a first-step measure of profit. (A business has many other expenses that need to be factored in, which you can read about in later chapters.)

Now, assume that before the business sells the products to its customers the replacement cost of many of the products being held in stock awaiting sale increases. The replacement cost value of the products is now higher than the original, actual purchase cost of the products. The company’s stock is worth more, is it not? Perhaps the business could raise the sales prices that it charges its customers because of the cost increase, or perhaps not. In any case, should the increase in the replacement cost of the products be recorded as profit? The manager may think that this holding gain should be recorded as profit. But the accepted accounting standards say that no profit is earned until the products are sold to the customers.

What about the opposite movement in replacement costs of products – when replacement costs fall below the original purchase costs? Should this development be recorded as a loss, or should the business wait until the products are sold? As you’ll see, the accounting rule that applies here is called lower of cost or market, and the loss is recorded. So the rule requires one method on the upside but another method on the downside. See why business managers and investors need to know something about the rules of the game? We should add that accounting rules are not all crystal-clear, which leaves a lot of wriggle room in the interpretation and application of these accounting standards. But first, a quick word about accounting rules and income tax accounting.

Income tax and accounting rules

Generally speaking (and we’re being very general when we say the following), HM Revenue & Customs’ income tax accounting rules for determining the annual taxable income of a business are in agreement with the accounting rules applied in most other developed economies. In other words, the accounting methods used for figuring taxable income and for figuring business profit before income tax are in general agreement. Having said this, we should point out that several differences do exist. A business may use one accounting method for filing its annual income tax returns and a different method for measuring its profit, both for management reporting purposes and for preparing its external financial statements to outsiders.

Flexibility in accounting standards

An often-repeated accounting story concerns three accountants being interviewed for an important position. The accountants are asked one key question: ‘What’s 2 plus 2?’ The first candidate answers, ‘It’s 4,’ and is told, ‘Don’t call us, we’ll call you.’ The second candidate answers, ‘Well, most of the time the answer is 4, but sometimes it’s 3 and sometimes it’s 5.’ The third candidate answers: ‘What do you want the answer to be?’ Guess who got the job?

The point is that accounting rules are not entirely airtight or cut-and-dried, and they’re often being updated. Many accounting standards leave a lot of room for interpretation. Guidelines would be a better word to describe some accounting rules. Deciding how to account for certain transactions and situations requires flexibility, seasoned judgement and careful interpretation of the rules. Furthermore, many estimates have to be made.

Sometimes, businesses use what’s called creative accounting to make profit for the period look better. Like lawyers who know where to find legal loopholes, accountants sometimes come up with inventive solutions but still stay within the guidelines. We warn you about these creative accounting techniques – also called massaging the numbers – at various points in this book. Articles in financial newspapers and magazines regularly focus on such accounting abuses.

Following established standards

The basic idea behind sticking closely to the accepted accounting standards is to measure profit and to value assets and liabilities consistently from business to business – to establish broad-scale uniformity in accounting methods for all businesses. The idea is to make sure that all accountants are singing the same tune from the same hymnbook. The purpose is also to establish realistic and objective methods for measuring profit and putting values on assets and liabilities. The authoritative bodies write the tunes that accountants have to sing.

All systems of accounting standards include minimum requirements for disclosure, which refers to how information is classified and presented in financial statements and to the types of information that have to be added to the financial statements in the form of footnotes. The professional accounting bodies provide details on these requirements.

The ASB, the body responsible for setting accounting standards in the UK, is pressing ahead with a programme to ‘converge’ UK accounting standards so that they match the international standards – almost. You can keep track of changes in company reporting rules on the Institute of Chartered Accountants in England and Wales’ website at www.icaew.com/en/technical/financial-reporting. The Institute of Chartered Accountants of Scotland (ICAS) (www.icas.org.uk) and the Chartered Accountants Ireland (ICAI) (www.charteredaccountants.ie) – Dublin Office can provide similar information.

How do you know if a business has actually followed the rules faithfully? We think it boils down to two factors. First is the competency and ethics of the accountants who prepared the financial reports. No substitute exists for expertise and integrity. But accountants often come under intense pressure to massage the numbers from the higher-level executives that they work for.

Which leads to the second factor that allows you to know whether a business has obeyed the dictates of accounting standards. Businesses have their financial statements audited by independent chartered or management accountants. In fact, limited companies are required by law to have annual audits and many private businesses hire accountants to do an annual audit, even if not legally required.

The Companies Act 2006 (which finally came into force in October 2009, and has the dubious distinction of being the longest Act in British parliamentary history – though the Brexit legislation may well knock it off that perch) has introduced some tough rules on how auditors, among others, should report on company accounts. Chapter 15 explains audits and why investors should carefully read the auditor’s report on the financial statements.

Protecting investors: Sarbanes-Oxley and beyond

A series of high profile financial frauds in US-based businesses such as Enron and WorldCom in the mid to late 1990s badly shook people’s confidence in US businesses. In response, the US government introduced the Sarbanes-Oxley Act, known less commonly but better understood as the Public Company Accounting Reforms and Investor Protection Act – 2002.

The central tenet of the Sarbanes-Oxley Act is to ensure truthfulness in financial reporting – a quest the accounting profession has been pursuing since Pacioli set out the rules of double-entry bookkeeping five centuries ago. The act closes the loopholes that creative accountants opened up, which made it difficult (and sometimes impossible) for shareholders to see how a business was performing until after the baddies had made off with the loot. The act applies to any business with shares listed on an American stock market that does business in the US – not just to US companies.

The British version – the Companies (Audit, Investigations and Community Enterprise) Act 2004 – is causing the accounting profession to clutch its collective head. This knock-on effect from Sarbanes-Oxley means that all companies selling shares to the public have to make changes to their accounts and accounting standards. You can read up on the UK rules at www.legislation.gov.uk/ukpga/2004/27/contents.