(141)-PARTICIPATING INTEREST

Participating Interest

Financial reporting standards (FRS) states that a participating interest is an interest is an interest held by an undertaking in the shares of another undertaking which it holds on a long term basis for the purpose of securing a contribution to its activities by the exercise of control or influence arising from or related to that interest.

• A holding of 20% or more of the shares of an undertaking is presumed to be a participating interest unless the contrary is shown.
• An interest in shares includes an interest which is convertible into an interest in shares, and includes an option to acquire shares or any interest which is convertible into shares.
• An interest held on behalf of an undertaking shall be treated as held by that undertaking.

A “participating interest”, like an investment in a “subsidiary undertaking”, need not be in a company, because an “undertaking” means one of three things.

1. A body corporate
2. A partnership
3. An unincorporated association carrying on a trade or business, with or without a view to profit

“Shares” therefore means allotted shares or for undertakings without share capital, the right to share in the capital and profits and the corresponding liability to meet losses and debt on winding up.

(140)-PARENT UNDERTAKING

Parent Undertaking

Financial Reporting Standards (FRS) states that an undertaking is the parent undertaking of another undertaking if any of the following apply.

• It holds a majority of the voting rights in the undertaking.
• It is a member of the undertaking and has the right or appoints or removes directors holding a majority of the voting rights at meetings of the board on all, or substantially all, matters.
• It has the right to exercise a dominate influence over the undertaking:
  1. By virtue of provisions contained in the undertaking’s memorandum or articles.
  2. By virtual of a control contract (in writing, authorized by the memorandum or articles of the controlled undertaking, permitted by law).
• It is a member of the undertaking and controls alone, under an agreement with other shareholders or members, a majority of the voting rights in the undertaking.
• It has a participating interest in the undertaking and one of two things applies.
  1. It actually exercises a dominant influence over the undertaking.
  2. It and the undertaking are managed on a unified basis.
• A parent undertaking is also treated as the parent undertaking of the subsidiary undertakings of its subsidiary undertakings.

This replaced the provisions criterion of owing a majority of equity with one of holding a majority of voting rights. Also, the board is controlled to be controlled if the holding company has the right to appoint directors with a majority of the voting rights on the board (not just to appoint a simple majority of the directors, regardless of their voting rights).

(139)-GROUP ACCOUNTS

Group Accounts

Definitions

You will probably know that many large companies actually consist of several companies controlled by one central or administrative company. Together these companies are called a group. The controlling company, called the parent or holding company, will own one some or all of the shares in the other companies, called subsidiary and associated companies.

There are many reasons for businesses to operate as groups; for the goodwill associated with the names of the subsidiaries, for tax or legal purposes and so forth. Company law requires that the results of a group should be presented as a whole.

In traditional accounting terminology, a group of companies consists of a holding company and one or more subsidiary companies which are controlled by the holding company.

There are two definitions of a group in company law.

1. Uses the terms holding company and “subsidiary” and applies for general purposes.
2. Wider and applies only for accounting purposes. It uses the terms parent “undertaking” and “subsidiary undertaking”

The purpose of this widening of the group for accounting purposes was to curb the practice of structuring a group in such a way that not all companies or ventures within it had to be consolidated. This is an example of off balance sheet financing and has been used extensively to make consolidated accounts look better than is actually justified.

(138)-THE ADVANTAGES OF CASH FLOW ACCOUNTING

The Advantages of Cash Flow Accounting

Some of the advantages of cash flow accounting are as follows

• Cash flow reporting satisfies the needs of all users better,
  1. For management, it provides the sort of information on which decisions should be taken: (in management accounting, “relevant costs” to a decision are future cash flows); traditional profit accounting does not help with decision making.
  2. For shareholders and auditors, cash flow accounting can provide a satisfactory basis for stewardship accounting.
  3. As described previously, the information needs of creditors and employees will be better served by cash flow accounting.
• Cash flow forecasts are earlier to prepare, as well as more useful, than profit forecasts.
• They can in some respect be audited more easily than accounts based on the accruals concept.
• The accruals concept is confusing, and cash flows are more easily understood.
• Cash flow accounting should be both respective, and also include a forecast for the future. This is of great information value to all users of accounting information.
• Forecasts can subsequently be monitored by the publication of variance statements which compare actual cash flows against the forecasts.
• Management need to control cash flows and the cash flow statement shows exactly which activities are generating and which using cash.

(137)-THE ADVANTAGES OF CASH FLOW ACCOUNTING

The Advantages of Cash Flow Accounting

Some of the advantages of cash flow accounting are as follows,

• Survival in business depends on the ability to generate cash. Cash flow accounting directs attention towards this critical issue.
• Cash flow is more comprehensive than “profit” which is dependent on accounting conventions and concepts.
• Creditors (long term and short term) are more interested in an entity’s ability to repay them than in its profitability. Whereas “profits” might indicate that cash is likely to be available, cash flow accounting is more direct with its message.
• Cash flow reporting provides a better means of comparing the results of different companies than traditional profit reporting.

(136)-STEPS TO PREPARING A CASH FLOW STATEMENT

Steps to Preparing a Cash Flow Statement

Step 1

Set out the Proforma cash flow statement with all the headings required by financial reporting standards (FRS).

Step 2

Complete the reconciliation of operating profit to net cash inflows as far as possible. When preparing the statement from balance sheets, you will usually have to calculate such items as depreciation, loss on sale of fixed assets and profit for the year.

Step 3

Calculate the figure for tax paid, dividend paid, purchase or sale of fixed assets, issue of shares and repayment of loans if these are not already given to you. Note that you may not be given the tax charge in the profit and loss account. You will then have to assume that the tax paid in the year is last year’s year-end provision and calculate the charge as the balance figure.

Step 4

If you are not given then profit figure, open up a working for the profit and loss account. Using the opening and closing balances, the taxation charge and dividends paid and purposed, you will be able to calculate profit for the year as the balancing figure to put in the statement.

Step 5

Complete the gross cash flow. Alternatively, the information may go straight into the statement.

Step 6

You will now be able to complete the statement by slotting in the figures calculate.

(135)-PREPARING A CASH FLOW STATEMENT

Preparing a Cash Flow Statement

In essence, preparing a cash flow statement is very straightforward. You should therefore simple learn the format given above and apply the steps noted in the example below. Note that the following items are treated in a way that might seem confusing, but the treatment is logical if you think in term of cash.

• Increase in stock is treated as negative (in brackets). This is because it represents a cash outflow; cash is being spent on stock.
• An increase in debtors would be treated as negative for the same reasons; more debtors mean less cash.
• Be contrast an increase in creditors is positive because cash is being retained and not used to pay off creditors. There is therefore more of it.

(134)-CASH FLOW STATEMENTS - INDIRECT METHOD

Cash Flow Statements -Indirect Method

Another way of arriving at net cash flows from operating activities is to start from operating profit and adjust non cash items, such as depreciation, debtors etc. This is known as the indirect method.

A Proforma calculation is given below.

Operating profit-----------------------------------------------------XXX
(Add)- Depreciation-----------------------------------------------XXX
Loss/Profit on sale of fixed assets-------------------------XXX
Increase/Decrease in stocks---------------------------------XXX
Increase/Decrease in debtors--------------------------------XXX
Increase/Decrease in creditors-----------------------------XXX
NET CASH FLOW FROM OPERATING ACTIVITIES--XXX

It is important to understand why certain items are added and other subtracted. Note the following points.

• Depreciation is not a cash expense, but deducted in arriving at the profit figure in the profit and loss account. It makes sense, therefore, to eliminate it by adding it back.
• By the same logic, a loss on a disposal of fixed asset needs to be added back and profit deducted.
• An increase in stocks means less cash, you have spent on buying stock.
• An increase in debtors means debtors have not paid as much, therefore less cash.
• If we pay off creditors, causing the figure to decrease to decrease, again we have less cash.

(133)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

Financing

Financing cash flows comprise receipts or repayment of principle from or to external providers of finance. The cash flows in this section can be shown in a single section with those under “management of liquid resources” provided that separate subtotals for each are given.

Financing cash inflows include:

• Receipts from issuing shares or other equity instruments
• Receipts from issuing debentures, loans and from other long term and short term borrowings (other than overdrafts)

Financing cash outflows include:

• Repayments of amounts borrowed (other than overdrafts)
• The capital element of finance lease rental payments
• Payments to reacquire or redeem the entity’s shares
• Payments of expenses or commission on any issue of equity shares

(132)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

Management of liquid resources

This section should include cash flows in respect of liquid resources as defined above. Each entity should explain what it includes as liquid resources and any changes in its policy. The cash flows in this section can be shown in a single section with those under “financing” provided that separate subtotals for each are given.

Cash inflows include:

• Withdrawals from short term deposits not qualifying as cash
• Inflows from disposal or redemption of any other investments held as liquid resources

Cash outflows include:

• Payments into short term deposits not qualifying as cash
• Outflows to acquire any other investments held as liquid resources

(131)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

Taxation

These are cash flows to or from taxation authorities in respect of the reporting entity’s revenue and capital profits. Value added tax (VAT) and other sales taxes are disclosed below.

• Taxation cash inflows include cash receipts from the relevant tax authority of tax rebates, claims or returns or over payments.
• Taxation cash outflows include cash payments to the relevant tax authority of tax, including payments of advance corporation tax.

Acquisitions and disposals

These cash flows are related to the acquisition or disposal of any trade or business, or of an investment in an entity that is an associate, a joint venture, or a subsidiary undertaking.

• Cash inflows here include receipts from sales of trades or business.
• Cash outflows here include payments to acquire trades or business.

Equity dividends paid

The cash outflows are dividends paid on the reporting entity’s equity shares, excluding any advance corporation tax.

(130)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

Capital expenditure and financial investment

These cash flows are those related to the acquisition or disposal of any fixed asset other than one required to be classified under “acquisitions and disposals” and any current asset investment not included in liquid resources. If no cash flows relating to financial investment fall to be included under this heading the caption may be reduced to “capital expenditure”.

The cash inflows here include:

• Receipts from sales or disposals of property, plant or equipment.
• Receipts from the repayment of the reporting entity’s loans to other entities.

Cash outflows in this category include:

• Payments to acquire property, plant or equipment
• Loans made by the reporting entity

(129)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

Returns on investments and servicing of finance

These are receipts resulting from the ownership of an investment and payments to providers of finance and non equity shareholders.

• Cash inflows from returns on investments and servicing of finance include
  1. Interest received, including any related tax recovered
  2. Dividend received, net of any tax credits
• Cash outflows from returns on investments and servicing finance include
  1. Interest paid (even capitalized), including any tax deducted and paid to the relevant tax authority.
  2. Cash flows that are treated as finance costs (this will include issue costs on debt and non equity share capital).
  3. The interest element of finance lease rental payments.
  4. Dividends paid on non equity shares of the entity.

(128)-CLASSIFICATION OF CASH FLOWS BY STANDARD HEADING

Classification of Cash Flows by Standard Heading

• Operating activities

Cash flows from operating activities are in general the cash effects of transactions and other events relating to operating or trading activities, normally shown in the profit and loss account in arriving at operating profit. They include cash flows in respect of operating items relating to provisions, whether or not the provision was included in operating profit.

A reconciliation between the operating profit reported in the profit and loss account and the net cash flow from operating activities should be given either adjoining the cash flow statements or as a note. The reconciliation is not part of the cash flow statement: if adjoining the cash flow statement, it should be clearly labeled and kept separate. The reconciliation should disclose separate the movement in stocks, debtors and creditors related to operating activities and other differences between cash flows and profits.

(127)-FINANCIAL REPORTING STANDARD FOR CASH FLOW STATEMENTS

Financial Reporting Standard for Cash Flow Statements

Financial Reporting Statements (FRS) sets out the structure of a cash flow statement and it also sets the minimum level of disclosure.

Objective

The financial reporting standard begins with the following statement,

The objective of this financial reporting standard is to ensure that reporting entities falling within its scope:

• Reporting their cash generation and cash absorption for a period by highlighting the significant components of cash flow in a way that facilitates comparison of the cash flow performance of different business.
• Provide information that assists in the assessment of their liquidity, solvency and financial adaptability.

Scope

The financial reporting standards (FRS) applies to all financial statements intended to give a true and fair view of the financial position and profit or loss, except those of various exempt bodies in group accounts situations or where the content of the financial statement is governed by other statues or regulatory regimes. In addition, small entities are excluded as define by companies legislation.

(126)-DEFINITIONS FOR CASH FLOW STATEMENTS

Definitions for Cash Flow Statements

The financial reporting standards (FRS) include the following important definitions. Note particularly the definitions of cash and liquid resources.

• An active market is a market sufficient depth to absorb the investment help without a significant effect on then price.
• Cash is cash in hand and deposits receivable on demand with any qualifying financial institution, less overdrafts from any qualifying financial institution repayable on demand. Deposits are repayable on demand if they can be withdrawn at any time without notice and without penalty or if a maturity or period of notice of not more than 24 hours or one working day has been agreed. Cash includes cash in hand and deposit denominated in foreign currencies.
• Cash flow is an increase or decrease in an amount of cash.
• Liquid resources are current asset investments held as readily disposable store of value. A readily disposable investment is one that:
  1. Is disposable by the reporting entity without curtailing or disrupting its business
  2. Is either, readily convertible into known amounts of cash at or close to its carrying amount or trade in an active market.
• Net debt is the borrowings of the reporting entity less cash liquid resources. Where cash and liquid resources exceed the borrowings of the entity reference should be to “net funds” rather than to “net debt”.
• Overdraft is a borrowing facility receivable on demand that is used by drawing on a current account with a qualifying financial institution.

(125)-LINKS WITH CASH FLOW AND OTHER PRIMARY STATEMENTS

Links with Cash Flow and Other Primary Statements

Because the information given by a cash flow statement is best appreciated in the context of the information given by the other primary statements, the Financial Reporting Standards (FRS) requires two reconciliations, between:

• Operating profit and the net cash flow from operating activities
• The movement in cash in the period and the movement in net debt

The movement in net debt should identify the following components and reconcile these to the opening and closing balance sheet amount:

• The cash flows of the entity
• Other non cash changes
• The recognition of charges in market value and exchange rate movements

(124)-FORMAT OF THE CASH FLOW STATEMENT

Format of the Cash Flow Statement

There are two methods for preparing cash flow statements,

1. Direct method.
2. Indirect method.

A cash flow statement should list its cash flows for the period classified under the following standard headings:

• Operating activities
• Returns on investments and servicing of finance
• Taxation
• Capital expenditure and financial investment
• Acquisitions and disposals
• Equity dividends paid
• Management of liquid resources
• Financing

The last two headings can be shown in a single section provided a subtotal is given for each heading.

Individual categories of inflows and outflows under the standard headings should be disclosed separately either in the cash statements or in a note to it unless they are allowed to be shown net. Cash inflows and outflows may be shown net if they relate to the management of liquid resources or financing and the inflows and outflows:

• Relate in substance to a single financing transaction
• Or are due to short maturities and high turnover occurring from rollover or reissue, for example relating to operating activities.

The requirement to show cash inflows and outflows separately does not apply to cash flows relating to operating activities.

Each cash flow should be classified according to the substance of the transaction giving rise to it.

(123)-CASH FLOW STATEMENTS

Cash Flow Statements

It has been argued that “profit” does not always give a useful or meaningful picture of a company’s operations. Readers of a company’s financial statements might even be misled by a reported profit figure.

• Shareholders might believe if a company makes a profit after tax, of say, 100000$ then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders’ expectations would be wrong.
• Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This option may not be correct: the ability to pay wages depends on the availability of cash.
• Cash is the life board of the business. Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due. Such payments might include “profit and loss” items such as material purchases, wages, interest and taxation etc, but also capital payments for new fixed assets and repayment of loan capital when this falls due.

From these examples, it may be apparent that a company’s performance and prospects depend not so much on the “profits” earned in a period, but more realistically on liquidity or cash flows.

The great advantage of a cash flow statement is that it is unambiguous and provides information which is additional to that provided in the rest of the accounts. It also describes the cash flows of an organization by activity and not by balance sheet classification.

(122)-SUMMARY FOR COMPANY ACCOUNTS

Summary for Company Accounts

• Limited companies have limited liability, which means that their members’ liability in the event of insolvency is limited to the amount of capital they put in.
• There are two types companies,
  1. Private companies
  2. Public companies
• Limited companies must keep accounting records.
• Limited companies have a share capital, it divided
  1. Authorized share capital
  2. Issued share capital
  3. Called up share capital
  4. Paid up share capital
• Dividends are appropriations of profit.
• Ordinary shares are different from preference shares, mainly because they carry no right to a fixed dividend.
• Revenue reserves are available for distribution. Capital reserves are not.
• Debentures are long term liabilities, not capital. Unlike dividends, debentures interest must be paid.
• Companies must pay corporate tax on their profits.

(121)-TAXATION FOR COMPANIES

Taxation for Companies

Companies pay corporation tax on the profit they earn. Note that because a company has a separate legal personality, its tax is included in its accounts. An unincorporated business would not show income tax in its accounts, as it would not be a business expense but the personal affair of the proprietors.

Presentation in accounts

• The charge for corporation tax on profits for the year is shown as a deduction from net profit, before appropriation.
• In the balance sheet, tax payable to the government is generally shown as a current liability as it is usually due within nine months of the year end.
• For various reasons, the tax on profits in the profit and loss account and the tax payable in the balance sheet are not usually the same amount.

(120)-LEDGER ACCOUNTS AND LIMITED COMPANIES

Ledger Accounts and Limited Companies

Limited companies keep ledger accounts and the only difference from sole trader, is the nature of some of the transactions, assets and liabilities.

Taxation

• Tax charged against profits will be accounted by:
  Profit and loss account – Debit
  Taxation account - Credit
• The outstanding balance on the taxation account will be a liability in the balance sheet, until eventually paid, when the accounting entry would be:
  Taxation account – Debit
  Cash – Credit

Dividends

A separate account will be kept for the dividends for each different class of shares.

• Dividends declared out of profits will be accounted for by:
  Profit and loss appropriation account – Debit
  Dividends payable account – Credit
• When dividends are paid:
  Dividends payable account – Debit
  Cash – Credit

Debenture Loans

Debenture loans being a long term liability will be shown as a credit balance in a debenture loan account.

• Interest payable on such loans is not credited to the loan account, but is credited to a separate creditor’s account for interest until it is eventually paid:
  Interest account (Expense) – Debit
  Interest payable (Current liability) – Credit
• When paid, the entries are:
  Interest payable – Debit
  Cash – Credit

Share capital and reserves

There will be a separate account for:

• Each different class of share capital
• Each different type of reserve

(119)-DEBENTURES

Debentures

Limited companies may issue debenture stock or loan stock. These are long term liabilities described on the balance sheet as loan capital. They are different from share capital in the following ways.

• Shareholders are members of a company, while provides of loan capital are creditors.
• Shareholders receive dividends (appropriation of profits) whereas the holders of loan capital are entitled to a fixed rate of interest (an expense charged against revenue)
• Loan capital holders can take legal action against a company if their interest is not paid when due, whereas shareholders cannot enforce the payment of dividends.
• Debentures or loan stock are often secured on company assets, whereas shares are not.

The holder of loan capital is generally in a less risky position than the shareholder. He has greater security, although his income is fixed and cannot grow, unlike ordinary dividends. As remarked earlier, preference shares are in practice very similar to loan capital, not least because the preference dividend is normally fixed.

Advantages of rising finance by borrowing by debentures

• Debentures holders are creditors, not shareholders, and so do not affect the control of the company.
• The interest rate is fixed and a known cost.
• The interest is usually allowable for offset against the company’s corporation tax.
• If a debenture is secured as assets the interest rate will normally be lower than, say, an overdraft.

Disadvantages of rising finance by borrowing debentures

• Debenture interest must be paid, whereas directors do not need to pay shareholders a dividend.
• Dividends are appropriations of profit and do not reduce the company’s corporation tax.
• Debenture holders can force the sale of any assets used as security, if their loan is not repaid on the due date.

(118)-BONUS ISSUES AND RIGHTS ISSUES

Bonus Issues and Rights Issues

Bonus issues

A company may wish to increase its share capital without needing to raise additional finance by issuing new shares. For example, a profitable company might expand from modest beginnings over a number of years. Its profitability would be reflected in large balances on its reserves, while its original share capital might look like that of a much smaller business.

It is open to such a company to re classify some of its reserves as share capital. Any reserve may be re classified in this way, including a share premium account or other statutory reserve. Such a re classification increases the capital base of the company and gives creditors grater protection.

Rights issues

A rights issue is an issue of shares for cash. The “rights” are offered to existing shareholders, who can sell them if they wish.

Rights issues are a popular way of raising cash by issuing cash by issuing shares and they are cheap to administer. In addition, shareholders retain control of the business as their holding is not diluted.

The disadvantage of rights issues is that shareholders are not obligated to take up their rights and so the issue could fail to raise the money required. For this reason companies usually try to find a broker to “underwrite” the issue, i.e. who will buy any rights not taken up by the shareholders.