In case of entities like companies which present its financial statements on accrual basis, Cash flow Statements fulfills vital information needs of users?
The Supreme Court in Reliance Energy Ltd Vs. Maharashtra State Road Development Corporation Ltd.
When P&L accounts and balance sheets are prepared on accrual basis, revenues and expenses are recognized on accrual basis
i.e. when events or transaction occurs. However, timing of cash flow is not reckoned in such system of accounting.
Similarly, in cases where accounts are based on accrual system of accounting, recognition of assets & liabilities is not dependent on the actual timing of cash spent on capital Expenditure & Cash inflow on Capital receipts.
Thus, financial statements prepared on accrual basis don not reflect the timing of Cash flow & amount of Cash flow.
The object of the cash flow statement is to assess the company ability to generate the cash flow in future and to assess reason for difference between “NET PROFIT” and “NET CASH FLOW” from operations.
In Fact Cash flow from operations is the regular sources of cash for any enterprise that determines whether or not an enterprise will continue to exist in the long run.
Accrual basis of accounting requires that revenues be recorded when earned and the expenses be recorded when incurred. Earned revenues more often include credit sales that have not been collected in cash & expense incurred that may not have been paid in cash during the accounting period.
Thus, Net Income will not indicate the net cash provided by operating activities or net loss will not indicate the net cash used in operating activities.
In order to calculate the net cash provided by (or used in) operating activities, it is necessary to replace revenues and expenses on accrual basis with actual receipts and actual payments in cash. This is done by eliminating non- cash revenues and non-cash expenses from the given earned revenues & incurred expenses in the profit & loss account.
Profit & Loss account is also debited with purely non-cash items which reduces and increase the profits respectively but do not affect the cash at all. Eg: Depreciation, P/L on sale of fixed assets, amortization of deferred revenue expenses and so on.
Since Cash provide by operations is to be calculated, certain Non-operation item like rent income, interest income, dividend income, refund of tax etc should be adjusted although these items may have recorded on cash basis. Such items are analysed separately in the cash flow statement as operating, financing & investing activities.
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