Editor's notes: Enterprise Accounting Guidelines - Cash Flow Statement (Revised)

New Requirement
Cash flow statements were anticipated in the EAS. While the EAS requires all enterprises to prepare a statement of changes in financial position (often called the funds statement), it does permit enterprises to prepare a cash flow statement if they so wish. In practice, however, apart from B-share companies that are required to report cash flows according to the requirements of IAS, few if any PRC enterprises prepared cash flow statements.

The PRC, Foreign Investment Enterprise Accounting System promulgated on 24 June 1992 requires foreign investment enterprises ("FIEs") to prepare a funds statement. That requirement is presumably now superseded by the new Cash Flow Standard. The Accounting Regulations for Selected Joint Stock Limited Enterprises, also issued in 1992 and amended by the Accounting Regulations for Joint Stock Limited Companies issued in January 1998, has a similar requirement.

Cash Versus Funds
The adoption of the Cash Flow Standard in the PRC was a matter of time and perhaps overdue. Many countries have replaced the funds statement with the cash flow statement. It was done in the United States as long ago as 1988. The IAS did it in 1994.

The main difference between a cash flow and a funds statement is that the latter shows changes in all the financial resources (i.e. funds) of the business, whereas a cash flow statement shows only cash receipts and cash payments, and it highlights the change in cash and cash equivalents rather than changes in working capital.

The following examples will illustrate the difference:

1. The acquisition of an asset by the issue of shares (a non-monetary transaction) is reflected in a funds statement but not in a cash flow statement.

2. The acquisition of a fixed asset on lease financing is reflected in the cash flow statement as and when the lease payments are made. In a funds statement, such a transaction is reflected as an application of funds at the time of entering into the lease.

3. In a funds statement, interest expense and investment income are shown on an accrual basis, although tax and dividends to shareholders are shown on a cash basis. In a cash flow statement, all these and other items are shown on a cash basis.

4. The application of funds for the purchase of fixed assets is reflected in a funds statement even though payment for the purchase may not yet have been made. In a cash flow statement, even though the fixed assets may have been acquired, so long as payment has not been made, their acquisition is not reflected.

The funds statement shows significant sources and applications of funds of an investing or financing nature regardless of whether or not they involve cash. For example, the issue of shares, whether for cash or in the conversion of convertible loan stock, is shown as a source of funds. In a cash flow statement, the issue of shares for cash is shown as a financing cash flow. But the issue of shares for convertible loan stock would not appear in a cash flow statement as it does not involve cash (however, significant non-cash transactions of an investing or financing nature are disclosed in a note).

Cash and Cash Equivalents
The term cash includes demand deposits. The term cash equivalents is defined in the same way as in the IAS. It refers to short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to insignificant risk of changes in value

The IAS explains that bank borrowings are generally considered to be financing activities. However, where short-term bank loans are an integral part of an entity's cash management, it may be acceptable to regard them as negative cash equivalents. A bank overdraft that fluctuates from being positive to overdrawn is regarded in the same way. Bank overdrafts are mentioned in the IAS, but the PRC standard is silent on this point, as it is on many details contained in the IAS. There seems to be an intention to keep things simple in the standard, which is probably an appropriate approach.

It may be noted in passing that not all investments that meet the definition of cash equivalents should be reflected as such. If the purchases and sales of such investments are an investing rather than a cash management activity, the related cash flows should be reflected as investing cash flows. The investment of excess cash in cash equivalents is part of cash management, says the IAS. In the case of investment enterprises, such cash flows are likely to be operating cash flows. Any change in what an enterprise regards as cash equivalents is usually considered a change in accounting policy.

Movements between items of cash and cash equivalents are not separately reflected in a cash flow statement. The IAS requires disclosure of the components of cash and cash equivalents; the PRC standard does not. However, in an appendix to the standard providing supplementary information, the amounts for cash and for cash equivalents at the end and at the beginning of the year are separately shown. Few PRC enterprises would have cash equivalents.

Classification of Cash Flows
The standard adopts the IAS classification of cash flows. Cash flows are either operating, investing or financing. Significantly, the PRC standard has adopted a less confusing approach in that it does not provide the IAS options on how payments and receipts of interest and dividends should be classified.

Under the PRC standard, other than for financial enterprises, interest paid on loans is a financing cash flow, and likewise dividends paid to shareholders. Under the IAS, these may alternatively be presented as operating cash flows.

Under the PRC standard, other than for financial enterprises, interest income is an investing cash flow, and likewise dividend income. Under the IAS, these may alternatively be presented as operating cash flows.

As the standard does not provide the options that the IAS does there will be consistency of presentation by all PRC enterprises. It is also less confusing for preparers of the cash flow statement. It is interesting to note that, in the exposure draft of the standard, interest paid and investment income are stated as operating cash flows. There has therefore been a re-think since then.

Classification of Cash Flows for Financial Enterprises
The standard specifically states that the following cash flows of financial enterprises should be classified as operating cash flows:

1. Loans made to outside parties and principal amount of loans collected;

2. Deposits accepted and principal amount of deposits paid;

3. Deposits accepted from and placed with other financial enterprises;

4. Borrowings from other financial enterprises;

5. Interest receipts and payments;

6. Collection of loans written off in a preceding period;

7. For securities enterprises, payments and receipts for the purchase and sale of securities; and

8. Receipts for lease financing.

Capitalized Expenditure
There was a statement in the exposure draft that capitalized interest paid on borrowings for investment should be reflected as investing cash flows. This statement does not appear in the standard. It must therefore be concluded that interest capitalized should be reflected in the same way as interest charged to income, i.e. as financing cash flows.

The IAS explains that capitalized development costs (as in research and development, or "R&D") and self-constructed fixed assets are investing activities. The PRC standard is silent on this and it would be reasonable to assume that the IAS treatment would be acceptable (except for any payments of interest included in such costs, which should be classified as a financing cash flow).

Direct Method Only for Operating Cash Flows
Most jurisdictions (e.g. US, UK and IAS) permit either the direct or indirect method of presenting operating cash flows. The PRC standard has, however, decided to mandate the direct method (as did Australia). This is a significant turnaround from the position taken in the exposure draft of allowing either method, and it would be interesting to know the considerations that influenced the change. The direct method is the "purer" form. Indeed, the US standard and the IAS recommend it over the indirect method. However, except in those countries where it is required, it is rarely used in practice because of the additional work involved in tracking the underlying cash transactions. Not being able to use the indirect method is probably not welcome news for those who actually have to prepare cash flow statements.

While the direct method shows operating cash receipts and payments, it does not provide a link between operating profit and the net cash flow from operating activities. Because the reconciliation between the two is considered essential to giving an indication of the quality of earnings, such a reconciliation is usually required when the direct method is used. To avoid having non-cash items in the cash flow statement itself, the reconciliation is shown in a note. The PRC standard requires such a reconciliation. The IAS, however, does not, because it was thought that such a requirement would have been a disincentive to enterprises considering using the direct method.

Net Cash Flows
Under the IAS, the standard states that cash flows are reported gross except that the following types of cash flows may be reported on a net basis:

1. Receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity; and

2. Receipts and payments for items in which the turnover is quick, the amounts large and the maturities short.

The PRC standard goes on to state that financial enterprises should show the following cash flows on a net basis:

1. Short-term loans made and principal amount of loans collected;

2. Deposit and withdrawal of current deposits and deposits placed with other financial enterprises;

3. Deposit and withdrawal of deposits due to and placed with other financial enterprises;

4. Borrowings from other financial enterprises;

5. Entrusted deposits and entrusted loans; and

6. For securities enterprises, payments and receipts for the purchases and sale of securities.

Cash Flows of Foreign Subsidiaries
The PRC standard requires the cash flows of an overseas subsidiary to be translated at the actual or average exchange rate. It would appear that the rate at the balance sheet date is not allowed.

Acquistions and Disposals of Subsidiaries
The PRC standard requires the same disclosures as does the IAS regarding subsidiaries acquired or disposed of during the year, namely:

1. The purchase consideration and the portion paid by cash; and

2. The amount of cash and the amount of non-cash assets and liabilities of the subsidiary by major categories.

Non-cash Investing or Financing Transactions
Like the IAS, the PRC standard requires disclosure of significant non-cash investing and financing cash flows in a note.

No Exemptions
In some jurisdictions, certain types of enterprises are exempted from having to prepare cash flow statements. For example, small enterprises with turnover or assets below specified amounts and subsidiaries that are wholly- or virtually wholly-owned. The IAS does not provide any exemptions and neither does the PRC standard. Neither of them states that when consolidated financial statements are prepared for a group, a cash flow statement need not be prepared for the parent company alone.

Improvement
For users of financial statements, the cash flow statement is an improvement over the funds statement. The focus is on cash, which is a better indicator of liquidity and financial flexibility than working capital. The cash flow statement can better provide the warning signals of a possible collapse of a business, especially in situations where turnover and profits are apparently healthy.

Lorena Tan
Price Waterhouse Asia Limited, Shanghai

(Lorena Tan is Technical Director of Price Waterhouse Asia Limited and located in the Shanghai office of Price Waterhouse Da Hua. The views expressed in this article do not necessarily reflect those of the firm.)

(Source: China Law & Practice [1998] issue 5)(Editor's notes pending updating.)

Endnotes

1. The revised Guidelines were issued on 18 January 2001 with effect as of 1 January 2001.