It is often argued that historical cash flow is more useful in appraising a company than historical profit, particularly because cash flows are factual and do not involve the exercise of judgement.
Required:
Explain FOUR arguments against this view. . (4 marks)
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Although it is true that cash flows are factual and not affected by accounting policies, there are a number of areas in which it could be argued that profit is a better measure of performance:
- Profit is accrual based. This has the following implications: – Management can manipulate cash flows to appear better than they are by delaying payments and bringing forward receipts; this is irrelevant to profits. – Certain items relating to the future are recognised in profit but not in cash flows. For example a provision for a liability is recognised in profit or loss so providing indicators of future cash flows.
- Non-cash items may be represented in profit or loss, but are obviously not represented in the statement of cash flows. An example is share-based payments. Although these do not involve the payment of cash, they are still relevant to performance appraisal.
- Due to the way in which cash flows are disclosed, normalisation for exceptional and one-off items is difficult to achieve. In the statement of profit or loss these items are disclosed and so can be excluded in order to assess sustainable performance more accurately.
- Management can time the purchase and sale of non-current assets in order to improve cash flow performance in a given year. The equivalent expense is depreciation; as this is recognised over the life of the underlying asset, there is limited opportunity to take a similar short-term approach to improving performance.