Cash flows or accounting flows?Figure 5.1
Six investment
projects of a
business, all of
which operate
during at least two
accounting periods
The problem of financial accounting is to try to make an assessment of the amount of wealth
generated by all of the business’s projects during a particular period when not all of each
project’s cash flows are self-contained within that period.Converting accounting flows to cash flows
When using the NPV approach it is projected cash flows, not accounting profits, that
should be discounted; yet frequently when projects are being assessed in advance of
possible implementation they are expressed in terms of anticipated profit, so we need
to convert such information to cash flows.
There are two areas where accounting profit needs to be adjusted:l working capital; and
l depreciation.As regards the operating items, that is, those items concerned with sales revenue
and material, labour and overhead costs, the adjustment to convert accounting flows
to cash flows can be done by taking account of the working capital requirement of the
project.‘
Investment appraisal has a somewhat different objective from that of financial
accounting, however. This is to assess a project over its entire life, not to assess it for a
particular portion of that life. This difference of purpose is represented graphically in
Figure 5.1. This shows a business with six investment projects (A to F), each of which
starts and ends at a different time. Financial accounting seeks to assess the profit for a
period such as p. During this period one project (Project E) ends, one (Project B) starts,
while the other four run throughout period p. Investment appraisal seeks to assess
whether any particular project is a viable one, before it starts. Profit measurement
tends to be cross-sectional, investment appraisal longitudinal.