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Chapter -22

Statement of cash flows


This chapter covers the following:
1. IAS 7 Statement of cash flows
2. Comparison of the statement of
cash flows and income statement
3. Interpretation of statements of cash
flow

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1. IAS 7 Statement of cash flows
– Objective of the statement of cash flows
• To provide information about the historical changes in cash and cash
equivalents
• to classify cash flows (i.e. inflows and outflows of cash ) arising from
operating, investing and financing activities.
– Usefulness of cash flow: To understand the liquidity, viability and financial
adaptability of entities.
– Format for Cash flow :IAS 7 does not prescribe a format for statements of
cash flows , it does require the cash flows to be classified into:
• Operating activities
• investing activities
• financing activities
– This classification may require a particular transaction to be shown partly
under one heading and partly under another.

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• The objective of the standard headings is to highlights the significant
components and facilitates comparison
• Each cash flow should be classified according to the substance of the
transaction that gives rise to it
• The necessary of cash flow is that profit figures are relatively easy to
manipulate whereas cash flow is difficult to manipulate. There are
many subjective judgements preparing profit such as
• inventory valuation
• depreciation
• allowance for receivables.
• Cash flows helps to form a basis for any future decision-making process.
• Definitions
– Cash: cash on hand (including overdrafts) and on demand deposits.
– Cash equivalents: short-term, highly liquid investments that are readily
convertible into known amounts of cash and are subject to an insignificant
risk of changes in value.

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Cash flows from operating activities: ( indirect method) $
Net profit before tax X
Adjustments for:
Add: Finance costs X
Less: Investment income (X)
Add: Depreciation X
Less: Profit on sale of non-current assets or add loss on sale of asset (X)
Add Provisions increase or Less :decrease of provision X/(X)
Less: Government grant amortisation (X)
Increase/decrease in prepayments (X)/X
Increase/decrease in accruals X/(X)
––––
Operating profit before working capital changes X
Increase/decrease in inventories (X)/X
Increase/decrease in trade receivables (X)/X
Increase/decrease in trade payables X/(X)
––––
Cash generated from operations X
Finance costs paid (X)
Income taxes paid (X)
––––
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Net cash from operating activities X
Cash flows from financing
• v
Cash flows from investing activities:
activities: Proceeds from issue of shares
X
including share premium
Purchases of property, plant and Proceeds from long-term
(X) X
equipment borrowings
Proceeds of sale of property, plant
X Payment of finance lease liabilities (X)
and equipment
Proceeds from government grants X Dividends paid on equity capital (X)
Interest received X ––––
Dividends received X Net cash used in financing
(x)
–––– activities
Net cash used in investing Cash from operating activities X
(x) Cash from investing activities X
activities
Cash from financing activities X
Net increase in cash and cash
x
equivalents
Add Cash and cash equivalents at
x
beginning of the period
Cash and cash equivalents at end
of the period x
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• Indirect method: This method
• begins with profit before tax from the income statement
• adjusts for interest to get back to profit from operations
• adjusts for non-cash items
• adjusts for increases and decreases in working capital. Calculation of net
cash flow from operating activities
• There is a difference between profit and cash flow.
• Profit before tax is computed using the accruals concept.
• Net cash flow from operating activities only records the cash inflows and
outflows arising out of trading.
• Adjustments are required to get from profit before tax back to cash flow.

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• Depreciation: Depreciation is not a cash flow.
• Depreciation has to be added back to reported profit in deriving cash from operating
activities.
• Profit/loss on disposal of non-current asset
• the cash inflow from sale is recorded under ‘investing activities’
• a loss on disposal is added to profit in deriving cash from operating activities
• similarly, a profit on disposal is deducted from profit.
• Change in receivables
• an increase in receivables is a deduction from profit in deriving cash from operating activities
• similarly, a decrease in receivables is an addition to profit.
• Change in inventory
• An increase in inventory is a deduction from profit in deriving cash from operating activities
• similarly, a decrease in inventory is an addition to profit.
• Change in payables
• an increase in payables is an addition to profit in deriving cash from operating activities
• similarly, a decrease in payables is a deduction from profit.
• Interest paid and income taxes paid
• The final adjustments to find cash flow from operating activities are:
• deduct interest paid
• deduct interest element of finance lease payments
• deduct income taxes paid.
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• Statement of financial position change in receivables
• A sale, once made creates income, irrespective of the date of the
cash receipt.
• The change between opening and closing receivables will represent
the adjustment required to move from reported revenue to net cash
inflow from sales.
• An increase in receivables is a deduction from reported profit. Less sales
are being received in cash in the current period than are being brought
forward from the previous period
• A decrease in receivables is an addition to reported profit.
• Statement of financial position change in inventories
• Inventory at the reporting date represents a purchase which has not
actually been charged against current profits. However, as cash was
spent on its purchase or a payable incurred, it does represent an
actual or potential cash outflow.
• Strictly, the amount of inventory paid for in cash should be calculated
and profit adjusted by the movement in such inventories between
the two reporting dates.
• In practice, the overall movement in inventory is taken as
• An increase in inventory is an outflow of cash
• A decrease in inventory is an inflow of cash
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• Statement of financial position change in payables
• A purchase represents the incurring of expenditure and a charge or
potential charge to the income statement. It does not represent a cash
outflow until paid.
• an increase in payables is an inflow of cash
• A decrease in payable is an outflow of cash
• Interest and dividends
• Interest paid is normally shown as part of operating activities.
• Dividends paid are shown in the IAS 7 specimen format as part of
financing activities, but may also be shown under operating activities.
• Income taxes
• Cash flows arising from taxes on income should be separately disclosed as
part of operating activities unless they can be specifically identified with
financing and investing activities. It is reasonable to include income taxes
as part of operating activities unless a question gives a clear indication to
the contrary.
• Total income tax on all activities should be shown as outflow of cash

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• Investing activities: These include
• cash paid for property, plant and equipment and other non-current assets
• cash received on the sale of property, plant and equipment and other non-
current assets
• cash paid for investments in or loans to other entities
• dividends received on investments.
• Financing activities
Financing cash flows comprise receipts or repayments of principal from or to
external providers of finance including:
• receipts from issuing shares or other equity instruments
• receipts from issuing debentures, loans, notes and bonds and from other long-
term and short-term borrowings (other than overdrafts, which are normally
included in cash and cash equivalents)
• repayments of amounts borrowed (other than overdrafts)
• the capital element of finance lease rental payments.
2. Comparison of the statement of cash flows and income statement
• Advantages of the statement of cash flows
• It may assist users of financial statements in making judgements on the
amount, timing and degree of certainty of future cash flows.

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• It gives an indication of the relationship between profitability and cash-
generating ability, and thus of the quality of the profit earned.
• Analysts and other users of financial information often, formally or
informally, develop models to assess and compare the present value of
the future cash flow of entities. Historical cash flow information could be
useful to check the accuracy of past assessments.
• A statement of cash flows in conjunction with a statement of financial
position provides information on liquidity, viability and adaptability. The
statement of financial position is often used to obtain information on
liquidity, but the information is incomplete for this purpose as the
statement of financial position is drawn up at a particular point in time.
• Cash flows cannot be manipulated easily and are not affected by
judgement or by accounting policies.
 Limitations of the statement of cash flows
• Statements of cash flows are based on historical information and
therefore do not provide complete information for assessing future cash
flows.
• There is some scope for manipulation of cash flows, e.g. a business may
delay paying suppliers until after the year end.
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• Cash flow is necessary for survival in the short-term, but in order to survive
in the long-term a business must be profitable. It is often necessary to
sacrifice cash flow in the short-term in order to generate profits in the
long-term (e.g. by investment in non-current assets). A huge cash balance
is not a sign of good management if the cash could be invested elsewhere
to generate profit or wages and salaries
3. Interpretation of statements of cash flow
– The statement of cash flows should be reviewed after preparation. In
particular, cash flows in the following areas should be reviewed:
• cash generation from trading operations
• dividend and interest payments
• capital expenditure
• financial investment
• management of financing
• net cash flow.

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• Cash generation from trading operations
• The figure should be compared to the operating profit. The reconciliation note to
the statement of cash flows is useful in this regard. Overtrading may be indicated by:
• high profits and low cash generation
• large increases in inventory, receivables and payables.
• Dividend and interest payouts
• These can be compared to cash generated from trading operations to see whether
the normal operations can sustain such payments. In most years they should.
• Capital expenditure and financial investment
• The nature and scale of a company’s investment in non-current assets is clearly
shown.
• A simple test may be to compare investment and depreciation.
• If investment > depreciation, the company is investing at a greater rate than its
current assets are wearing out – this suggests expansion.
• If investment = depreciation, the company is investing in new assets as existing ones
wear out. The company appears stable.
• If investment < depreciation the non-current asset base of the company is not being
maintained. This is potentially worrying as non-current assets are generators of
profit.

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• Management of financing
• The changes in financing (in pure cash terms) are clearly shown.
There may be a note to the statement of cash flows which links
the inflows/outflows with the movement in the statement of
financial position. There may be significant non-cash flow
changes in the capital structure of the business.
• Gearing can be considered at this point.
• Cash flow
• The statement clearly shows the end result in cash terms of the
company’s operations in the year. Do not overstate the
importance of this figure alone, however. A decrease in cash in
the year may be for very sound reasons (e.g. there was surplus
cash last year) or may be mainly the result of timing (e.g. a new
loan was raised just after the end of the accounting period).
• To help in determining the future cash position, other areas of
the published accounts should be considered as illustrated
below.

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: Prepare taxation account to find out tax paid
Taxation A/c

Tax paid (balance fig.) Xxx Op. balance of tax Xxx


Closing balance of tax. . xxxx Corp tax xxx
Corp tax xxx Deferred tax xxx
Deferred tax xxx Current year taxation (as Xxx
per P & L a/c)
xxx xxx

C. balance of gov. grant Xxxx Op. balance of gov. grant Xxx


current xx Current xxx
long term xx Government grant A/c Long term xxx
Profit & loss a/c xxxx Cash received as grants (Bal Xxx
figures)
xxx xxx

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Prepare property account to find out property acquired in the current
year. Property A/c (Net Book Value)

Opening balance xxx Original value of Xxx


Property acquired property disposed
(Balancing figures) . X Closing balance xxx
x
xxx xxx
Prepare interest payable account to find out interest paid
Interest payable A/c
Interest paid (balance Op. balance of interest Xxx
fig.) Xx Current year intetest Xxx
Closing balance of xxxx (as per P & L a/c)
interest. .
xxx xxx
Prepare property disposal account to find out cash received on disposal.
Property disposal A/c
Opening balance Xxxx Loss on sale of property xxx
Profit on sale of xxxx Depreciation xxx
Property Cash received on
disposal (Sale value of Xx
asset)
17 xxx xxx