ACCA F3 (INT) Financial Accounting - 2010 - Study text - Emile Woolf Publishing
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Chapter 14: Statements of cash flows
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There are items of cash flow that do not appear in the income statement. Examples
are:
Cash flows relating to the acquisition or disposal of investments, such as the
purchase of new non-current assets, and cash from the sale of non-current assets.
(The income statement includes gains or losses on the disposal of non-current
assets, but this is not the same as the cash proceeds from the sale.)
Cash flows relating to financial transactions, such as obtaining cash by issuing
shares or obtaining loans, the repayment of loans and the payment of dividends
to ordinary shareholders.
1.3 Purpose of a statement of cash flows
A statement of cash flows provides information about where a business obtained its
cash during the financial period, and how it made use of its cash. It also shows
whether there was an increase or a decrease in the amount of cash held by the entity
between the beginning and the end of the period.
A statement of cash flows groups the sources or uses of cash under three broad
headings:
cash from operating activities
cash used in (or obtained from) investing activities
cash paid or received in financing activities.
Cash from operating activities A
Cash used in (or obtained from) investing activities B
Cash paid or received in financing activities. C
= Increase or decrease in cash in the period A + B +C
Any of the items A, B or C could be positive or negative cash flows.
1.4 Cash and cash equivalents
A statement of cash flows reports the increase or decrease in cash and cash
equivalents during the financial period. A statement of cash flows ends as follows:
Net cash inflow (or outflow) during the period A
Cash and cash equivalents at the beginning of the period B
Cash and cash equivalents at the end of the period A + B
The cash inflow (or outflow) during the period can be either a positive or a negative
amount.
For the purpose of a statement of cash flows, cash and cash flow equivalents are
treated as the same:
Cash = cash in hand (= petty cash and other cash not in the bank) + cash in the
business bank account
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Cash equivalents = items that are the equivalent of cash and could be converted
into cash very quickly without risk of loss (= for example cash in a deposit
account or a savings account)
Chapter 14: Statements of cash flows
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Statement of cash flows: indirect and direct methods
The indirect method
The direct method
2 Statement of cash flows: indirect and direct methods
IAS 7 provides two methods of presenting a statement of cash flows, the indirect
method and the direct method. These two methods differ only in the presentation of the
cash flows from operating activities. In all other respects they are exactly the same.
2.1 The indirect method
The indirect method presents the cash flows from operating activities by starting
with the profit before taxation for the period, and making adjustments to the profit
figure to arrive at a cash flow figure. A suggested format for the indirect method is
given below. Illustrative figures are included.
Statementofcashflows:indirectmethod
$ $
Cashflowsfromoperatingactivities
Profitbeforetaxation 80,000
Adjustmentsfor:
Depreciationandamortisationcharges 20,000
Interestchargesintheincomestatement 2,300
Gainsondisposalofnon‐currentassets (6,000)
Lossesondisposalofnon‐currentassets 4,500
100,800
Increase/decreasein:
Increaseintradeandotherreceivables (7,000)
Decreaseininventories 2,000
Increaseintradepayables 3,000
Cashgeneratedfromoperations 98,800
Taxationpaid(taxonprofits) (21,000)
Interestchargespaid (2,500)
Netcashflowfromoperatingactivities75,300
Cashflowsfrominvestingactivities
Purchaseofproperty,plantandmachinery (40,000)
Proceedsfromsaleofnon‐currentassets 6,000
Interestreceived/dividendsreceived 1,500
Netcashusedininvestingactivities(32,500)
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Cashflowsfromfinancingactivities
Proceedsfromissueofshares 30,000
Proceedsfromnewloan 10,000
Repaymentofloan (17,000)
Dividendspaidtoshareholders (25,000)
Netcashusedinfinancingactivities(2,000)
Netincrease/decreaseincash/cashequivalents 40,800
Cash/cashequivalentsatthebeginningoftheyear5,000
Cash/cashequivalentsattheendoftheyear45,800
2.2 The direct method
The direct method is the same in most respects. However, the cash flows from
operations are presented in a different way, as follows:
Statementofcashflows:directmethod
$
Cashflowsfromoperatingactivities
Cashreceiptsfromcustomers 348,800
Cashpaymentstosuppliers (70,000)
Cashpaymentstoemployees (150,000)
Cashpaidforotheroperatingexpenses (30,000)
Cashgeneratedfromoperations 98,800
Taxationpaid(taxonprofits) (21,000)
Interestchargespaid (2,500)
Netcashflowfromoperatingactivities 75,300
The remainder of the statement of cash flows using the direct method is exactly the
same as for the indirect method.
Chapter 14: Statements of cash flows
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Operational cash flows: the indirect method
Profit before taxation
Adjustment for depreciation and amortisation
Adjustment for interest charges in the income statement
Adjustment for gains or losses on disposal of non-current assets
Working capital adjustments: introduction
Interest paid and tax paid
3 Operational cash flows: the indirect method
With the indirect method of presenting a statement of cash flows, adjustments are
made to the figure for profit before tax for the period in order to arrive at a figure
for net cash flow from operating activities.
3.1 Profit before taxation
The starting point for the statement of cash flows for a company is the operating
profit after deducting interest but before taxation.
This profit figure is adjusted to calculate the amount of cash received by the
business or the amount of cash paid out as a consequence of its trading operations.
3.2 Adjustment for depreciation and amortisation
Depreciation charges and amortisation charges are not cash flows. They are
expenses in the income statement, but do not represent payments of cash.
In order to obtain a figure for cash flow from the figure for profit, charges for
depreciation and amortisation must therefore be added back to the profit figure.
3.3 Adjustment for interest charges in the income statement
Because the accruals concept is applied in accounting, the amount of interest
charges in the income statement might differ from the amount of interest actually
paid in the year. Interest charges are accrued for the purpose of measuring profit in
the income statement, and there could be accrued interest charges in the statement
of financial position.
Since interest charges (income statement) and interest payments (cash flow) might
differ, it is necessary in the statement of cash flows to:
add back the interest charge in the income statement, and
deduct the interest actually paid (= the cash payments of interest).
The indirect method of presenting a cash flow statement therefore includes an
adjustment for interest charges. The interest charge in the income statement is
added back as an adjustment. The actual amount of interest paid is deducted later in
the statement.
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3.4 Adjustment for gains or losses on disposal of non-current assets
Gains or losses on the disposal of non-current assets are not cash flows. The gain or
loss is calculated as the difference between:
the net cash received from the disposal, and
the carrying value (net book value) of the asset at the date of disposal.
The relevant cash flow is the net cash received from the sale. In the statement of cash
flows, this is treated as a cash flow from investing activities, not a cash flow from
operating activities.
To prepare a statement of cash flows using the indirect method, the gain or loss on
disposal is shown as an adjustment in the calculation of operating cash flows.
Adjustments from profit to cash flow from operating activities
Deduct any gains on the disposal of non-current assets, or
Add any losses on the disposal of non-current assets.
These adjustments remove the effect of the gain or loss on disposal (a non-cash
item) from the operating profit.
In the section on cash flows from investing activities
Include the net cash flows received from the disposal of non-current assets as cash
inflows.
Example
A company disposed of an item of equipment for $40,000. The equipment had
originally cost $60,000 and the accumulated depreciation charged up to the date of
disposal was $32,000.
$
Cost 60,000
Accumulateddepreciation 32,000
Carryingvalueatdateofdisposal 28,000
Cashproceedsfromsale 40,000
Gainondisposal 12,000
In the statement of cash flows, the gain on disposal of $12,000 should be deducted as
an adjustment to the operating profit. The cash proceeds of $40,000 should be
included as a cash inflow under the heading: ‘Cash flows from investing activities’.
Chapter 14: Statements of cash flows
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Exercise 1
A company made a loss on the disposal of a company motor vehicle of $8,000. The
vehicle originally cost $50,000 and at the date of disposal, accumulated depreciation
on the vehicle was $20,000.
Required
What are the items that should be included for the disposal of the vehicle in the
statement of cash flows for the year:
(a) in the adjustments to get from operating profit to cash flow from operations?
(b) under the heading: ‘Cash flows from investing activities’?
3.5 Working capital adjustments: introduction
In the indirect method of presenting a statement of cash flows, the section on cash
flows from operating activities includes adjustments for:
inventories
trade receivables and prepayments
trade payables and accruals.
These adjustments are explained in the next section of this chapter.
3.6 Interest paid and tax paid
The final items in the operating cash flows part of a statement of cash flows are the
amount of interest paid and the amount of tax paid in the period.
As explained earlier, the amount of interest paid might not be the amount shown in
the income statement for interest charges. Similarly, the cash payments for tax might
not be the same as the tax charge in the income statement.
The amount of these payments can be calculated from figures in the opening and
closing statements of financial position for the period, and the income statement for
the period. The method of calculating the amount of tax paid is as follows:
$
Liability for tax in thestatement of financial position, beginning of
the year A
Taxation charge for the year B
(A + B)
Liability for tax in thestatement of financial position, end of the
year C
Taxation paid in the year (A + B – C)
The amount of interest paid in the year can be calculated in the same way, from the
opening and closing liabilities for interest (accrued interest) and the figure for
interest charges in the income statement.
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Example
A company had liabilities in its statement of financial position at the beginning and at
the end of Year 1, as follows:
Liabilityfor
interestcharges
Liability
fortaxation
BeginningofYear1 $4,000 $53,000
EndofYear1 $3,000 $61,000
During the year, interest charges in the income statement were $22,000 and taxation
on profits were $77,000. The amounts of interest payments and tax payments (cash
flows) for inclusion in the statement of cash flows can be calculated as follows:
TaxInterest
$ $
Liabilityatthebeginningoftheyear 53,000 4,000
Taxationcharge/interestchargefortheyear 77,000 22,000
130,000 26,000
Liabilityattheendoftheyear (61,000) (3,000)
Taxpaid/interestpaidduringtheyear 69,000 23,000
Chapter 14: Statements of cash flows
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Indirect method: adjustments for working capital
Working capital defined
Changes in working capital and the effect on cash flow
Changes in trade and other receivables
Changes in inventory
Changes in trade payables
Summary of the rules for working capital changes
4 Indirect method: adjustments for working capital
With the indirect method of presenting a statement of cash flows, adjustments
should be made for changes in working capital during the year.
4.1 Working capital defined
For the purpose of preparing a statement of cash flows, working capital is defined
as:
$
Inventory A
Plus: Trade and other receivables B
Minus: Trade payables (C)
Working capital A + B – C
Trade and other receivables include any prepayments.
Trade payables include accrued expenses, provided the accrued expenses do not
relate to other items dealt with separately in the statement of cash flows, in
particular:
accrued interest charges
taxation payable.
Interest charges and payments for interest are presented separately in the statement
of cash flows, and so accrued interest charges should be excluded from the
calculation of changes in trade payables and accruals. Similarly, taxation payable is
dealt with separately; therefore taxation payable is excluded from the calculation of
working capital changes.
Accrued interest and accrued tax payable must therefore be deducted for the total
amount for accruals, and the net accruals (after making these deductions) should be
included with trade payables.
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4.2 Changes in working capital and the effect on cash flow
When working capital increases, the cash flows from operations are more than the
operating profit, by the amount of the increase.
Similarly, when working capital is reduced, the cash flows from operations are more
than the operating profit, by the amount of the reduction.
This important point will be explained with several simple examples.
4.3 Changes in trade and other receivables
Sales revenue in a period differs from the amount of cash received from sales by the
amount of the increase or decrease in receivables during the period.
Example: trade and other receivables
A company had receivables at the beginning of the year of $6,000 and at the end of
the year receivables were $9,000. During the year, sales were $50,000 in total.
Purchases were $30,000, all paid in cash. The company holds no inventories. The
operating profit for the year was $20,000 ($50,000 – $30,000).
The cash flow from operations is calculated as follows:
$
Receivablesatthebeginningoftheyear 6,000
Salesintheyear 50,000
56,000
Receivablesatendoftheyear (9,000)
Cashreceived 47,000
Cashpaid(purchases) 30,000
Cashflowfromoperations 17,000
The cash flow is $3,000 less than the operating profit, because receivables increased
during the year by $3,000.
The rule: adjusting from operating profit to operating cash flows to allow for
receivables
When trade and other receivables go up during the year, cash flows from
operations are less than operating profit by the amount of the increase.
When trade and other receivables go down during the year, cash flows from
operations are more than operating profit by the amount of the reduction.
In a statement of cash flows presented using the indirect method, the adjustment for
receivables is therefore: