ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Chapter 17: Statements of cash flows
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Overview of statements of cash flows
The sections of a statement of cash flows
Examples of a statement of cash flows
2 Overview of statements of cash flows
2.1 The sections of a statement of cash flows
The content and format of statements of cash flows are specified by IAS7
Statements of cash flows. IAS7 does not specify what the exact format of a
statement of cash flows should be, but it provides suggested layouts in an appendix.
Entities are required by IAS7 to report cash flows for the period under three
headings:
cash flows from operating activities
cash flows from investing activities
cash flows from financing activities.
All cash flows (except for changes from cash to cash equivalents or from cash
equivalents to cash) can be included in one of these three categories.
Together, the cash flows arising from these three categories of activity explain the
increase or decrease in cash and cash equivalents during the financial period.
The cash flows for each category might be positive or negative. The total of the cash
flows for all three categories together explains the overall increase or decrease in
cash and cash equivalents during the period.
Cash flows from operating activities
Operating activities are the normal trading activities of the entity. Cash flows from
operating activities are the cash inflows or cash outflows arising in normal trading
activities.
Operating activities normally provide an operating profit before tax. However,
profit is not the same as cash flow, and the cash flows from operating activities are
different from profit.
A statement of cash flows normally makes a distinction between:
cash generated from operations, which is the cash from sales less the cash
payments for operating costs, and
net cash from operating activities, which is the cash generated from operations,
less interest payments and tax paid on profits.
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Cash flows from operating activities exclude cash from the disposal of non-current
assets, such as the sale of land and buildings or machinery.
Cash flows from investing activities
The second section of a statement of cash flows shows cash flows from investing
activities. Investing activities are defined by IAS7 as ‘the acquisition and disposal of
long-term assets and other investments not included in cash equivalents’. They
include both:
investing in new non-current assets, for example by purchasing new items of
property, plant and equipment
disinvesting, by disposing of items of property, plant and equipment.
Cash flows from investing activities might also include cash received from
investments, such as interest or dividends received.
Cash flow from financing activities
The third section of the statement of cash flows shows the cash flows from financing
activities. These activities are defined by IAS7 as ‘activities that resulting changes in
the size and composition of the contributed equity and borrowings of the entity.’
They include cash flows from:
the issue or buy-back of shares for cash
the issue of bonds or the redemption of bonds (for cash)
new loans and the repayment of loan principal
normally, the payment of dividends to equity shareholders.
2.2 Examples of a statement of cash flows
This chapter explains how a statement of cash flows should be prepared for a single
company. It might be useful to look at some examples of a complete statement of
cash flows (for a single company) before looking in closer detail at how they are
prepared.
IAS7 permits two methods of presenting the cash flows from operating activities:
the direct method, and
the indirect method.
The two methods differ only in the way that they present the cash flows for cash
generated from operations. In all other respects, the figures in the statement of cash
flows using the direct method are identical to the figures in a statement using the
indirect method – cash flows from investing activities and financing activities are
presented in exactly the same way.
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Example: the direct method
The example here uses the ‘direct method’ of presenting the cash flows from
operating activities.
Entity AZ
Cash flow statement for the year ended 31 December Year 9
$000 $000
Cash flows from operating activities
Cash receipts from customers 5,700
Cash payments to suppliers and employees (4,350)
–
––––
Cash generated from operations 1,350
Interest paid (200)
Taxation paid (400)
–
––––
Net cash from operating activities 750
Cash flows from investing activities
Purchase of property, plant and equipment (640)
Proceeds from the sale of equipment 70
Interest received 40
Dividends received 20
–
––––
Net cash used in investing activities (510)
Cash flows from financing activities
Proceeds from the issue of share capital 800
Proceeds from long-term loan 200
Redemption of debt securities (620)
Payment of finance lease liability (30)
Dividends paid (450)
–
––––
Net cash inflow from financing activities (100)
–––––
Net increase in cash and cash equivalents 140
Cash and cash equivalents at the beginning of the period 35
–––––
Cash and cash equivalents at the end of the period 175
–––––
Example: the indirect method
The example below shows how the same entity might use the ‘indirect method’ of
presenting the cash flows from operating activities.
Entity AZ
Cash flow statement for the year ended 31 December Year 9
$000 $000
Cash flows from operating activities
Profit before taxation 585
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Adjustments for:
Depreciation and amortisation 400
Investment income (60)
Interest expense 190
Loss on disposal of non-current asset 250
–––––
1,365
Increase in trade and other receivables (45)
Decrease in inventories 16
Increase in trade payables 14
–––––
Cash generated from operations 1,350
Interest paid (200)
Taxation paid (400)
–––––
Net cash from operating activities 750
Cash flows from investing activities
Purchase of property, plant and equipment (640)
Proceeds from the sale of equipment 70
Interest received 40
Dividends received 20
–––––
Net cash used in investing activities (510)
Cash flows from financing activities
Proceeds from the issue of share capital 800
Proceeds from long-term loan 200
Redemption of debt securities (620)
Payment of finance lease liability (30)
Dividends paid (450)
–––––
Net cash inflow from financing activities (100)
–
––––
Net increase in cash and cash equivalents 140
Cash and cash equivalents at the beginning of the period 35
–
––––
Cash and cash equivalents at the end of the period 175
–
––––
If you compare the two statements of cash flows, you will see that the figures in the
two statements are identical from ‘Cash generated from operations’ down to the
end. The only differences are in the presentation of the cash flows that produced the
‘Cash generated from operations’.
IAS7 allows entities to use either method of presentation.
Chapter 17: Statements of cash flows
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Preparing a statement of cash flows: cash flows from operating
activities – 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, taxation and dividends
Interest paid and tax paid
3 Preparing a statement of cash flows: cash flows from
operating activities – indirect method
With the indirect method of presenting statements 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 (i.e. profit after tax).
Adjustments are then made to this profit figure in order to calculate the amount of
cash received by the entity (or the amount of cash paid out) as a consequence of its
trading operations.
All the adjustments are for items that have affected profit but that do not represent cash
flows. The purpose of the adjustments is to work toward a figure for cash flow from
operating activities.
3.2 Adjustment for depreciation, amortisation and impairment
Depreciation charges and amortisation charges are not cash flows. They are
expenses that have reduced profit, but they do not represent payments of cash.
In order to obtain a figure for cash flow from the figure for profit, the charges for
depreciation and amortisation must therefore be added back to the profit figure.
In the same way, any impairment of non-current assets charged as an expense in
profit or loss is not a cash flow, and should be added back to the profit before tax
figure to arrive at a figure for cash generated from operations.
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Calculating the depreciation charge
You might be required in an examination question to calculate the depreciation
charge for the year, for inclusion in the statement of cash flows. A method of
calculating the depreciation charge is:
$ $
Accumulated depreciation at end of year A
Accumulated depreciation at beginning of year B
Accumulated depreciation on disposals during the year (C)
(B – C) = D
Depreciation charge for the year A – D
Alternatively, the figure can be calculated by reconstructing the ledger account:
Accumulateddepreciation
$
Disposals C
Balancec/d A
_______
X
_______
$
Balanceb/d B
Depreciationchargefor
theyear(balancingfigure) X
_______
X
_______
3.3 Adjustment for interest charges in profit or loss
Because the accruals concept is applied in accounting, the amount of interest
charges in profit r loss for the year might differ from the amount of interest actually
paid in the year. Interest charges are accrued for the purpose of measuring profit,
and there could be accrued interest charges in the statement of financial position.
Since interest charges (in profit or loss) and interest payments (cash flow) might
differ, it is necessary in the statement of cash flows to:
add back the interest charge for the year, and
deduct the interest actually paid (= the cash payments of interest).
The indirect method of presenting a statement of cash flows therefore includes an
adjustment for interest charges. The interest charge against profit for the year is
added back as an adjustment. The actual amount of interest paid is deducted later in
the statement.
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.
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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. These are reported as cash flows from investing activities, not cash flows
generated from operations.
Example
A company disposed of an item of equipment for $80,000. The equipment had
originally cost $150,000 and the accumulated depreciation charged up to the date of
disposal was $100,000. The costs of disposal were $5,000.
$
Cost 150,000
Accumulateddepreciation 100,000
–
––––––
Carryingvalueatdateofdisposal 50,000
Cashproceedsfromsale,minusdisposalcosts 75,000
–
––––––
Gainondisposal 25,000
–
––––––
In the statement of cash flows, the gain on disposal of $25,000 should be deducted as
an adjustment to the operating profit. It is not the cash flow from the disposal of the
asset. The net cash proceeds of $75,000 should be included as a cash inflow 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.
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3.6 Interest, taxation and dividends
The previous examples of the indirect and the direct methods of presenting
statements of cash flows both include interest paid and tax paid as operating cash
flows. The two methods of presentation are identical after the figure for cash
generated from operations.
However, IAS7 allows some variations in the way that cash flows for interest and
dividends are presented in a statement of cash flows, although the following should
be shown separately:
interest received
dividends received
interest paid
dividends paid.
Interest payments
IAS7 states that there is no consensus about how to treat interest payments by an
entity, other than a financial institution such as a bank. Interest payments may be
classified as either:
an operating cash flow, because they are deducted when calculating operating
profit before taxation, or
a financing cash flow, because they are costs of obtaining finance.
In examples of statements of cash flows in the appendix to IAS7, interest paid is
shown as a separate line item within cash flows from operating activities. This
approach is therefore used here.
Interest and dividends received
Interest received and dividends received may be classified as either:
an operating cash flow, because they are added when calculating operating
profit before taxation, or
an investing cash flow, because they represent returns on investment.
In examples of statements of cash flows in the appendix to IAS7, interest received
and dividend received are shown as separate items within cash flows from
investing activities. This approach is therefore used here.
Dividends paid
IAS7 allows dividend payments to be treated as either:
a financing cash flow because they are a cost of obtaining financial resources, or
a component of the cash flows from operating activities, in order to assist users
to determine the ability of the entity to pay dividends out of its operating cash
flows.
Chapter 17: Statements of cash flows
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In examples of statements of cash flows in the appendix to IAS7, dividends paid are
shown as a line item within cash flows from financing activities. This approach is
therefore used here.
Taxes on profits
Cash flows arising from taxation on income should normally be classified as a cash
flow from operating activities (unless the tax payments or refunds can be
specifically associated with an investing or financing activity).
The examples of statements of cash flows in this chapter therefore show both
interest paid and tax paid as cash flow items, to get from the figure for cash
generated from operations to the figure for ‘net cash from operating activities’.
3.7 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 of interest
expense charged against profit. Similarly, the cash payments for tax might not be
the same as the tax charge for the year.
The amount of the payments of interest and tax can be calculated from figures in the
opening and closing statements of financial position for the period, and the
statement of comprehensive income for the period.
Payments of taxation
The method of calculating the amount of tax paid is as follows:
$
Liabilityfortaxinthestatementoffinancialposition,beginning
oftheyear
A
Taxationchargefortheyear B
–––––––
(A+B)
Liabilityfortaxinthestatementoffinancialposition,endofthe
year
C
–––––––
Taxationpaidintheyear (A+B–C)
–––––––
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Alternatively, the figure can be calculated by reconstructing a ledger account:
Taxationliability
$
Cashpaid(balancingfigure) X
Balancec/d C
_______
X
_______
$
Balanceb/d A
Taxchargefortheyear B
_______
X
_______
However, the taxation liability should include the deferred tax liability as well as
the current tax liability, and the tax charge for the year is the total amount of tax
charged against profit (current tax, deferred tax and adjustment for under- or over-
provision of tax in the previous year).
Interest payments
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 for the year.
$
Liabilityforinterestinthestatementoffinancialposition,
beginningoftheyear
A
Interestchargefortheyear B
–––––––
(A+B)
Liabilityforinterestinthestatementoffinancialposition,endof
theyear
C
–––––––––
Interestpaidintheyear (A+B–C)
–––––––––
Example
A company had liabilities in its statements of financial position at the beginning and
at the end of Year 1, as follows:
Liabilityforinterestcharges Liabilityfortaxation
BeginningofYear1 $17,000 $102,000
EndofYear1 $19,000 $131,000
During the year, interest charges in the income statement were $66,000 and taxation
on profits were $277,000. The amounts of interest payments and tax payments (cash
flows) for inclusion in the statement of cash flows can be calculated as follows: