ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 9: Statements of cash flows
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The statement of cash flows provides information on the liquidity, viability and
adaptability of the entity, which is not provided by the other financial statements.
A company might have high net assets and large profits, but these are not a
guarantee of financial viability. If the entity makes sales on credit, but later cannot
collect the amounts receivable that it is owed by customers, it may not have cash to
spend on replacing the inventory it has sold, in order to make further sales.
Cash is the lifeblood of a business; the statement of cash flows therefore plays an
important role in understanding the financial position of an entity.
1.2 The basic format of a statement of cash flows
You should already be familiar with the preparation of statements of cash flows for
individual entities, from your earlier studies (although you might have called them
‘cash flow statements’ at the time). The basic rules are revised briefly here.
IAS 7 does not specify a required format for a statement of cash flows. However, it
provides illustrative formats. It also states that cash flows should be presented
under three headings:
cash flows from operating activities
cash flows from investing activities
cash flows from financing activities.
Cash flows are itemised under each of these three headings, and the total cash flow
is also shown for each heading. Together, they explain the total increase or decrease
in cash and cash equivalents during the financial period.
Statements of cash flows, as their name indicates, report cash flows that have
occurred during the period. Non-cash transactions are excluded. For example, if a
company re-values an item of property or makes a bonus issue of shares, these
transactions would not feature in the statement of cash flows because they do not
involve a receipt or payment of cash.
The only non-cash items included in a statement of cash flows are adjustments to
the profit before tax, when the indirect method is used to present cash flows from
operating activities.
1.3 Cash flows from operating activities
Cash flow from operating activities can be presented using one of two methods:
the direct method
the indirect method.
1.4 Cash flows from operating activities: the direct method
The direct method shows the gross cash receipts or the gross cash payments for each
major category of operational cash flows. These will include:
cash receipts from the sale of goods and services
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cash payments to suppliers
cash payments to and on behalf of employees.
However, the cash payments to suppliers and to (and on behalf of) employees may
be combined as a single figure.
No distinction is made between cash flows that relate to the cost of sales,
distribution costs and administrative expenses.
Example
An example of the direct method of presenting cash flows from operating activities
is shown below.
Cashflowsfromoperatingactivities
$000
Cashreceiptsfromcustomers 22,000
Cashpaidtosuppliers (7,000)
Cashpaidtoandonbehalfofemployees (4,000)
Cashpaidforotheroperatingexpenses (2,000)
–––––––––––––
Cashgeneratedfromoperations 9,000
Interestpaid (500)
Incometaxespaid (3,000)
–––––––––––––
Netcashfromoperatingactivities 5,500
–––––––––––––
The cash flows from operating activities have a sub-total for cash generated from
operations. This sub-total is followed by interest payments and income tax
payments (tax on profits).
Calculating cash receipts and cash payments
The cash received from sales can be calculated from the sales figure in the income
statement/statement of comprehensive income and the opening and closing
balances for trade receivables:
$
Trade receivables at the beginning of the year A
Sales in the year B
(A + B)
Trade receivables at the end of the year C
Cash received from sales (A + B – C)
Cash paid to suppliers can be calculated first by establishing purchases for the year.
Purchases are: Opening inventory + Cost of sales – Closing inventory.
Payments to suppliers can then be calculated as: Opening trade payables +
Purchases – Closing trade payables.
Chapter 9: Statements of cash flows
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Similarly payments for wages and salaries can be calculated as:
Opening accrued wages and salaries + Wages and salaries expenses (in the income
statement) – Closing accrued wages and salaries.
Interest payments and income tax payments
The amount of interest paid might not be the amount shown in profit and loss for
interest charges. Similarly, the cash payments for tax might not be the same as the
tax charge reported in profit and loss.
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 (or
profit and loss section of the statement of comprehensive income) for the period.
The method of calculating the amount of tax paid is as follows:
$
Liability for tax, beginning of the year A
Taxation charge for the year B
(A + B)
Liability for tax, 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) in the statement of
financial position and the figure for interest charges in profit or loss.
Example
A company had liabilities in its statement of financial position at the beginning and
at the end of Year 1, as follows:
Liabilityforinterestcharges Liabilityfortaxation
BeginningofYear1 $54,000 $153,000
EndofYear1 $43,000 $181,000
During the year, interest charges reported in profit or loss were $82,000 and taxation
on profits were $257,000. The amounts of interest payments and tax payments (cash
flows) for inclusion in the statement of cash flows can be calculated as follows:
Tax Interest
$ $
Liabilityatthebeginningoftheyear 153,000 54,000
Taxationcharge/interestchargefortheyear 257,000 82,000
––––––––––––––––– –––––––––––––––––
410,000 136,000
Liabilityattheendoftheyear (181,000) (43,000)
–––––––––––––––––– ––––––––––––––––––
Taxpaid/interestpaidduringtheyear 229,000 93,000
–––––––––––––––––– –––––––––––––––––
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1.5 Cash flows from operating activities: the indirect method
The indirect method of presenting cash flows from operating activities is much
more common in practice than the direct method. A statement of cash flows using
the indirect method reports the same figure for ‘Cash generated from operations’
and the same figure for ‘Cash flows from operating activities’ as the direct method.
The difference between the direct and the indirect methods is in the way that the
figure for ‘Cash generated from operations’ is reached.
The indirect method starts with the reported profit before tax for the financial
period, and then makes a number of adjustments to reach the figure for cash flows
from operations. These adjustments to the figure for profit before tax are for all the
non-cash items included in the profit or loss section of the statement of
comprehensive income (the income statement). These non-cash items include the
following:
depreciation and amortisation charges (and impairment of assets)
gains or losses on the disposal of non-current assets
interest charges reported in profit or loss
interest income and dividend income from investments
changes in inventories
changes in trade receivables (and prepayments)
changes in trade payables (and accruals).
An example of the indirect method of presenting cash flows from operating
activities is shown below.
Cashflowsfromoperatingactivities
$000
Profitbeforetaxation 9,140
Adjustmentsfor:
Depreciation 750
Gainondisposalofplantandmachinery (300)
Interestexpense 460
Interestincome (150)
–––––––––––––
9,900
Increaseintradeandotherreceivables (300)
Decreaseininventories 800
Increaseintradepayables 400
–––––––––––––
Cashgeneratedfromoperations 10,800
Interestpaid (500)
Taxonprofitspaid (3,000)
–––––––––––––
Netcashfromoperatingactivities 7,300
–––––––––––––
Chapter 9: Statements of cash flows
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Adjustment for depreciation and amortisation
Depreciation charges and amortisation charges are not cash flows. They are
expenses charged against profit, but do not represent payments of cash. In order to
derive a figure for cash flow from the figure for profit, charges for depreciation and
amortisation must therefore be added back to the profit figure.
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.
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.
Adjustment for interest charges in profit or loss
Because the accruals concept is applied in accounting, the amount of interest
charges included in profit or loss might differ from the amount of interest actually
paid in the year. It is therefore necessary in the statement of cash flows to:
add back the interest charge in profit or loss, 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 in profit or loss is added back as
an adjustment. The actual amount of interest paid is deducted lower down in the
statement (after ‘Cash generated from operations’).
Adjustment for interest received and dividends received from investments
If the profit before tax includes interest received or dividends received from
investments, these should be deducted in calculating the cash generated from
operations. Interest and dividend receipts are treated as cash flows from investing
activities in the statement of cash flows, and so are shown in a different part of the
statement.
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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. ‘Working capital’ is
defined here as:
trade receivables and other receivables, plus prepayments
inventory
trade payables including accruals, excluding accrued interest and tax liabilities
When working capital increases, the cash flows from operations are less than the
operating profit, by the amount of the increase.
Similarly, when working capital is reduced, the cash flows from operations are less
than the operating profit, by the amount of the reduction.
When the indirect method is used to present cash flows from operating activities,
adjustments are therefore needed for these working capital items, to get from
‘profit’ to ‘cash flow’.
If there is an increase in working capital, the amount of the increase is subtracted
to get from ‘profit’ to ‘cash flow’. Increases in receivables and inventory and
reductions in trade payables are therefore deducted.
If there is a reduction in working capital, the amount of the reduction is added to
get from ‘profit’ to ‘cash flow’. Reductions in receivables and inventory and
increases in trade payables are therefore added.
The amount of the increase or decrease in each item is calculated by comparing the
amounts in the opening and closing statements of financial position. (Note: with
consolidated statements of cash flows, an adjustment has to be made when a
subsidiary is acquired or disposed of in the year. This point is explained later.)
The basic rules are set out in the following table:
Statement of cash flows: adjustments to get from profit before tax to cash flow
from operations
Increase in trade and other receivables
Subtract
Increase in inventory
Subtract
Increase in trade payables Add
Decrease in trade and other receivables Add
Decrease in inventory Add
Decrease in trade payables
Subtract
Chapter 9: Statements of cash flows
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Example
A company made an operating profit before tax of $107,000 in the year just ended.
Depreciation and amortisation charges were $66,000. There was a gain of $35,000 on
disposals of non-current assets and there were no interest charges. Values of
working capital items at the beginning and end of the year were:
Receivables Inventory Tradepayables
Beginningoftheyear $39,000 $22,000 $17,000
Endoftheyear $31,000 $45,000 $24,000
Taxation paid was $27,000.
Required
Calculate the amount of cash generated from operations, as it would be shown in a
statement of cash flows using the indirect method.
Answer
$ $
Cashflowsfromoperatingactivities
Profitbeforetaxation 107,000
Adjustmentsfor:
Depreciationandamortisationcharges 66,000
Gainsondisposalofnon‐currentassets (35,000)
–––––––––––––––– ––––
138,000
Decreaseintradeandotherreceivables 8,000
Increaseininventories (23,000)
Increaseintradepayables 7,000
Cashgeneratedfromoperations 130,000
Taxationpaid(taxonprofits) (27,000)
–––––––––––––––– ––––
Netcashflowfromoperatingactivities103,000
1.6 Cash flows from investing activities
This is the second part of a statement of cash flows. It can include both inflows and
outflows but only those cash outflows that result in the recognition of an asset are
eligible for classification as investing activities.
Cash flows in this section of the statement of cash flows include the following:
cash paid to purchase non-current assets (property, plant and equipment)
cash received from the disposal of non-current assets
cash paid to acquire a subsidiary
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cash received from the sale of shares in a subsidiary
interest received from investments (cash received)
dividends received from investments (cash received).
Cash flows arising from the acquisition or the disposal of a subsidiary are explained
later.
Cash paid for the purchase of non-current assets
When there are no disposals or revaluations of non-current assets during the year,
purchases of non-current assets (normally assumed to be the amount of cash paid
for these purchases) may be calculated in either of the following ways:
Method 1
Non-current assets at cost at the end of the year
A
Non-current assets at cost at the beginning of the year
(B)
Equals purchases of non-current assets during the year
A – B
(Assumed to be cash flows during the year)
Method 2
Non-current assets at carrying amount (net book value or NBV) at the
end of the year
X
Minus: Non-current assets at carrying amount (NBV) at the beginning
of the year
(Y)
Plus: The depreciation and amortisation charge for the year.
Z
X + Z – Y
When there are disposals of non-current assets during the year, the purchases of
non-current assets may be calculated as follows:
$
Assets at cost at the end of the year A
Assets at cost at the beginning of the year B
(A – B)
Disposals during the year: original asset cost C
Purchases A – B + C
Example
The property, plant and equipment of Entity P at the beginning and the end of its
financial year were as follows:
Atcost
Accumulated
depreciation
Netbookvalue
$ $ $
Beginningoftheyear 550,000 (125,000) 425,000
Endoftheyear 680,000 (148,000) 532,000
Chapter 9: Statements of cash flows
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During the year a vehicle was disposed of for a gain of $34,000. The original cost of
this asset was $200,000.
The cash paid for plant and equipment in the year (purchases) may be calculated as
follows:
$
Assetsatcostattheendoftheyear
680,000
Assetsatcostatthebeginningoftheyear 550,000
130,000
Disposalsduringtheyear:originalassetcost 200,000
Purchases
330,000
When there are revaluations during the year
When there are revaluations of non-current assets during the year, the purchases of
non-current assets should be calculated as follows:
Purchases of property, plant and equipment
$
Property, plant and equipment:
At cost or valuation, at the end of the year A
At cost or valuation, at the beginning of the year B
A – B
Add: Cost/re-valued amount of assets disposed of in the year C
Subtract: Any asset revaluation during the year (D)
Purchases during the year (A – B) + C – D
Cash from disposals of non-current assets
A statement of cash flows should include the net cash received from any disposals
of non-current assets during the period. This might have to be calculated from the
gain or loss on disposal and the carrying amount of the asset at the time of its
disposal.
Disposal of property, plant and equipment
Property, plant and equipment: $
At cost (or re-valued amount at the time of disposal) A
Accumulated depreciation, at the time of disposal (B)
Net book value/carrying amount at the time of disposal (A – B)
Gain or (loss) on disposal C
Net disposal value (assumed cash flow)
(A – B) + or – C
If there is a gain on disposal, the net cash from the disposal is more than the
carrying value.
If there is a loss on disposal, the net cash from the disposal is less than the carrying
value.
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Example
During an accounting period, an entity disposed of some equipment and made a
gain on disposal of $15,000. The equipment originally cost $120,000 and at the time
of its disposal, the accumulated depreciation on the equipment was $77,000.
What was the amount of cash obtained from the disposal of the asset?
Answer
Disposalofequipment
$
Atcost
120,000
Accumulateddepreciation,atthetimeofdisposal (77,000)
–––––––––––––––– ––––
Carryingamountatthetimeofdisposal 43,000
Gainondisposal
15,000
–––––––––––––––– ––––
Netdisposalvalue(assumedcashflow) 58,000
–––––––––––––––– ––––
1.7 Cash flows from financing activities
The third part of a statement of cash flows, after cash flows from investing activities,
is cash flows from financing activities. These cash flows include:
cash proceeds from issuing new shares
cash proceeds from a new loan or issuing new bonds
cash paid to redeem shares or bonds
cash paid to redeem a loan
payment of finance lease obligations (reductions in liabilities to lessors)
usually, dividends paid to shareholders (although these might be included as
operating cash flows instead of financing cash flows).
Cash from new share issues
The cash raised from new share issues can be established by comparing the equity
share capital and the share premium in the statements of financial position at the
beginning and the end of the year.
$
Share capital + Share premium at the end of the year A
Share capital + Share premium at the beginning of the year B
= Cash obtained from issuing new shares in the year (A – B)