2. Format of the Statement of Cash Flows

Question 1

What does cash flows from operating activities consist of? (4)

Answer 1

Cash flows from operating activities can consist of:
1. Cash receipts from the sale of goods and rendering of services
2. Cash receipts from royalties, fees, commissions and other revenue
3. Cash payments to suppliers for goods and services
4. Cash payments to and on behalf of employee

Question 2

What two possible layouts for cash generated from operations does IAS 7 allow?

Which is preferred and why?

Answer 2

1. The indirect method
2. The direct method

The direct method is preferred by IAS 7, as it is more easily understood by the users, but is not compulsory. In practical terms, the indirect method is likely to be easier and less time consuming to prepare and is more likely to be examined.

Note: In the exam, you should use the indirect method, unless the question specifies otherwise.

Question 3

Using the direct method, how would cash generated from operations be analysed?

Why are certain items added and other deducted?

Why are entities encouraged to use this method?

Answer 3

Using the direct method, cash generated from operations would be analysed as follows and shown as a note to the statement of cash flows:

Cash generated from operations for the year ended December 20X4:

Cash received from customers X
Cash payments to suppliers (X)
Cash payments to and on behalf of employees (X)
Cash generated from operations X

The reasons for certain items being added and others being deducted is very straightforward with this method - cash inflows are added and cash outflows are deducted.

Entities are encouraged to use this method as it provides information that is not available under the indirect method which may be useful in estimating future cash flows.

Question 4

Using the indirect method, how is cash generated from operations calculated?

Answer 4

Using the indirect method, cash generated from operations is calculated by performing a reconciliation between:
1) Profit/(Loss) before tax as reported in the statement of profit or loss
2) Cash generated from operations

Question 5

How is the reconciliation in the indirect method of calculating cash generated from operations produced?

Answer 5

Reconciliation of profit/(loss) before tax to cash generated from operations for the year ended 31 December 20X4

Profit/(loss) before tax X
Finance Cost X
Finance Income (X)
Depreciation Charge X
Amortisation Charge X
Impairment Loss X
Loss/(Profit) on disposal of non-current assets X/(X)
(Increase)/decrease in inventories (X)/X
(Increase)/decrease in trade and other receivables (X)/X
(Increase)/decrease in prepayments (X)/X
Increase/(decrease) in trade and other payables X/(X)
Increase/(decrease) in accruals X/(X)
Increase/(decrease) in provisions X/(X)
Cash generated from operations X

Question 6

Why are depreciation, amortisation and impairment losses added to profit to calculate cash generated from operations?

Answer 6

Depreciation, amortisation and impairment losses are not cash expenses, but are deducted in arriving at the profit figure in the statement of profit or loss.

It makes sense, therefore, to add them back to profit before tax to eliminate the impact of these non-cash expenses.

Question 7

How is a loss/profit on the disposal of a non-current asset treated in calculating cash generated from operations?

Answer 7

A loss on a disposal of a non-current asset (arising through the under provision of depreciation) needs to be added back and a profit on disposal needs to be deducted.

Remember: the profit or loss on disposal is NOT the same as the proceeds received on the sale. The proceeds received are a cash flow, but they are presented in the investing activities section rather than the operating activities section.

Question 8

How is an increase in inventory treated in calculating cash generated from operations?

Answer 8

An increase in inventory means the company has spent cash on buying/manufacturing the inventory and is therefore deducted.

Question 8

How is an increase in receivables treated in calculating cash generated from operations?

Answer 8

An increase in receivables means that more of the revenue included in profit before tax has not been collected and therefore the company has less cash and so is deducted.

Question 9

How is a prepayment treated in calculating cash generated from operations?

Answer 9

Prepayments result in cash being paid out before expenses are incurred and therefore an increase in prepayments is negative for a company’s cash flow and so are deducted.

Question 10

How would a decrease in payables be treated in calculating cash generated from operations?

Answer 10

If a company pays off its payables, causing the figure to decrease, again it has less cash. So a decrease in payables is deducted to arrive at the cash flow generated from operations.

Question 11

How do accruals affect cash generated from operations?

Answer 11

Accruals result in cash being paid out after the expenses are incurred and therefore an increase in accruals is positive for a company’s cash flow.

Question 12

How is a provision treated in calculating cash generated from operations?

Answer 12

Provisions are not cash flows - the cash flow occurs when the related expense is paid. An increase in provision will have decreased profit before tax and required to be added back when calculating cash generated from operations.

Question 13

How are finance costs and finance income treated in calculating cash generated from operations?

Answer 13

Finance costs are added back and finance income is deducted as they are not part of the cash generated from operations sub-total.

Finance costs form part of the interest paid calculation which is included in arriving at cash flow from operating activities and finance income forms part of the interest received calculation which is included in the investing activities section.

In the exam a negative sign or parentheses should be used to denote a negative number.

Question 14

To arrive at ‘net cash from operating activities’, what must the cash generated from operations be adjusted for? (2)

Answer 14

1. Tax paid - cash flows from operating activities also include payments and refunds of income tax unless they can be specifically identified with investing or financing activities. Income tax payments relate to profits from operations and so they are a cash flow from operating activities;
2. Interest paid - cash amounts of interest paid in the period may be presented in either the operating activities or financing activities section. In ‘Accounting’ it is always assumed that interest paid is presented in operating activities. For the purposes of ‘Accounting’, it is always assumed that interest received is presented in investing activities.

Question 15

How can the cash flows for interest paid and income tax paid be calculated?

What items of information are required?

Answer 15

For each item , the following information may be available:
1. Opening balance at the start of the period (opening statement of financial position)
2. Statement of profit or loss (the amount of the item, as reported)
3. Closing balance at the end of the period (closing statement of financial position)

The cash flow is a balancing figure obtained from these three figures.

A T Account can be used as a working.

Question 16

What calculation can be used to calculate payments of income tax in the year?

Answer 16

The opening and closing statements of financial position will show a liability for income tax.

The income tax charge for the year is shown in the statement of profit or loss.

The figure for income taxes paid during the year is derived as a balancing figure.

Question 17

What items could included in the calculation of cash flows from investing activities? (6)

Answer 17

1. Cash payments to acquire property, plant and equipment, intangible assets and other non-current assets, including those relating to capitalised development costs and self-constructed property, plant and equipment
2. Cash receipts from sales of property, plant and equipment, intangible assets and other non-current assets
3. Cash payments to acquire equity or debt of other entities
4. Cash receipts from sales of equity or debt of other entities
5. Interest received
6. Dividends received

Question 18

How can you calculate cash receipts from sales of property, plant and equipment?

Answer 18

A T-account can be used for calculating the cash receipts from sales of property, plant and equipment (PPE).

The company’s account will include the amount of any profit or loss on disposal.

A note to the accounts on non-current assets will show the cost and the accumulated depreciation for property, plant and equipment disposed of during the year. The cash received from the sale is the balancing figure in the T-account.

Question 19

What is cash flow from financing activities?

Answer 19

This section of the statement of cash flows shows the share of cash which the entity’s capital providers have claimed during the period.

This is an indicator of likely future interest and dividend payments.

Question 20

Give examples of cash flows that arise from financing activities? (4)

Answer 20

1. Proceeds from issue of shares
2. Movement in borrowings
3. Dividends paid
4. Net cash from/(used in) financing activities

Question 21

How can the cash received from the issue of new shares be calculated?

Answer 21

The amount of cash received from new issues of shares can usually be calculated from the opening and closing statement of financial position figures for share capital and share premium, adjusted to take account of bonus share issues.

Recall that a company may make a bonus issue of shares from its retained earning or share premium accounts (or both). Remember that in a bonus issue, the new share capital is created by means of reducing the reserve account rather than by a cash issue.

If the bonus issue is made from retained earnings, the amount of the bonus issue must be reflected. No adjustment is needed in respect of bonus issues made from share premium.

Question 22

Why is calculating cash flows from the issue of shares difficult? What is required to do this?

Answer 22

Calculating the cash flows from the issue of shares, particularly when there is a bonus issue, can be difficult and requires understanding of the accounting adjustments to account for such transactions to then work back to calculate the cash flows.

This is a good example of the practical approach needed when calculating cash flows - the information in the opening statement of financial position and the notes regarding any bonus issues to from an expected balance for share capital/premium and compare it to the actual balances to determine the cash flow.

Question 23

How can the cash from raising a loan be calculated?

Answer 23

The cash derived from obtaining a new loan during the year should be apparent from a comparison of the opening and closing statement of financial position figures for non-current interest-bearing borrowings.

You should assume that an increase during the year represents new financing and should be taken as the amount of cash received from financing.

Question 24

What loans in the statement of financial position should be taken into consideration when calculating the cash from raising a loan?

Answer 24

It is important that all loans in the statement of financial position should be taken into consideration in the calculation.
There may be a loan that is within 12 months of repayment. If so, it will be included within current liabilities in the year-end statement of financial position as ‘short-term borrowings’, when it would have been a non-current liability in the statement of financial position at the start of the year.
The loan has not been repaid during the year, merely re-classified from non-current liability to current liability.

Question 25

How should cash flows from dividends be disclosed?

Give two ways in which they can be classified? (2)

Answer 25

Cash flows from dividends paid should be disclosed separately.

Under IAS 7, dividends paid by the entity can be classified in one of two ways:
1. As a financing cash flow, showing the cost of obtaining financial resources - This is the presentation adopted in ‘Accounting’.
2. As a component of cash flows from operating activities so that users can assess the entity’s ability to pay dividends out of operating cash flows.

In the exam, you should always present dividends paid as a financing cash outflow.