21 Statements of cash flows

Question 1

Define Cash; Cash equivalents; Cash flows; Operating activities; Investing activities; Financing activities

Answer 1

 Cash comprises cash on hand and demand deposits.  Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.  Cash flows are inflows and outflows of cash and cash equivalents.  Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.  Investing activities are the acquisition and disposal of non-current assets and other investments not included in cash equivalents.  Financing activities are activities that result in changes in the size and composition of the equity capital and borrowings of the entity.

Question 2

Explain Cash and cash equivalents

Answer 2

To fulfil the above definition, an investment’s maturity date should normally be within three months from its acquisition date

Question 3

Explain Operating activities

Answer 3

Most of the components of cash flows from operating activities will be those items which determine the net profit or loss of the entity, ie they relate to the main revenue-producing activities of the entity. The standard gives the following as examples of cash flows from operating activities:

(a) Cash receipts from the sale of goods and the rendering of services (b) Cash receipts from royalties, fees, commissions and other revenue (c) Cash payments to suppliers for goods and services (d) Cash payments to and on behalf of employees

Question 4

The cash flows classified under this heading show the extent of new investment in assets which will generate future profit and cash flows. The standard gives the following examples of cash flows arising from investing activities. WHAT ARE THESE CASHFLOWS CALLED

Answer 4

Investing activities

Question 5

The standard gives the following examples of cash flows arising from investing activities.

Answer 5

Cash payments to acquire property, plant and equipment, intangibles and other non-current assets, including those relating to capitalised development costs and self-constructed property, plant and equipment (b) Cash receipts from sales of property, plant and equipment, intangibles and other non-current assets (c) Cash payments to acquire shares or debentures of other entities (d) Cash receipts from sales of shares or debentures of other entities (e) Cash advances and loans made to other parties (f) Cash receipts from the repayment of advances and loans made to other parties

Question 6

Financing activities 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. The standard gives the following examples of cash flows which might arise under this heading

Answer 6

Cash proceeds from issuing shares (b) Cash payments to owners to acquire or redeem the entity’s shares (c) Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or longterm borrowings (d) Principal repayments of amounts borrowed under finance leases Item (d) needs more explanation. Where the reporting entity uses an asset held under a finance lease, the amounts to go in the statement of cash flows as financing activities are repayments of the principal (capital) rather than the interest. The interest paid will be shown under operating activities.

Question 7

Most of the components of cash flows from operating activities will be those items which determine the net profit or loss of the entity, ie they relate to the main revenue-producing activities of the entity. The standard gives the following as examples of cash flows from operating activities

Answer 7

(a) Cash receipts from the sale of goods and the rendering of services (b) Cash receipts from royalties, fees, commissions and other revenue (c) Cash payments to suppliers for goods and services (d) Cash payments to and on behalf of employees

Question 8

Reporting cash flows from operating activities The standard offers a choice of method for this part of the statement of cash flows

Answer 8

(a) Direct method: disclose major classes of gross cash receipts and gross cash payments (b) Indirect method: net profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows

Question 9

Why is the direct method preferred?

Answer 9

The direct method is the preferred method because it discloses information, not available elsewhere in the financial statements, which could be of use in estimating future cash flows. The example below shows both methods.

Question 10

Using the indirect method This method is undoubtedly easier from the point of view of the preparer of the statement of cash flows. The net profit or loss for the period is adjusted for:

Answer 10

(a) Changes during the period in inventories, operating receivables and payables (b) Non-cash items, eg depreciation, provisions, profits/losses on the sales of assets (c) Other items, the cash flows from which should be classified under investing or financing activities.

Question 11

It is important to understand why certain items are added and others subtracted. Note the following. 5 points

Answer 11

Depreciation is not a cash expense, but is deducted in arriving at profit. It makes sense, therefore, to eliminate it by adding it back. (b) By the same logic, a loss on a disposal of a non-current asset (arising through underprovision of depreciation) needs to be added back and a profit deducted. (c) An increase in inventories means less cash – you have spent cash on buying inventory. (d) An increase in receivables means the company’s debtors have not paid as much, and therefore there is less cash. (e) If we pay off payables, causing the figure to decrease, again we have less cash.

Question 12

Cash flows from interest and dividends received and paid should each be disclosed separately. Each should be classified in a consistent manner from period to period as either operating, investing or financing activities. T/F

Answer 12

Cash flows from interest and dividends received and paid should each be disclosed separately. Each should be classified in a consistent manner from period to period as either operating, investing or financing activities

Question 13

Dividends paid by the entity can be classified in one of two ways:

Answer 13

(a) As a financing cash flow, showing the cost of obtaining financial resources (b) 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

Question 14

Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. Taxation cash flows are often difficult to match to the originating underlying transaction, so most of the time all tax cash flows are classified as arising from operating activities. T/f

Answer 14

Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. Taxation cash flows are often difficult to match to the originating underlying transaction, so most of the time all tax cash flows are classified as arising from operating activities

Question 15

Other disclosures All entities should disclose, together with a commentary by management, any other information likely to be of importance, for example:

Answer 15

(a) Restrictions on the use of or access to any part of cash equivalents (b) The amount of undrawn borrowing facilities which are available (c) Cash flows which increased operating capacity compared to cash flows which merely maintained operating capacity

Question 16

In essence, preparing a statement of cash flows is very straightforward. You should therefore simply learn the format and apply the steps noted in the example below. Note that the following items are treated in a way that might seem confusing, but the treatment is logical if you think in terms of cash

Answer 16

Increase in inventory is treated as negative (in brackets). This is because it represents a cash outflow; cash is being spent on inventory. (b) An increase in receivables would be treated as negative for the same reasons; more receivables means less cash. (c) By contrast an increase in payables is positive because cash is being retained and not used to settle accounts payable. There is therefore more of it.

Question 17

Prepare a statement of cash flows for Kane Co for the year ended 31 December 20X2 in accordance with the requirements of IAS 7, using the indirect method

Answer 17

Step 1 Set out the proforma statement of cash flows with the headings required by IAS 7.

Step 2 Begin with the cash flows from operating activities as far as possible. When preparing the statement from statements of financial position, you will usually have to calculate such items as depreciation, loss on sale of non-current assets, profit for the year and tax paid (see Step 4)
Step 3 Calculate the cash flow figures for purchase or sale of non-current assets, issue of shares and repayment of loans if these are not already given to you

Step 4 Start with profit before tax. You will often be given this. If not it can be calculated by working back from the movement in retained earnings

Step 5 You will now be able to complete the statement by slotting in the figures given or calculated

Question 18

So what kind of information does the statement of cash flows, along with its notes, provide? Some of the main areas where IAS 7 should provide information not found elsewhere in the financial statements are

Answer 18

(a) The relationships between profit and cash can be seen clearly and analysed accordingly. (b) Cash equivalents are highlighted, giving a better picture of the liquidity of the company. (c) Financing inflows and outflows must be shown, rather than simply passed through reserves.

Question 19

One of the most important things to realise at this point is that it is wrong to try to assess the health or predict the death of a reporting entity solely on the basis of a single indicator. When analysing cash flow data, the comparison should not just be between cash flows and profit, but also between cash flows over a period of time (say three to five years). . t/f

Answer 19

One of the most important things to realise at this point is that it is wrong to try to assess the health or predict the death of a reporting entity solely on the basis of a single indicator. When analysing cash flow data, the comparison should not just be between cash flows and profit, but also between cash flows over a period of time (say three to five years).

Question 20

Cash flow figures should also be considered in terms of their specific relationships with each other over time. A form of ‘cash flow gearing’ can be determined by comparing operating cash flows and financing flows, particularly borrowing, to establish the extent of dependence of the reporting entity on external funding. Other relationships can be examined:

Answer 20

(a) Operating cash flows and investment flows can be related to match cash recovery from investment to investment. (b) Investment can be compared to distribution to indicate the proportion of total cash outflow designated specifically to investor return and reinvestment. (c) A comparison of tax outflow to operating cash flow minus investment flow will establish a ‘cash basis tax rate’

Question 21

The advantages of cash flow accounting The advantages of cash flow accounting are:

Answer 21

The advantages of cash flow accounting are: (a) Survival in business depends on the ability to generate cash. Cash flow accounting directs attention towards this critical issue. (b) Cash flow is more comprehensive than ‘profit’ which is dependent on accounting conventions and concepts. (c) Creditors (long and short-term) are more interested in an entity’s ability to repay them than in its profitability. Whereas ‘profits’ might indicate that cash is likely to be available, cash flow accounting is more direct with its message. (d) Cash flow reporting provides a better means of comparing the results of different companies than traditional profit reporting. (e) Cash flow reporting satisfies the needs of all users better: (i) For management, it provides the sort of information on which decisions should be taken (in management accounting, ‘relevant costs’ to a decision are future cash flows); traditional profit accounting does not help with decision-making. (ii) For shareholders and auditors, cash flow accounting can provide a satisfactory basis for stewardship accounting. (iii) As described previously, the information needs of creditors and employees will be better served by cash flow accounting. (f) Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts. (g) They can in some respects be audited more easily than accounts based on the accruals concept. (h) The accruals concept is confusing, and cash flows are more easily understood. (i) Cash flow accounting should be both retrospective, and also include a forecast for the future. This is of great information value to all users of accounting information. (j) Forecasts can subsequently be monitored by the publication of variance statements which compare actual cash flows against the forecast.

Question 22

The Disadvantages of cash flow accounting The advantages of cash flow accounting are:

Answer 22

The main disadvantages of cash accounting are essentially the advantages of accruals accounting (proper matching of related items). There is also the practical problem that few businesses keep historical cash flow information in the form needed to prepare a historical statement of cash flows and so extra record keeping is likely to be necessary

Question 23

What are the Criticisms of IAS 7

Answer 23

The inclusion of cash equivalents has been criticised because it does not reflect the way in which businesses are managed: in particular, the requirement that to be a cash equivalent an investment has to be within three months of maturity is considered unrealistic. The management of assets similar to cash (ie ‘cash equivalents’) is not distinguished from other investment decisions.