Chapter 16 Statement of cash flows

Question 1

1.1 The importance of cash and the need for a statement of cash flow

Answer 1

Profitable businesses can face cash shortages due to the fact that profit and cash are different. Net cash flow is all cash received by a company in a period less all cash paid out. Profit is the result of recording income and expenses in the period to which they relate (accruals concept) regardless of if cash is paid. Profit is reached after charging non-cash expenses such as depreciation. Net cash flow does not equal profit.
Profit is a key performance indicator, but cash flow can be more important in the going concern status of a company. Without cash, credit suppliers cannot be paid, and a company can be wound up. IAS 7 requires companies to produce a statement of cash flows, to see the business has generated positive cash flows. Statements of cash flow are:
- Factual/objective: they are not influenced by accounting policies and accounting estimates
- Easily understood by users
- Provide extra information on business activities
- Allows users to assess the future prospects of a business
- Show how adaptable a company is
- Show whether a company is in a position to pay amounts as they fall due
- Facilitate comparison between companies by requiring the use of standard headings

Question 2

2.1 Format of a statement of cash flow

Answer 2

Cash flows from operating activities: principal revenue producing activities of the business, including day to day trading.
Cash flows from investing activities: associated with the purchase and sale of non-current assets and income from investments held.
Cash flows from financing activities: associated with the long term financing of a company
Cash and cash equivalents includes cash in hand and deposits available on demand. Cash equivalents is liquid assets with a maturity date less than 3 months in the future.
The change in cash and cash equivalents is calculated as the net of all cash flows identified in the cash flow statement. This figure reconciles to the difference between the brought forward and carried forward statement of financial position figure for cash and cash equivalents. Cash equivalents are shown together with cash in order to recognise the fact that they are highly liquid and will be converted to cash within a short timescale.

Question 3

3.1 How to calculate cash flows from operating activities

Answer 3

Direct method (IAS 7 prefers this method but use the indirect method in the exam unless stated otherwise). Cash sales + cash received from credit customers – cash purchases – cash paid to credit suppliers – cash expenses = cash generated from operations.
Indirect method: profit before tax + finance cost - investment income + depreciation charge + loss/(profit) on disposal of non-current assets + amortisation + decrease/(increase) in inventories + decrease/(increase) in trade receivables + increase/(decrease) in trade payables
Adjustments to profit before tax:
- Finance cost: added back to profit as it is not part of cash from operations and may include accrued amounts
- Investment income: deducted as it is not part of cash from operations, from investing activities
- Deprecation and amortisation charge: added back as it is a non-cash item
- Loss/profit on disposal: added back because non-cash item
- Decrease in inventories: added on because the decrease liberates extra cash
- Increase in trade receivables: deducted because this income has not yet been realised as cash
- Decrease in trade payables: deducted as the reduction in payables reduces cash

Question 4

3.2 Other cash flows from operating activities

Answer 4

Cash outflows may include interest paid and income taxes paid.
The cash flow should be calculated by reference to the charge to profits from the item (shown in SoPL) and any opening or closing payable balance shown on the SoFP.

Question 5

4.1 Investing activities

Answer 5

Cash inflows may include interest received, dividends received and proceeds from sale of equipment, outflows may include purchase of property, plant, and equipment.
Th calculations of interest and dividends received takes account of both the income receivable in the profit and loss and any relevant receivables balance from the opening and closing statement of financial position.
The calculation of property, plant and equipment requires T accounts of cost accounts, accumulated depreciation accounts and disposals accounts. Data provided in the source financial statements should then be entered into these T accounts and required cash flows found (often as balancing figures).

Question 6

5.1 Financing activities

Answer 6

Cash inflows may include proceeds of share issues and issue of loans/debentures. Outflows may include repayment of loans and dividends paid. The calculation of share issue proceeds is the comparison of the sum brought forward and sum carried forward balances on the share capital and share premium accounts.
The calculation of proceeds of issues of loans is derived by subtracting the brought forward balance from the carried forward.
Calculation of dividends paid ordinary dividends are accounted for when paid and irredeemable preference dividends on an accruals basis.