Statement of cash flows

Chapter learning objectives

Upon completion of this chapter you will be able to:

● explain the differences between profit and cash flows

● explain the need for management to control cash flows
● explain the value of a statement of cash flows to users of financial
statements
● explain the inward and outward flows of cash in a typical company
● calculate cash flows from operating activities using the indirect method
● calculate cash flows from operating activities using the direct method
● calculate the cash flows from investing activities
● calculate the cash flows from financing activities
● prepare extracts from statement of cash flows from given information.

1 The need for a statement of cash flows

Profit and liquidity

The accounting concepts of accruals and matching are used to compute a profit figure which
shows the additional wealth created for the owners of a business during an accounting period.
However, it is important for a business to generate cash as well as to make profits. The two do
not necessarily go hand in hand.

Objectives of IAS 7

The Objectives of IAS 7 are to ensure that companies:

● Report their cash generation and cash absorption for a period by highlighting the
significant component of cash flow in a way that facilitates comparison of the cash flow
performance different businesses.
● provide information that assists in the assessment of their liquidity, solvency and
financial adaptability.

The importance of statements of cash flow

Statement of cash flow is an important statement for the users of accounts because:

● They help users to assess liquidity and solvency an adequate cash position is essential in
the short term both to ensure the survival of the business and to enable debts and
dividends to be paid.
● They help users to assess financial adaptability will the company be able to take effective
action to alter its cash flows in response to any unexpected events?
● They help users assess future cash flows an adequate cash position in the longer term is
essential to enable asset replacement, repayment of debt and fund further expansion.
● Cash flow means survival a company may be profitable but, if it does not have an
adequate cash position, it may not be able to survive.
● They help to highlight where cash is being generated the statement of cash flow will
clearly detail cash that is being generated from the core activities of the business and
other non-operating activities.
● Cash flows are objective a cash flow is a matter of fact whereas the calculation of profit
is subjective.
● they help to indicate problems early.
 Profit

Profit represents the increase in net assets in a business during an accounting period. This
increase can be in cash or it may be tied up in other assets, for example:

● non-current assets may have been purchased

● there may be an increased amount of receivables
● there may be increased investment in inventory
● the liabilities of the business may have decreased, i.e. more cash has been spent this year
in paying off suppliers more quickly than was the case last year.

The benefits of a statement of cash flows

A statement of cash flows is needed as a consequence of the above differences between profits
and cash. It helps to:

● provide additional information on business activities

● assess the current liquidity of the business
● allow the user to see the major types of cash flows into and out of the business
● estimate future cash flows
● determine cash flows generated from trading transactions rather than other cash flows.

The drawbacks of a statement of cash flow

The drawbacks of a statement of cash flows

● The statement of cash flows is backward looking. Users of the accounts are particularly
interested in the future.
● No interpretation of the statement of cash flows is provided within the accounts. Users
are required to draw their own conclusions as to the relevance of the figures contained
within it.
● Non-cash transactions, e.g. a bonus issue of shares are not highlighted on the face of the
statement of cash flows (although they are disclosed elsewhere within the accounts).
These are of interest to users as they will impact future cash flows.

2 Format of a statement of cash flows

IAS 7 Statement of cash flows requires companies to prepare a statement of cash flows within
their financial statements. The cash flow must be presented using standard headings.

Key points

Key points:
 ● Operating activities are the principal revenue-producing activities of the business. This
section of the statement begins with cash generated from operations. This figure can be
calculated using either the direct or indirect method.
● Investing activities are cash spent on non-current assets, proceeds of sale of non-current
assets and income from investments.
● Financing activities include the proceeds of issue of shares and long-term borrowings
made or repaid.
● Net increase or decrease in cash and cash equivalents is the overall increase (or decrease)
in cash and cash equivalents during the year. After adding the cash and cash equivalents
at the beginning of the year, the final balance of cash and cash equivalents at the end of
the year emerges.
● Cash means cash in hand and deposits available on demand.
● Cash equivalents means 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. (Investments are thus not cash equivalents unless they have these two attributes of
being readily convertible and with little or no risk of change in value.)

IAS 7 notes

IAS 7 requires a note to the statement of cash flows giving details of the make-up of cash and
cash equivalents:
3 Cash generated from operations

There are two methods of calculating cash from operations – thedirect or indirect method. The
method used will depend upon theinformation provided within the question.

Direct method

This method uses information contained in the ledger accounts of the company to calculate the
cash from operations figure as follows:

Examples of using direct method

Example of calculations using direct method

The gross cash flows necessary for the direct method can be derived:

(1) from the accounting records of the entity by totalling the cash receipts and payments directly,
or

(2) from the opening and closing statement of financial positions and income statement for the
year by constructing summary control accounts for:

● sales (to derive cash received from customers)

 ● purchases (to derive cash payments to suppliers)
● wages (to derive cash paid to and on behalf of employees).

Example using control accounts

The statement of financial positions of a business are:

Extracts from the income statement for the year are:

Additional information

(1) Payables consist of

(2) Purchase invoices relating to the acquisition of non-current assets totalling $80,000 have been
posted to the payables ledger during the year.

Calculate the net cash flow from operating activities using the direct method.

Solution
Workings

(W1)

(W2)

Tutorial note: information relating to non-current assets isnot included in the payables ledger
control account above in order tocompute cash paid to suppliers of operating costs.

(W3)
Indirect method

This method reconciles between profit before tax (as reported in the income statement) and cash
generated from operations as follows:

This working begins with the profit before tax as shown in the income statement. The remaining
figures are the adjustments necessary to convert the profit figure to the cash flow for the period.

Depreciation added back to profit because it is a non-cash expense

Interest expense Added back because it is not part of cash generated from operations (the interest
actually paid is deducted later)

Increase in trade receivables deducted because this is part of the profit not yet realized into cash
but tied up in receivables

Decrease in inventories added on because the decrease in inventories liberates extra cash

Decrease in trade payables deducted because the reduction in payables must reduce cash

In order to prepare a statement of cash flows, information from the current and prior year
statement of financial position and the current year income statement is used. The following
financial statements provide the source data for the requirements of Test your understanding
1throughout this chapter:

Test your understanding 1

Requirement 1
Statement of cash flows source data

Statement of financial position of Geronimo at 31 December

Income statement of Geronimo at 31 December 20X6

Operating expenses include a loss on disposal of non-current assets of $5,000.

● During the year plant which originally cost $80,000 and with depreciation of $15,000
was disposed of.

Calculate the cash generated from operations using the indirect method.

4 Cash from operating activities

Cash flows may include:

● interest paid
● dividends paid
● Income taxes paid.

Calculation of interest/income taxes paid

The cash flow should be calculated by reference to:

● the charge to profits for the item (shown in the income statement); and
● any opening or closing payable balance shown on the statement of financial position.

A T account working may be useful:

If there is no change to the opening or closing then it should be the statement of financial
position payable amount.

Calculation of dividends paid

The cash flow should again be calculated by reference to thecharge to profits and the opening or
closing dividend payable shown inthe statement of financial position.

Note that the charge to profits for dividends is not shown in theincome statement. It can,
however, be derived using an accumulatedprofits T account working.

Test your understanding 2

Requirement 2

Identify and calculate the remaining amounts to be shown under the heading Cash flows from
operating activities within Geronimos statement of cash flows.

5 Cash from investing activities

Cash inflows may include:

● interest received
● dividends received
● proceeds of sale of equipment.

Cash outflows may include:

 ● purchase of property, plant and equipment.

Calculation of interest and dividends received

Again, the calculation should take account of both the income receivable shown in the income
statement and any relevant receivables balance from the opening and closing statement of
financial positions.

A T account working may be useful:

Test your understanding 3

Requirement 3

Identify and calculate the dividends and interest received to be shown under the heading cash
flow from investing activities within Geronimos statement of cash flows.

Calculation of purchase of property, plant and equipment and proceeds of sale of equipment

These amounts are often the trickiest to calculate within astatement of cash flows. It is therefore
recommended that T accountworkings are used.

The following T accounts will be required for each class of assets:

● cost account
● accumulated depreciation account
● disposals account (where relevant).

Data provided in the source financial statements should then be entered into these T accounts and
the required cash flows found often as balancing figures.
NB If there is evidence of a revaluation, remember to include the uplift in value on the
debit side of the cost T account.

In some cases, insufficient detail is provided to produceseparate cost and accumulated

depreciation accounts. Instead, a net bookvalue account should be used:

Test your understanding 4

Requirement 4

Identify and calculate the cash outflow to purchase property, plant and equipment and the
proceeds from the sale of equipment to be shown under the heading Cash flows from investing
activities within Geronimos statement of cash flows.

6 Cash from financing activities

Cash inflows may include:

● proceeds of issue of shares

● proceeds of issue of loans/debentures.

Cash outflows may include:

● repayment of loans/debentures.

Calculation of proceeds of issue of shares

This cash inflow is derived by comparison of the sum brought forward and sum carried forward
balances on two accounts:

● share capital
● share premium.

Calculation of proceeds of issue of loans/repayment of loans

This cash flow is derived by simply subtracting the brought forward balance from the carried
forward.

Test your understanding 5

Requirement 5

Identify and calculate each of the amounts to be shown under the heading Cash flows from
financing activities within Geronimos statement of cash flows.

Test your understanding 6

Requirement 6

Complete the following proforma statement of cash flows for Geronimo using your answers to
Test your understanding 1 requirements1–5.

Statement of cash flows for Geronimo for year ended 31 December 20X6
Cash and cash equivalents at end period

Test your understanding 7

You are given below, in summarised form, the accounts of Algernon, a limited company, for
20X6 and 20X7.
Income statement
Notes:

A $20,000 dividend has been paid in the year.

(a) Prepare a statement of cash flows for Algernon for 20X7, to explain as far as possible the
movement in the bank balance. The statement of cash flows should be prepared using the direct
method.

(b) Using the summarized accounts given, and the statement you have just prepared, comment on
the position, progress and direction of Algernon.

Test your understanding 8

Part of a companys statement of cash flows is shown below:

The following criticisms of the extract have been made:

(1) The loss on disposal should have been added, not deducted.
(2) Increase in receivables should have been added, not deducted.

(3) Increase in payables should have been deducted, not added.

Which of the criticisms is valid?

A 1, 2 and 3

B 1 only

C 2 and 3 only

D none of them

Test your understanding 9

Which of the following could appear in a companys statement of cash flows?

(1) Proposed dividend

(2) Dividends received

(3) Bonus issue of shares

(4) Surplus on revaluation of non-current assets

A 1 and 2

B 1,2 and 3

C 2 only

D 2 and 3

Test your understanding 10

The following details are provided to the accountant ofCaddyshack Ltd, which has an operating
profit of $469,850 in the yearended 31 December 20X6:

(1) Depreciation of $37,400 has beencharged to the income statement; this included an amount
of $7,600 whichwas the loss on disposal of a non-current asset.

(2) The following extract of the statement of financial position at 31 December 20X5 and 20X6
have been provided:

What is the cash generated from operations?

A $511,250

B $510,850

C $501,250

D $503,250

Chapter summary
Test your understanding answers

Test your understanding 1

Requirement 1
(W1)

Test your understanding 2

Requirement 2

Interest paid
Dividends paid
 Test your understanding 3

Requirement 3

There is no balance for interest receivable at the start or end ofthe year; therefore interest
received must equal interest receivable inthe income statement

Interest received $15,000

Dividends received
 Test your understanding 4

Requirement 4

(see Solution to Requirement 1 for accumulated depreciation account.)

Test your understanding 5

Requirement 5
Repayment of loan

● Balance on loan account was $300,000 in 20X5; in 20X6 it is $200,000.

● Therefore $100,000 has been repaid.

Test your understanding 6

Requirement 6

Statement of cash flows for Geronimo for year ended 31 December 20X6
 Test your understanding 7

Statement of Cashflows for Algernon for year ended 31 December 2007

Workings

(W1) Receipts from sales

(W2) Payables and wages control

(W3) Cost of sales

Tutorial note Little information has been given as tothe nature of the costs of the company; for
example, no information issupplied on wages and salaries. The payments figure thus includes
allcash outflows relating to trading activities. Depreciation would havebeen charged in either
cost of sales or expenses and this needs to beadjusted for. It does not matter whether the
adjustment is shown in thepayables control or the cost of sales accounts.
(b) Algernon has invested substantially in buildings, investments, inventory and receivables inthe
year. The finance has come from new share capital in part but mainlyfrom loans. The equity to
assets ratio of the company has thus decreased. The working capital has been financed by an
equal increase intrade payables.

The profits have been fully distributed as dividends despite thehalving of profits from last year. It
might have been wiser to cut backon dividends in the period of expansion until the benefits of
theexpansion are seen in the form of higher profits.

Test your understanding 8

The correct answer is B

A loss on disposal should be added back to profit as it is a non-cash expense.

Test your understanding 9

The correct answer is C

Dividends received involve a cash receipt. The other transactions do not involve a movement of
cash.

Test your understanding 10

The correct answer is D

Note that the movement in the interest accrual is not part of the reconciliation as this is dealt with
within the Interest paid line of the statement of cash flows.

Cash flow Statement

The main difference appears in the operating cash flow section:

● The direct method uses actual cash transactions and does not make any modifications
● The indirect method changes the operating section from an accrual basis to a cash basis.
Example of a Direct Method Cash Flow Statement

A direct method cash flow statement includes the company’s operating, financing, and investing
cash flow.

Operating activities are any activities necessary to operate a business. Investing activities are any
activities related to non-current assets, such as investments.¹

Financing activities display a company’s financing structure. It shows how a company uses a
combination of debt and/or equity.

Statement of Cash Flows for the Year ended December 31, 2022
Cash flow from operating activities
Cash Received from customers 1,500,000
Cash paid for materials (200,000)
Cash paid to employees (400,000)
Interest expenses (30,000)
Income taxes (170,000)
Net cash provided by operating activities 700,000
Cash flow from investing activities
Purchasing PPE (250,000)
Net cash used in investing activities (250,000)
Cash flow from finance activities
Proceeds from long term debt 150,000
Debt Payments (15,000)
Net cash provided by financing activities 135,000
Net increase in Cash 585,000
Beginning Cash balance 115,000
Ending Cash balance 700,000

Using Indirect Method

:[Company name]
Statement of Cash Flows
For the [time period] ended [date]

Cash flows from operating activities

Net income: [Amount]………………………………….X
Adjustments for:
[Noncash activity]: [Amount]……………….……………X
[Asset]: [Amount]…………………………………..……..X
[[Liability]: [Amount]………………………………………X
Net cash from operating activities: [Amount]

Cash flows from investing activities

[Activity]: [Amount]…………………………………………X
Net cash from investing activities: [Amount]……………X

Cash flows from financial activities

[Activity]: [Amount]…………………………..……………...X
Net cash from financial activities: [Amount]………………X

Net cash increase/decrease: [Amount]

Beginning cash amount: [Amount]
Ending cash amount: [Amount]