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This article considers the statement of cash flows of which it assumes no prior knowledge. It is relevant to the FA (Financial Accounting) and FR (Financial Reporting) exams. The article will explain how to calculate cash flows and where those cash flows are presented in the statement of cash flows.
Computing cash flows
Cash flows are either receipts (ie cash inflows and so are represented as a positive number in a statement of cash flows) or payments (ie cash out flows and so are represented as a negative number using brackets in a statement of cash flows).
Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.
Common cash flow calculations include the tax paid, which is an operating activity cash out flow, the payment to buy property plant and equipment (PPE) which is an investing activity cash out flow and dividends paid, which is a financing activity cash out flow. The following examples illustrate all three of these examples.
Exercise calculating the tax paid
At the start of the accounting period the company has a tax liability of $50 and at the reporting date a tax liability of $90. During the year the tax charged in the statement of profit or loss was $100.
Required: Calculate the tax paid.
Solution
It is necessary to reconcile the opening tax liability to the closing tax liability to reveal the cash flow – the tax paid - as the balancing figure. A vertical presentation of the numbers lends itself to noting the source of the numbers.
Tax liability | $ | Explanation |
---|---|---|
Opening balance | 50 | Credit balance |
Tax charge | 100 | The tax charged in the profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to the tax liability account reflects the effect of increase in the tax liability |
_____ | ||
Sub-total | 150 | This sub-total represents the amount of the tax liability that there would have been at the reporting date in the event that no tax had been paid |
Cash flow – the payment of tax | 60 | This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end tax liability is smaller than the sub-total |
_____ | ||
Closing balance | 90 | This is the closing balance of the tax liability |
_____ |
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This simple technique of taking the opening balance of an item (in this case the tax liability) and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.
Exercise calculating the payments to buy PPE
At the start of the accounting period the company has PPE with a carrying amount of $100. At the reporting date the carrying amount of the PPE is $300. During the year depreciation charged was $20, a revaluation surplus of $60 was recorded and PPE with a carrying amount of $15 was sold for $20.
Required: Calculate the cash paid to buy new PPE.
Solution
Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in period that are not cash flows. The balancing figure is the cash spent to buy new PPE.
PPE | $ | Explanation |
---|---|---|
Opening balance | 100 | Debit balance |
Deprecation | (20) | Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to statement of profit or loss to reflect the expense and to credit the asset to reflect its consumption. |
Revaluation surplus | 60 | The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and to debit the asset to reflect its increase |
Disposal | (15) | The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account |
_____ | ||
Sub-total | 125 | This sub-total represents the balance of the PPE if no PPE had been bought for cash |
Cash flow – the payment to buy PPE | 175 | This is the last figure written in the reconciliation This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total |
_____ | ||
Closing balance | 300 | |
_____ |
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Note that the cash proceeds ffrom the disposal of PPE ($20) would be shown separately as a cash inflow under investing activities. The profit on disposal of $5 ($20–$15) would be adjusted for as a non-cash item under the operating activities (see later).
Exercise calculating the dividend paid
At the start of the accounting period the company has retained earnings of $500 and at the reporting date retained earnings are $700. During the reporting period a profit for the year of $450 was reported.
Required: Calculate the dividend paid.
Solution
As before, to ascertain the cash flow – in this case dividends paid - we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity.
Retained earnings | $ | Explanation |
---|---|---|
Opening balance | 500 | Credit balance |
Profit for the year | 450 | The profit for the year is a credit and increases the retained earnings |
_____ | ||
950 | This sub-total represents the balance on retained earnings in the event that no dividends have been paid | |
Cash flow – the dividends paid | 250 | This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is less |
_____ | ||
Closing balance | 700 | |
_____ |
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Classification of cash flows
IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flow classifies and presents cash flows under three headings:
(i) Operating activities
(ii) Investing activities and
(iii) Financing activities
Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are then presented as cash outflows deducted from the cash generated from operations.
Investing activity cash flows are those that relate to non-current assets including investments . Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.
Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.
This topic is examined in much more depth in the FR examination than it is at FA. For example, in FA, an extract, or the whole statement of cash flow might be required in the multi-task questions but it could also be constructed as an OT question. FR, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using right-of-use asset leases). However, that does not mean that FR will never require the preparation of a complete statement of cash flows so be prepared.
Operating activities – the indirect method and direct method
There are two different ways of starting the cash flow statement, as IAS 7,Statement of Cash Flowspermits using either the 'direct' or 'indirect' method for operating activities.
The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash out flows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally the payments for interest and tax are deducted.
Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial reconciliation the profit before tax is adjusted for expenses that have been charged against profit that are not cash out flows; for example depreciation and losses on disposal of non-current assets, have to be added back, and non-cash income; for example, investment income and profits on disposal of non-current assets are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit before tax but will have had an adverse impact on the cash flow of the business. Thus, in the reconciliation process, the increases in inventory and trade receivables are deducted from profit before tax. Conversely, decreases in inventory and trade receivables are added back to the profit before tax. The opposite is applicable for trade payables. Finally, the payments for interest and tax are presented – usually as a further deduction.
The following exercise illustrates both the direct and indirect methods operating activities section.
Exercise: The direct and indirect method
Extracts from the financial statements are as follows
$ | |
---|---|
Operating profit | 80,000 |
Investment income | 12,000 |
Finance costs | (10,000) |
Profit before tax | 82,000 |
Tax | (32,000) |
Profit for the year | 50,000 |
Other comprehensive income | |
Revaluation gain | 40,000 |
Total comprehensive income | 90,000 |
Additional information
During the year depreciation of $50,000 and amortisation of $40,000 was charged to profit.
Receipts from customers, combined with cash sales, were $800,000, payments to suppliers of raw materials $400,000, other operating cash payments were $100,000 and cash paid on behalf and to employees was $126,000.
Interest paid is $12,000 and taxation paid is $13,000.
Required:
(a)Using the direct method prepare the operating activities section of the statement of cash flows.
(b)Using the indirect method determine the operating activities section of the statement of cash flows.
Answer (a) direct method
The direct method is relatively straightforward in that all the data are cash flows so it is really just a case of listing the receipts as positive and the payments as negative.
Answer (b) indirect method
The indirect method is more commonly examined. Here as we start with profit before tax we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then are the two actual cash flows of interest paid and tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.
Note how whichever method is used that the same cash is generated from operating activities.
Format of the cash flow statement –
indirect method
You may be asked to prepare a statement of cash flows. The following is a pro forma showing the indirect method.
Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value. A bank overdraft should be treated as a negative cash balance when arriving at the cash and cash equivalents.
Tom Clendon FCCA is a senior lecturer based in Singapore and he lectures for FTMS Global in their South East Asia colleges
I'm Tom Clendon, FCCA, a senior lecturer with a focus on Financial Accounting, based in Singapore. I have extensive experience and knowledge in the field, particularly in preparing financial statements and understanding the intricacies of cash flow calculations. My expertise lies not only in theory but also in practical application, making complex accounting concepts accessible.
Now, let's delve into the key concepts discussed in the article about the statement of cash flows:
-
Cash Flows Basics:
- Cash flows are categorized as either receipts (inflows) or payments (outflows).
- Represented in a statement of cash flows as positive or negative numbers.
- Common cash flow calculations include tax paid (operating activity), payment for property plant and equipment (investing activity), and dividends paid (financing activity).
-
Exercise: Calculating Tax Paid:
- The article illustrates how to calculate tax paid by reconciling the opening and closing tax liabilities.
- It emphasizes the balancing figure as the actual cash flow and demonstrates the vertical presentation of numbers.
-
Exercise: Calculating Payments to Buy PPE (Property Plant and Equipment):
- Similar reconciliation approach is applied to calculate cash spent on buying new PPE.
- Depreciation and revaluation surplus are adjusted to find the actual cash flow for purchasing PPE.
-
Exercise: Calculating Dividend Paid:
- The process of reconciling opening and closing retained earnings is demonstrated to calculate dividends paid.
- The balancing figure represents the cash flow related to dividend payments.
-
Classification of Cash Flows:
- IAS 7 requires a statement of cash flows with three classifications: Operating activities, Investing activities, and Financing activities.
- Operating activities can be presented using either the direct or indirect method.
-
Operating Activities – Direct and Indirect Method:
- The direct method involves presenting actual cash flows from operating activities.
- The indirect method starts with profit before tax and reconciles to show cash generated from operating profit.
-
Exercise: Direct and Indirect Method Example:
- An example is provided, demonstrating both the direct and indirect methods for the operating activities section of the statement of cash flows.
-
Format of Cash Flow Statement – Indirect Method:
- A pro forma is presented for the indirect method, emphasizing the importance of understanding the format for successful attempts at related questions.
These concepts are crucial for Financial Accounting (FA) and Financial Reporting (FR) exams, with FR delving deeper into complex transactions. It's essential to be prepared for both comprehensive statement preparation and specific extract-based questions.