Statement Of Cash Flows

METHODIST UNIVERSITY MBA PROGRAMME MBAD 505: FINANCIAL ACCOUNTING STATEMENT OF CASH FLOWS Introduction The basic purpose of a statement cash flows is to provide information about the sources and application of cash and cash equivalents of an entity. Information about cash receipts and cash payments of an entity during an accounting period would help creditors and others in assessing: a) b) c)

the entity’s ability to generate positive cash flows in future periods. the entity’s ability to meet its obligations and to pay dividends. the reasons for the difference between the accounting net income and the related net cash flows from operations of an entity for an accounting period. both the cash and non-cash aspects of an entity’s investment and financing transactions for the period.

d)

The two key financial objectives of every entity are to operate profitably and stay liquid and solvent. The income statement is designed to measure the results of operations of an entity in meeting its profit objective for a given period of time. The statement of income is based on accrual accounting. Therefore, the revenues, expenses, gains, and losses reported in the statement of income do not necessarily represent cash inflows and outflows. In general, five distinct classes of items cause differences between income flows and cash flows: a)

b)

c)

d)

e)

Items that appear on the statement of income that do not represent cash inflows and outflow, such as depreciation, amortization expense and depletion. Such items are referred to as non-cash items. Operating cash flows that do not appear on the statement of income but appear instead on the statement of financial position as prepayments, deferrals, unearned revenue, or reductions of accruals. Credit items that have been included in the calculation of operating profit but do not affect the cash inflows and outflows in the same period. Examples include credit sales, credit purchases and accrued expenses. Activities that result in changes in size and composition of equity capital and borrowings of the enterprise. Such activities referred to as financing activities, usually affect cash but may not be reflected fully in the statement of income. Examples include the issuing of shares, redemption of shares, borrowings and repayment of the principal amount borrowed. Activities that result in the acquisition and disposal of long term assets and other investments not included in cash equivalents. Such activities, referred to as investing activities, usually affect cash flows but may not be fully reflected on the statement of income. Examples include the purchase 1

or sale of equity and or debt instruments of other enterprises and the purchase or sale of items of property, plant and equipment. The statement of financial position reflects the financial position of an entity at a particular point in time. To some extent, the statement of financial position may be able to reflect the liquidity and solvency of an accounting entity. Users of accounting information, however, require more information to enable them assess the ability of an entity to meet her obligations as and when they fall due. This need is best served through the preparation and presentation of a statement of cash flows. Unlike the statement of financial position and the statement of income, which are required by the Companies Act, the statement of cash flows is a requirement of the International Financial Reporting Standards, International Accounting Standard No.7 in particular. The statement of cash flows or statement of sources and application of funds or statement of changes in financial position is not a legal requirement. Benefits of cash flow information. a)

b)

c)

d) e)

A statement of cash flows when used in conjunction with the rest of the financial statements provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (i.e. liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. A statement of cash flows enables the comparability of the reporting of results by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events. Cash flow information is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices. Historical cash flow information is often used as an indicator of the amount, timing and certainty of cash flows.

Definitions a) b)

Cash comprises of cash on hand, and demand deposits (including those in foreign currencies) net of bank overdrafts. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are not subject to any significant risk of changes in value. They include short-term securities; investments that have a short maturity of three months or less from the specified redemption date. 2

Cash flows are inflows and outflows of cash and cash equivalents.

c)

Presentation of statements of cash flows. The statement of cash flows should classify cash flows during the period between: a) b) c)

operating activities, investing activities, and financing activities.

Operating activities. Cash flows from operating activities are primarily derived from the principle revenue producing activities of an enterprise. They generally arise from transactions that involve the determination of net profit. Examples of operating activities include: a) b) c) d)

cash receipts from the sale of goods and rendering of services; cash receipts from royalties, fees, commissions and other revenues; cash payments to suppliers for goods and services; cash payments to and on behalf of employees; e) cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits; and f) cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and Where an enterprise holds securities for trade purposes, cash flows arising from the sale or purchases of such securities are classified as operating activities since they are similar to inventory acquired specifically for resale. In the case of financial institutions, cash advances and loans made by them are classified as operating transactions since they relate to the main revenue producing activities of that enterprise. Investing activities. These are the acquisition and disposal of long term and other investments not included in cash equivalents. Separable disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Examples of cash flows arising from investing activities are:

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a) cash payments to acquire property, plant and equipment, intangibles and other long term assets. These payments include those relating to capitalized development costs and self constructed property, plant and equipment; b) cash receipts from sales of property, plant and equipment, intangibles and other long-term assets; c) cash payments to acquire equity or debt instruments of other enterprises and interests in joint ventures (other than payments of those instruments considered to be cash equivalents and those held for dealing or trading purposes); d) cash receipts from sales of equity or debt instruments of other enterprises and interests in joint ventures (other than receipts for those instruments considered to be cash equivalents and those held for dealing or trading purposes); e) cash advances and loans made to other parties (other than advances and loans made by a financial institution); and f) cash receipts from the payment of advances and loans made to other parties (other than advances and loans for a financial institution). Financing activities. These are activities that result in changes in size and composition of the equity capital and borrowings of the enterprise. Examples of cash flows arising from financing activities are: a) cash proceeds from issuing shares or other equity instruments; b) cash payments to owners to acquire or redeem the enterprise’s shares; c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings; d) cash repayments of amounts borrowed; and e) cash payments by a lessee for the reduction of outstanding liability relating to a finance lease. Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a statement of cash flows. Such transactions should be disclosed else where in the financial statements in a way that provides all the relevant information about these investing and financing activities. Examples of such transactions include: a) b) c)

the conversion of debt into equity; the acquisition of an entity by means of an equity issue; and the acquisition of assets either by assuming directly related liabilities.

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Format of Presentation: Enterprises are required to report cash flows from operating activities using either the a) direct method, or b) indirect method. The direct method: Under this method information about major classes of gross cash receipts and gross cash payments are disclosed. Illustrative format XYZ CO. LTD. STATEMENT OF CASH FLOWS FOR THE PERIOD ENDED 31ST DECEMBER 2008. Cash flows from operating activities: Sh. Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Income taxes paid Net cash from operating activities

Sh. XX (XX) XX (XX) XX

Cash flows from investing activities: Interest received Dividends received Proceeds from sale of marketable securities Purchase of marketable securities Purchase of plant and equipment Proceeds from sale of equipment Net cash from investing activities

XX XX XX (XX) (XX) XX XX

Cash flows from financing activities Proceeds from issue of share capital Proceeds from long term borrowing Interest paid Dividends paid Net cash from financing activities Change in cash and cash equivalents

XX XX (XX) (XX) XX XX 5

Add: Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period

XX XX

The indirect method Illustrative format XYZ CO. LTD. STATEMENT OF CASH FLOWS FOR THE PERIOD ENDED 31ST DECEMBER 2008 Cash flows from operating activities Sh. Sh. Net profit before tax XX i. Adjustments for items included in the determination of net profit but do not involve movement of cash in the current accounting period: Depreciation of tangible assets XX Amortization of intangible assets XX ii. Adjustment for items included in profit determination but do not relate to operating activities (in the cash flow sense) Gain on asset disposal (XX) Loss on asset disposal XX Investment income (XX) Interest expense XX Operating profit before working capital changes XX (Increase) Decrease in receivables (XX)/XX (Increase) Decrease in inventory (XX)/XX (Increase) Decrease in prepayments (XX)/XX (Decrease)Increase in accruals (XX)(XX (Decrease) Increase in trade payables (XX)/XX Cash generated from operations XX Income taxes paid (XX) Net cash from operating activities

XX

Cash flows from investing activities Interest received Dividends received Proceeds from sale of marketable securities

XX XX XX 6

Purchase of marketable securities Purchase of plant and equipment Proceeds from sale of equipment Net cash from investing activities XX

(XX) (XX) XX

Cash flows financing activities Proceeds from issue of share capital Proceeds from long-term borrowing Interest paid Dividends paid Net cash from financing activities XX Change in cash and cash equivalents XX

XX XX (XX) (XX)

Add: Cash and cash equivalents at beginning of period XX Cash and cash equivalents at end of period XX

Alternative presentation (indirect method) As an alternative, in an indirect method cash flow statement, operating profit before working capital changes is sometimes presented as follows: XYZ CO. LTD. STATEMENT OF CASH FLOWS FOR THE PERIOD ENDED 31ST DECEMBER 2008 Cash flows from operating activities Sh. Sh. Revenues excluding investment income XX Operating expenses excluding depreciation XX Operating profit before working capital changes XX

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