CHAPTER22 CASH FLOW STATEMENTS 1THE NEED FOR A CASH FLOW STATEMENT • Profit represents the increase in net assets in a business during an accounting period. • This increase can be in : ---Cash ---Non-current assets ---Receivables ---Inventory • Or the liabilities of the business may have decreased ,i.e more cash has been spent this year in paying off suppliers than was the case last year. • A cash flow statement is needed because of the differences between profits and cash. It achieves the following: ---Provides additional information on business activities ---Helps to assess the current liquidity of the business. ---Allows the user to see the major types of cash flows into and out of the business ---Helps the user to estimate future cash flow ---Determines cash flows generated from trading transactions rather than other cash flows. 2 IAS 7 CASH FLOW STATEMENTS • IAS 7 requires enterprises to present a cash flow statement as part of their financial statements. • A cash flow statement can be presented in a number of ways: ---As a summary of the cash receipts and payments of an enterprise (a summarized cash book) ---From the balance sheet and income statement, opening with a reconciliation between reported profit and operating cash flow. • IAS 7 requires the cash flow statement to be presented using standard headings ,to ensure that cash flows are reported in a form that: ---Highlights the significant components of cash flow. ---Facilitates comparison of the cash folw performance of different business. • The standard leading shown n the statement are: ---Operating activities ---Investing activities ---Financing activities • Specimen format for a cash flow statement from IAS 7 • CASH FLOW STATEMENT FOR THE PERIOD ENDED… • $’000 $’000 • Cash flows from operating activities • Net profit before taxation X • Adjustments for: • Depreciation X • Interest expense X • Operating profit before working • capital changes X • (Increase)/decrease in trade receivables (X)/X • (Increase)/decrease in inventories (X)/X • (Increase)/decrease in trade payables X / (X) • Cash generated form operations X • Interest paid (X) • Dividends paid (X) • Income taxed paid (X) • Net cash from operating activities X/(X) • Cash flows from investing activities • Purchase of property, plant and equipment (X) • Proceeds of sale of equipment X • Interest received X • Net cash used in investing activities X • X/(X) • Cash flows form financing activities • Proceeds of issue of shares X • Repayment of loans (X) • Net cash used in financing activities X/(X) • Net increase/(decrease) in cash and cash X/(X) • equivalents • Cash and cash equivalents at the beginning • of the period X • Cash and cash equivalents at the end of the • period X • Cash flows from operating activities :begins with the profit before tax as shown in the income statement. The figures below 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 Added back because it is not expense part of cash generated from operations (the interest actually paid is deducted later) Increase in Deducted because this is part of trade the profit not yet realized into receivables cash but tied up in receivables Decrease in Added on because the decrease in inventories inventories liberates extra cash Decrease in Deducted because the reduction in trade payables payables must reduce cash Interest paid Dividends paid These are the amount actually paid in the year Income taxed paid • Cash flows from investing activities :cash spent on non-current assets, proceeds of sale of non- current assets and income from investments. • Cash flows from financial activities: the proceeds of issue of shares and long-term borrowing made or repaid. • Net increase in cash and cash equivalents :the overall increase9or decrease) in cash and cash equivalents during the year. Add the cash and cash equivalents at the beginning of the year to give the final balance of cash and cash equivalents at the end of the year. ---‘cash’：cash on hand and deposits available on demand. ---‘Cash equivalents': 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 usually excludes investments, unless they re readily convertible and with little or no risk of change in value). • IAS 7 requires a note to the cash flow statement giving details of the make-up cash and cash equivalents: Cash and cash equivalents • At end of At • year beginning • of year • $’000 $’000 • Cash on hand and • balance at banks X X • Short-term investments X X • X X 3 PREPARATION OF A CASH FLOW STATEMENT • Direct method :figure for the cash statement derived from the accounting records or form the other financial statements. • Indirect method: figures derived from the other financial accounting statements: ---Balance sheets for the current year end and the previous period ---Income statement for the period. • The alternative reconciliations are as follows Direct method $’000 Indirect method $’000 Cash received from Profit/(loss) before tax X/ (X) customers X Cash payments to suppliers Depreciation charges X (X) Cash paid to and on (Increase)/decrease (X)/X behalf of employees (X) in inventories Other cash payments (X) (Increase)/decrease (X)/X in receivables (Increase)/decrease (X)/X in payables Net cash inflow/(outflow) Net cash inflow/(outflow) from operating activities X/ (X) from operating activities X/ (X) • Indirect method ---You are usually presented with two balance sheets: for the end of the prior period and for the end of the current period. All the differences between the opening and closing balances are various types of cash flow, or are otherwise needed to produce the cash flow statement. ---To calculate the operating cash flow: (1) Find the profit figure: ◇Take it from operating cash flow, or ◇Calculate the increase in retain profit and add back the period’s dividends and tax charge to arrive at profit before tax. (2)Adjust the profit figure for: ◇ Non –cash expenses like depreciation, and ◇ Movements in working capital items such as inventory, receivables and payables. (3)where there are sales of non- current assets you will need to find figures for additions or disposals, and depreciation on disposals. ◇ Set up three T accounts for non-current asset cost, aggregate depreciation and disposal ◇ Enter the opening and closing balances from the balance sheets. ◇ Do the double entry in the ledger accounts and the cash flow statements for all additional information given to you in the question ◇ The balancing figures will give you the figures you need • (4) set up a format as follows, leaving plenty of space between the headings, then go through the given balance sheets from the top entering the differences in the correct positions in the format. Cash flows from operating to give Net cash from operating X activities activities Cash flows from investing to give Net cash used in investing X activities activities Cash flows from financing to give Net cash used in financing X activities activities Net increase in cash and cash equivalents X Cash and cash equivalents balance at beginning of year X (from prior period balance sheet) Cash and cash equivalents balance at end of year X (agree to closing balance sheet) • Direct method ---Gross cash flows can be derived: (1) from the accounting record: total the cash receipts and payments directly, or (2) for net cash flow from operating activities, from the opening and closing balance sheets and income statements 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) (W1) Receivables ledger control • $ $ • Balance b/d X Cash receipts (balancing X • figure) • Sales revenue X Balance c/d X • X X (W2)Payables ledger control (excluding non-current asset purchases) • $ $ • Cash paid (bal fig) X Balance b/d X • Balance c/d X Purchases • -Cost of sales X • -Administration X • X X (W3)Wages control • $ $ • Net wages paid X Balance b/d X • (bal fig) X Cost of sales X • Balance c/d Administration X • X X • Alternatively, the figure for net cash flows from operating activities could be derived from the reconciliation shown above. • A further working for non- current assets may be required. (W4) Non-current assets (NBV) • $ $ • Balance b/d X Depreciation charge X • Addition (bal fig) X Balance c/d X • X X Whether you use the direct or the indirect method, here are the steps you should take in the exam. Step 1 Allocate one or two pages to the cash flow statements so that easily identifiable cash flows can be inserted. Allocated a father page to workings. Step 2 Go through the balance sheets and take the balance sheet movements to the cash flow statement or to workings as appropriate, Tick off the information in the balance sheets once it has been used. Step 3 Go through the additional information provided and deal with as per Step2 Step 4 The amounts transferred to working can now be reconciled so that the remaining cash flows can be inserted on the statements. Step 5 Complete the cash flow statement. 4 INTERPRETATION USING THE CASH FLOW STATEMENT • The cash flow statement reveals: ---Whether the overall activities reveal a positive cash flow ---Whether the operating activities yield a positive cash flow ---The manner in which capital expenditure has been financed (for example, whether it has come from internally-generated resources, borrowings, issue of shares or from cash balance) • Cash flow statements allow users to evaluate: ---How the enterprise generates and uses cash and cash equivalents. ---Changes in net assets, financial structure (including liquidity and solvency) and the ability of the enterprise to adapt to changing circumstances. ---The ability of the enterprise to generate cash ---Between different enterprises, because the effects of using different accounting treatments are eliminated ---Forecasts of future cash flows ---The accuracy of past assessments of future cash flows.