Financial Reporting

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IAS 7 – The Statement of Cash Flows

The exam results are out and students are now beginning to think about studying for the May/June 2009 exam diet.  Students who are studying financial reporting papers at any level will come across a primary financial being that of a Cash Flow Statement (referred to in IAS as ‘the statement of cash flows’).

The statement of cash flows invariably causes headaches for lots of students because they can become complicated in certain areas and do require a large element of ‘incomplete records’ skills.

This article will consider the cash flow statement under the provisions of IAS 7 ‘Cash Flow Statements’.  We will look at each component part of the statement of cash flows, and consider the workings in each area when preparing a cash flow statement.  A practical example directly linked to this article is posted in the ‘Steve’s Q & A Forum’ within the main AccountancyStudents Discussion Forums entitled ‘IAS 7 – A Comprehensive Example’ which is available for free download at the end of the thread.

What are the benefits of a cash flow statement?

The concepts underlying the statement of financial position and the statement of comprehensive income have long been established in financial reporting.  They are, respectively, the stock measure or a snapshot at a point in time of an entity’s resources and obligations, and a summary of the entity’s economic transactions and performance over an interval of time.  The third major financial statement, the cash flow statement, is a more recent innovation but has evolved substantially since it has been introduced.

The purpose of the statement of cash flows is to provide information about the operating cash receipts and cash payments of an entity during a period, as well as providing insight into its various investing and financing activities.  It is a vitally important financial statement because the ultimate concern of investors is the reporting entity’s ability to generate cash flows which will support payments (typically, but not necessarily, in the form of dividends) to the shareholders.  More specifically, the statement of cash flows should help investors and creditors assess:

• the ability to generate future positive cash flows;
• the ability to meet obligations and pay dividends;
• reasons for differences between income and cash receipts and payments; and
• both cash and non-cash aspects of entities’ investing and financing transactions.

Definitions

During the course of your financial reporting studies, you will come across various definitions which you need to understand:

Cash
Cash on hand and demand deposits with banks or other financial institutions.

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.  Treasury bills, commercial paper, and money market funds are all examples of cash equivalents.

Direct Method
A method that derives the net cash provided by or used in operating activities from major components of operating cash receipts and payments.  In other words payments and receipts are anlaysed ‘direct’ from the cash book.

Financing Activities
The transactions that cause changes in the size and composition of an entity’s capital and borrowings.

Indirect Method
A method used that derives the net cash provided by, or used in, operating activities by adjusting net income or (loss) for the effects of transactions of a non-cash nature e.g. depreciation, increases and decreases in working capital and profits and losses on the disposal of non-current assets.

Investing Activities
The acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Operating Activities
The transactions not classified in financing or investing activities, generally involving producing and delivering goods or providing services.

Cash Accounting
Students have always prepared financial statements on the ‘accruals’ basis of accounting.  That is to recognise transactions and events in the periods in which they arise, as opposed to the periods in which they are paid.  This accords with the IASB’s Framework Document and the general principles laid down therein.

The statement of cash flows, as its name implies, includes only actual inflows and outflows of cash and cash equivalents.  Accordingly, it excludes all transactions that do not directly affect cash receipts and payments.  The reason for not including non-cash transactions in the statement of cash flows and placing them elsewhere in the financial statements is that it preserves the statement’s primary focus on cash flows from operating, investing and financing activities.

Therefore it is important to understand that the statement of cash flows will only ever be prepared on a ‘cash’ basis as opposed to an ‘accruals’ basis.

Classifications of Cash Flows

The statement of cash flows prepared in accordance with IAS 7, requires the classification of cash flows into three categories:

Investing Activities
These include the acquisition and disposal of property, plant and equipment and other long-term assets and debt and equity instruments of other enterprises that are not considered cash equivalents or held for dealing or trading purposes.  Investing activities also includes cash advances and collections on loans made to other parties (other than advances and loans of a financial institution).  Examples are:

Inflows

• capital collections from loans and sales of other entities’ debt instruments;
• sale of equity instruments of other entity’s and from returns of investment in those instruments; and
• sale of plant and equipment.

Outflows

• loans made and acquisition of other entities’ debt instruments;
• purchase of equity instruments of other enterprises (unless held for trading purposes or considered to be cash equivalents); and
• purchase of plant and equipment.

Financing Activities
These include obtaining resources from and returning resources to the owners.  Also included is obtaining resources through borrowings (short-term or long-term) and repayments of amounts borrowed.  Examples include:

Inflows

• proceeds from issuing share capital;
• proceeds from issuing debt (short or long-term); and
• not-for-profits’ donor-restricted cash that is limited to long-term purposes.

Outflows

• dividend payments;
• repurchase of company’s shares; and
• repayment of the capital element of debt including capital lease obligations.

Operating Activities
These include all transactions that are not investing and financing activities.  In general, cash flows that relate to, or are the corollary of, items reported in the statement of comprehensive income are operating cash flows.  Operating activities are principal revenue-producing activities of an entity and include delivering or producing goods for sale and providing services.  Examples are:

Inflows

• receipts from sales of goods or services;
• sale of loans, debt or equity instruments carried in a trading portfolio;
• returns on loans (i.e. interest); and
• returns on equity securities (i.e. dividends).

Outflows

• payments to suppliers for goods and services;
• payments to or on behalf of employees;
• payments of taxes;
• payments of interest;
• purchase of loans, debt or equity instruments carried in a trading portfolio.

Direct vs. Indirect Method

Direct Method
The operating activities section of the statement of cash flows (usually the start of the statement of cash flows) can be presented under the direct or the indirect method.  IFRS does prefer the direct method of preparing the statement of cash flows, but it is common in studying to prepare under the indirect method because this method is less time-consuming and more familiar to the student.

The direct method shows the items that affected cash flow and the magnitude of those cash flows.  Cash received from, and cash paid to, specific sources (such as customers and suppliers) are presented, as opposed to the indirect method’s converting accrual-basis net income (loss) to cash flow information by means of add-backs and deductions.  Entities using the direct method are required under IAS 7 to report the following major classes of gross cash receipts and gross cash payments:

• cash collected from customers;
• interest and dividends received (1)
• cash paid to employees and other suppliers
• interest paid (2)
• income taxes paid; and
• other operating cash receipts and payments.

(1) alternatively, interest and dividends received may be classified as investing cash flows rather than as operating cash flows because they are returns on investments. 

(2) IAS 7 permits interest paid to be classified as a financing cash flow because this is the cost of obtaining finance. 

An important advantage of the direct method is that it permits the user to better comprehend the relationships between the company’s net income (loss) and its cash flows.  For example, payments of expenses are shown as cash disbursements and are deducted from cash receipts.  In this way, the user is able to recognise the cash receipts and payments for the period. 

Illustration

The following is an illustration of how the direct method works:

Cash Flows from Operating Activities:
Cash from sale of goods X
Cash dividends received * X
Cash Provided by Operating Activities: X
Cash paid to suppliers               (X)
Cash paid for operating expenses         (X)
Cash paid for income taxes **         (X)
Cash Disbursed for Operating Activities         (X)

Net Cash Flows from Operating Activities X

* alternatively could be classified as an investing cash flow
** taxes paid are usually classified as operating activities.  However, when it is practical to identify the tax cash flow with an individual transaction that gives rise to cash flows that are classified as investing or financing activities, then the tax cash flow is an investing or financing activity as appropriate.

Indirect Method
The statement of cash flows prepared using the indirect method emphasises the changes in the components of most current asset and current liability accounts.  This method is the most widely used.  Although most of the adjustments are obvious some changes require more careful analysis.  For example, it is important to compute cash collected from sales by relating sales revenue to both the change in trade receivables and the change in the related bad debt allowance account.

Illustration

Cash Flows from Operating Activities:
Net income before taxes X
Adjustments for:
Depreciation X
Loss on sale of non-current assets X
Interest expense X
Operating profit before working capital
Changes X
Increase/decrease in trade receivables X/(X)
Increase/decrease in trade payables X/(X)
Increase/decrease in inventories X/(X)

Cash Generated from Operations X

Interest paid (X)
Income taxes paid (X)

Net Cash Flow from Operating Activities X

To Add or (Deduct)
The key to remembering whether to add or deduct increases/decreases in working capital to or from operating profit before working capital changes is to consider whether the effect of the increase or decrease is an ‘inflow’ or ‘outflow’ of cash.

Increases in trade receivables mean you have had less receipts from customer than the previous year (hence the increase in receivables) and thus it follows this is an ‘outflow’ of cash and should be deducted.  Conversely, any decreases in trade receivables means an ‘inflow’ and should be added to operating profit.

Increases in inventories means that more money is tied up in inventory so this represents an outflow and should be deducted.  Decreases mean more inventory has been turned to cash (think about the order of liquidity in the statement of financial position) so should be added on to operating profit.

Increases in trade payables mean you have paid out less cash than the previous year to your suppliers and this means you have retained more money in the bank, hence an ‘inflow’ so an addition to operating profit.  Decreases in trade payables mean you have paid more money to your suppliers so an ‘outflow’ therefore a deduction from operating profit.

The ‘Incomplete Records’ Approach

More often than not in financial reporting studies there are key figures which need including in the statement of cash flows which are not automatically given in the financial statements.  A typical example of this is tax paid.  The financial statements will show the tax creditor brought forward and the tax charge for the year, which could also include deferred tax movements and adjustments to the tax charge relating to prior years.  We have to use the ‘incomplete records’ approach (i.e. a process of elimination) to arrive at the tax ‘paid’ amount to include in the statement of cash flows.  Consider the following example:

Dohner Inc statement of financial position as at 31 December 2007 showed a tax liability amounting to $40,000.  As at 31 December 2008 it shows a liability of $75,000 with the tax charge for the year in the statement of comprehensive income amounting to $80,000. 

Required

Calculate the corporation tax paid in the year to 31 December 2008.

Solution

We know the opening liability was $40,000 and the closing liability is $75,000, which includes the provision for the year in the statement of comprehensive income of $80,000, so putting this into a ‘control’ account or ‘T’ account we can arrive at the tax ‘paid’ figure as follows:

Balance b/f = $40,000
Charge for the year = $80,000
Balance c/f = ($75,000)
Tax paid = ($45,000) – balancing figure

Sale Proceeds on Disposal of Non-Current Assets

You will often be required to compute the disposal proceeds on the sale of non-current assets as this figure will often not be given to you during your studies.  Consider the following example:

XYZ Inc disposes of property plant and equipment with a net book value of $15,000.  We have been told earlier in the question that the loss on disposal of non-current assets which had to be added back to operating profit was $2,000.

Required

Calculate the disposal proceeds received on disposal of the property plant and equipment.

Solution

We have been told that the net book value of the assets in question that have been disposed of are $15,000.  We could summarise this as:

Cost         $30,000
Accumulated depreciation     ($15,000)
Net book value         $15,000

The loss on disposal amounted to $2,000 which means we only received $13,000 proceeds (i.e. net book value $15,000 but we made a loss when disposing of these of $2,000).

If the question said we had, in fact, made a profit on this disposal of $2,000 then we would say: net book value = $15,000 PLUS $2,000 = disposal proceeds of $17,000.  In other words a third party has given us $17,000 for non-current assets that only have a book value of $15,000.

Non-Current Asset Additions

This is also another figure which needs to be calculated to be included in the statement of cash flows, but is relatively easy to arrive at.  In summary, this is what you do:

NBV non-current assets brought forward (from prior year statement of financial position)
Less
Depreciation charge for the year (often given and added back to operating profit)
NBV of non-current assets disposed of in the year
Add
NBV non-current assets carried forward
Equals
A balancing figure which will be the additions during the year

Interest Paid

Another common working which needs to be undertaken relates to interest paid in the year.  Typically, some questions will often say that interest is payable half-yearly, therefore it follows that the interest charge in the statement of comprehensive income is often not the same as the interest that has been physically paid.  This will require a working.  Consider the following example:

The statement of comprehensive income for Cosmos Enterprises shows finance costs of $10,000.  The statement of financial position shows that the opening interest creditor amounted to $3,000 and that we have provided for the second instalment which is due after the reporting date of $4,000.

Required

Calculate the interest paid in the year.

Solution

Again, we have to take an incomplete records approach to this solution.  We know that last year we provided for $3,000 interest which was going to be paid in the current year and we have also provided for $4,000 which is going to be paid in the next year, so:

Opening creditor   $3,000
Interest charge per SoCI $10,000
Closing creditor           ($4,000)
Paid in the year             $9,000 = balancing figure

Proceeds from Share Capital

This is often a confusing calculation to undertake because invariably it can involve more than one equity headings.  Consider the following example:

The issued equity share capital of Lucas Inc as at 31 December 2007 was 6,000 ordinary shares $1 with a share premium account balance of $1,200.

The statement of financial position as at 31 December 2008 showed that the issued equity share capital amounted to $8,000 and the share premium account had increased to $4,200.

Required

Calculate the amount of the proceeds received on the issuance of the additional equity share capital.

Solution

This is a relatively straight forward calculation. The confusion often lies in the fact that you have to consider the changes in both the equity share capital account and the share premium account, but you can combine the two in arriving at the proceeds calculation as follows:

Equity shares b/f (6,000 x $1) $6,000
Share premium account b/f $1,200
Less share capital account b/f       ($8,000)
Less share premium account b/f     ($4,200)

Balancing figure = proceeds amount $5,000

Conclusion

With lots of practise, a question asking you to prepare a statement of cash flows, extracts of one or asking for commentaries on one should be a gift.  The key problematic areas I often find answering on the forums are when to add or subtract increases/decreases in working capital and how to arrive at:

• tax paid in the year
• non-current asset additions
• sale proceeds on disposal of non-current assets
• interest paid in the year
• proceeds on the issuance of share capital

We have covered these in the article however, it is important that you practise as many questions as possible when dealing with the statement of cash flows.  As well as the technical aspects, you also need to understand how they are laid out as this is a crucial aspect of IAS 7.

Steve Collings FMAAT ACCA DipIFRS is Audit Manager at Leavitt Walmsley Associates Ltd (http://www.lwaltd.com) and a partner in AccountancyStudents.

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