chapter22 cfs

8/13/2019 Chapter22 CFS

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Chapter 22 Statement of Cash Flows

1. Objectives

1.1 Explain the purpose of preparing a statement of cash flows.

1.2 Define cash, cash equivalents and cash flows.

1.3 Evaluate the usefulness of a statement of cash flows.

1.4 Prepare a statement of cash flows with supporting notes in the format as specified in

!"# $.

1.% &lassif' and report inflows and outflows of cash and cash equivalents under the

standard headings(

)i* operating activities

)ii* investing activities

)iii* financing activities.

1.+ Prepare statement of cash flows for a single compan' using the direct and indirect

methods.

, p e r a t i n g

" c t i v i t i e s

- n v e s t i n g

" c t i v i t i e s

. i n a n c i n g

" c t i v i t i e s

/ s e f u l n e s s 0

- n t e r p r e t a t i o n

# p e c i f i c - t e m s

& o n t e n t

D e f i n i t i o n

# c o p e

2. Introduction

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2.1 either the statement of comprehensive income nor the statement of financial position

provides sufficient information aout the entit's inflows and outflows of cash and

cash equivalents.

2.2 5he o6ective of the standard is 7to require reporting entities which fall within its

scope to prepare a cash flow statement as part of their financial statements setting out

on a standard asis their cash generation and asorption for a period.8

2.3 5he purposes of preparing a statement of cash flows are as follows(

)i* Proper management cash flow is essential to the survival of an enterprise, and

accordingl', the reporting of cash flow information would e helpful to the

users of financial statements in assessing the liquidit' of the enterprise.

)ii* 5he statement of comprehensive income and the statement of financial

position, which are prepared using accruals accounting, form a primar' asis

to pro6ect the future cash flows of an entit'. 5he aim of statement of cash flows

is to eliminate the longterm provisions and other allocations associated with

accrual accounting and to depict the historical cash generating or cash

asorption mechanisms of an entit'. 5he cash flow statement, in con6unction

with a statement of comprehensive income and a statement of financial

position provides information on liquidit', validit' and financial adaptailit'.

2.4 "ll entities that adopt !9#s will now e required to prepare a statement of cash

flows in accordance with !"# $ and to present it as an integral part of their financial

statements for each period for which financial statements are presented.

2.% 5his means that the following exemptions included in ##"P 1% will no longer e

availale(

)i* certain entities with revenue of less than !: 2; million per annum< and

)ii* charities and nonprofit ma=ing entities whose financial statements are

prepared on a cash asis.

2.+ 5he standard applies to all financial statements intended to give a true and fair view of

the financial position and profit and loss except for the following()i* &ompanies are exempt under s. 141D of the &ompanies rdinance and are

therefore exempt from the requirement to give a 7true and fair view8 in their

financial statements.

)ii* >an=ing and insurance companies which ta=e advantage of exemptions under

Part --- of the 5enth #chedule to the &ompanies rdinance.

)iii* &harities and nonprofit ma=ing entities whose accounts are prepared on a cash

asis.

3. Definition of erms

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3.1 DEFINITIONS

)a* Cash? &ash in hand and deposits repa'ale on demand with an' an= or

other financial institutions. 5hese include cash in hand and deposits

denominated in foreign currencies.

)* Cash equivalent ( )? #hortterm, highl' liquid investments which are

readil' convertile into a =nown amount of cash without notice and which

were within three monthsof maturit' when acquired< less advances from

an=s repa'ale within three months from the date of the advance. &ash

equivalents include investments and advances denominated in the foreign

currencies, provided the' fulfill the aove criteria.

)c* Cash flow? an increase or decrease in an amount of cash or cash equivalent

resulting from a transaction.

"ccording to these definitions, cash equivalents must e highl' liquid and can

e converted into =nown amount of cash without notice and without incurring

and significant ris=s of changes in value owing to changes in interest rate.

)d* Operating activities ( ) are the principal revenueproducing

activities of the enterprise and other activities that are not investing orfinancing activities.

)e* Investing activities ()are the acquisition and disposal of longterm

assets and other investments not included in cash equivalents.

)f* Financing activities ( )are activities that result in changes in the

si@e and composition of the equit' capital and orrowings of the enterprise.

3.2 !"# $ adopts threemonth maturit' as a cutoff for oth cash equivalents and an=

orrowings.3.3 "ccording to !"# $, an investment purchased with more than three months to

maturit' does not ecome a cash equivalent when its remaining maturit' is three

months.

3.4 #imilarl', an= orrowings with a maturit' of more than three months when drawn

down do not ecome cash equivalents when their remaining maturit' ecomes three

months.

!. Contents of a Statement of Cash Flows

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4.1 5o facilitate comparisons of the cash flow performance etween different usiness,

!"# $ requires that the inflows and outflows of cash and cash equivalents are

classified under certain standard headings and reported accordingl'. 5hese headings

are(

)i* perating activitiesalance at eginning of the 'ear

&ash inflowF)outflow* from financing

Exchange difference

>alance at end of the 'ear

". Specific Items

%.1 -n the preparation of a cash flow statement, the treatment of the following itemsdeserves special mention(

)i* Discontinued activities& Ctd for the 'ear ended 31 Decemer

2;;A is shown elow(

:;;; :;;;

#ales +,;;;

&ost of sales )4,;;;*

ross profit 2,;;;

#elling and distriution expenses 4;%

"dministrative expenses 2$; )+$%*

1,32%

-nterest pa'ale

on deentures )3;*

on finance lease )3;*

Dividend received from investment 2;

Profit efore taxation 1,2A%

5axation )3%;*

B3%

Dividend )42;*

9etained profit for the 'ear %1%

5he following information is availale for the 'ear ended 31 Decemer 2;;A(

1. " machine costing :22;,;;; on which depreciation of :A3,;;; had een

provided was sold during the 'ear at a profit of :1;,;;;.

2. " new machine was acquired during the 'ear for :%;;,;;; through a finance

agreement. 5he rental paid during the 'ear amounted to :1%;,;;;, of which

interest element was :3;,;;;.

3. o additions to intangile assets were made during the 'ear.

4. " rights issue was made during the 'ear of one new ordinar' share of :1 each

for ever' ten shares held.

2equire#/

Prepare a statement of cash flows for ">& Ctd for the 'ear ended 31 Decemer 2;;A

under !"# $.

Solution/

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&. 'sefulness of the Statement of Cash Flows

() #vantages of the statement of cash flows

$.1 " statement of cash flows can provide information which is not availale from alance

sheet and income statements.

)i* -t ma' assist users of financial statements in ma=ing ad6ustments on the

amount, timing and degree of certaint' of future cash flows.

)ii* -t gives an indication of the relationship etween profitailit' and cash

generating ailit', and thus of the qualit' of the profit earned.

)iii* "nal'sts and other users of financial information often, formall' or informall',develop models to assess and compare the present value of the future cash flow

of entities. istorical cash flow information could e useful to chec= the

accurac' of past assessments.

)iv* " cash flow statement in con6unction with a alance sheet provides

information on liquidit', viailit' and adaptailit'. 5he alance sheet is often

used to otain information on liquidit', ut the information is incomplete for

this purpose as the alance sheet is drawn up at a particular point in time.

)v* &ash flow cannot easil' e manipulated and is not affected ' 6udgement or '

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accounting policies.

(1) imitations of the statement of cash flows

$.2 #tatement of cash flows should normall' e used in con6unction with income

statements and alance sheets when ma=ing an assessment of future cash flows.

)i* #tatement of cash flows are ased on historical information and therefore do

not provide complete information for assessing future cash flows.

)ii* 5here is some scope for manipulation of cash flows. or example, a usiness

ma' dela' pa'ing suppliers until after the 'earend, or it ma' structure

transactions so that the cash alance is favoural' affected. -t can e argued

that cash management is an important aspect of stewardship and therefore

desirale. owever, more delierate manipulation is possile )e.g. assets ma'

e sold and then immediatel' repurchased*.

)iii* &ash flow is necessar' for survival in the short term, ut in order to survive in

the long term a usiness must e profitale. -t is often necessar' to sacrifice

cash flow in the short term in order to generate profits in the long term )e.g. '

investment in noncurrent assets*. " huge cash alance is not a sign of good

management if the cash could e invested elsewhere to generate profit.

(C) The a#vantages an# #isa#vantages of the #irect an# in#irect metho#s

$.3 5he two methods which can e used to prepare the cash flow statement are the direct

)gross* and indirect )net* methods as we have seen.

$.4 5he advantages of the direct method are as follows(

)i* -nformation is shown which is not shown elsewhere in the financial statements.

5his is therefore of advantage to the user of the information.

)ii* 5he method does show the true cash flow involved in the trading operations ofthe entit'.

$.% 5he disadvantage is the significant cost that there ma' e in preparing the information.

iven that the information is not revealed elsewhere in the financial statements, it

follows that there must e some cost in otaining the information.

$.+ 5he advantages of the indirect method are as follows(

)i* >' examining the reconciliation etween reported profit and net cash flow

from operating activities, the user can easil' relate trading profits to cash flow

and thus understand the 7qualit'8 of earnings made ' the entit' in the

accounting period. Earnings are of a good qualit' if the' are represented '

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real cash flows now or in the near future.

)ii* 5here is a low cost in preparing the information.

$.$ 5he disadvantage is the lac= of information on the significant elements of trading cash

flows.

(. Interpretation of Cash Flow Data

A.1 5he estimation of the future cash flows in ver' important in determining the solvenc'

or otherwise of a usiness. 5he financial statements are, of course, historical records,

ut the' can provide some evidence of solvenc'.

() Interpretation of the cash flow statement

A.2 5he cash flow statement should e the initial data to review. Points to watch for

within the various headings in the cash flow statement include(

(a) Cash generation from trading operations

A.3 5he figure should e compared to the profit from operations. 5he reconciliation with

which the cash flow statement opens if the indirect method is used is useful in this

regard. vertrading ma' e indicated '(

)i* high profits and low cash generation

)ii* large increases in inventor', receivales and pa'ales.

(b) Dividend and interest payouts

A.4 5hese can e compared to cash generated from trading operations to see whether the

normal operations can sustain such pa'ments. -n most 'ears the' should.

(c) Capital expenditure and financial investment

A.% 5he nature and scale of a compan's investment in noncurrent assets is clearl'

shown.

(d) Cash flow

A.+ 5he statement clearl' shows the end result in cash terms of the compan's operations

in the 'ear. Do not overstate the importance of this figure alone however. " decrease

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in cash in the 'ear ma' e for ver' sound reasons )e.g. there was surplus cash last

'ear* or ma' e mainl' the result of timing )e.g. a new loan was raised 6ust after the

end of the accounting period*.

(1) Cash requirements

A.$ 5here are four areas to consider when identif'ing whether or not the compan' has

sufficient cash.

(a) Repayment of existing loans

A.A "ll loans to e repaid in the next couple of 'ears should e considered including an'

convertile loans if the conversion rights are unli=el' to e exercised.

(b) Increase in working capital

A.B -f the usiness is expanding )ma=ing more sales* wor=ing capital will also need to

increase. 5he extra cash needed to finance the expansion can easil' e calculated '

comparing wor=ing capital to sales

-nventor' H 9eceivales ? Pa'ales x 1;;G

#ales

A.1; #uppose this is 2;G and sales are currentl' :%m, a 1;G increase in sales requires

finance of :;.1m ):%m x 1;G x 2;G* to increase the wor=ing capital.

(c) Capital expenditure reuirements

A.11 5he notes to the financial statements ma' disclose capital expenditure contracted for.-t is necessar' to consider if the compan' will have sufficient cash to meet this

capital expenditure.

(d) !ther commitments

A.12 &ontingent liailities ? Iost contingent liailities do not cr'stallise, ut if the

liailities are ver' high, their cr'stallisation can cause real prolems for the

compan'. #ome anal'sts compare the contingent liailities with total shareholders

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funds to assess the materialit' of those commitments. -n particular an' sharp

increases in the amounts involved should act as a warning.

A.13 Ceasing commitments ? -t these are material, the' should e carefull' monitored in

relation to the cash availale. 5he financial statements should disclose oth finance

lease commitments and also operating lease commitments.

(C) Cash shortfall

A.14 -f there appears to e a cash shortfall, the compan' ma' have to ta=e one or more of

the following steps(

)i* increase its overdraft )if it is not alread' at the limit*

chapter22 cfs

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