STATEMENT OF CASH FLOWS
1 Business Context
Cash is essential if a business is to continue its operations. Cash, or access to cash, is needed to pay for an entity’s outlays on a continuing basis and is a fundamental part of its operating cycle. An entity’s operating cycle is the period of time that a normal operating transaction takes to complete within a business, for example the time between the receipt of the order to final payment being made by the customer. If an entity is unable to pay its debts as they fall due, then it risks insolvency. Cash and liquidity are different concepts to profit. It is possible for a highly profitable entity to have liquidity problems if it does not manage the flow of cash within its business effectively. Cash is about the liquidity of a business, and hence cash flows concern the change in that liquidity. Cash management is not just about surviving; it is about the process of utilizing cash resources to their optimal effect. For an investor to be able to assess the effectiveness of a business, it is important that information is included in the financial statements not only on the entity’s performance and financial position but also on its cash flows. When used alongside a statement of financial position, for example, a statement of cash flows provides users with information on the changes in net assets of the entity. An entity may have a strong financial position and good performance during the period, but may also have suffered significant cash outflows. The financial information is therefore not complete without the cash flow information, which may tell a different story to the original assessment of an entity’s performance.
2 Chapter Objectives
This chapter covers the preparation and presentation of a statement of cash flows as part of
an entity’s financial statements.
IAS 1 Presentation of financial statements sets out the content of an entity’s financial statements. It includes the requirement for a statement of cash flows to be presented. On completion of this chapter you should be able to:
understand the objectives and scope of IAS 7 Statement of cash flows;
identify the important terminology and definitions which relate to the presentation of the statement of cash flows in the financial statements;
distinguish between cash and cash equivalents, and other assets and liabilities;
identify the main sections of a statement of cash flows and the cash flows relating to each of them; and
apply knowledge and understanding of IAS 7 through basic calculations.
3 Objectives, Scope and Definitions of IAS 7
3.1 Objective and scope
The objective of IAS 7 is to provide information about the historical changes in cash, and cash equivalents, of an entity. This information is presented via a statement of cash flows that classifies cash flows under the headings of:
operating activities;
investing activities; and
financing activities.
The preparation of a statement of cash flows as part of an entity’s financial statements is required of all entities, with no exceptions.
3.2 What is cash?
The nature of cash may, at first, seem obvious, but cash may be held in many forms. Some forms of cash can be accessed immediately while there is a delay in accessing others. As defined by IAS 7, cash includes not only cash itself but also any instrument that can be converted into cash so quickly that it is in effect equivalent to cash. In IAS 7, the statement of cash flows seeks to identify changes in:
Classification Amounts included
Cash “Cash in hand and demand deposits”. [IAS 7.6]
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”. [IAS 7.6]
An essential element of a cash equivalent is that it is held for the purpose of meeting short-term cash commitments as they fall due and not for long-term investment purposes. To meet the definition of a cash equivalent, the item should be “readily convertible” which suggests that it has a short maturity of, say, three months or less from the date of acquisition. Cash equivalents may therefore include:
Short term deposits;
Loan notes;
Bank deposit accounts; and
Government securities.
Equity investments should normally be excluded, because, unlike government securities, they
are subject to a significant risk of changes in value.
Bank borrowings normally form part of an entity’s financing activities, which are discussed
below. A bank overdraft, however, is often used as a key element of an entity’s daily cash
management; for example a positive cash balance may be held at the end of one day with an
overdraft the next. In such circumstances the overdraft should be included as a component of
cash and cash equivalents.
3.3 Sources and uses of cash
Cash flows are inflows and outflows of cash and cash equivalents (hereafter referred to as
‘cash’).
IAS 7 requires sources and uses of cash to be analyzed under the following headings:
Headings Description
Operating activities “The principal revenue-producing activities of the entity and other
activities that are not investing or financing activities”. [IAS 7.6]
Investing activities “The acquisition and disposal of long-term assets and other
investments not included in cash equivalents”. [IAS 7.6]
Financing activities “Activities that result in changes to the size and composition of
the contributed equity and borrowings of an entity”. [IAS 7.6]
Illustration 1
The list of transactions and balances set out below should be included in the cash flow
headings as shown in the table.
– cash payments to purchase a non-current asset;
– the issue of shares for cash;
– cash received from customers;
– a short-term cash deposit requiring 20 days’ notice for its withdrawal;
– a cash repayment of a bank overdraft (assuming the overdraft is used as an integral part
of the entity’s cash management);
– revaluation of land;
– cash repayment of a loan;
– cash received as commission;
– a bonus issue of shares; and
– cash payment to purchase listed government securities (with a maturity date in one
month’s time).
Operating cash flow
Investing cash flow
Financing cash flow
Cash and cash equivalents
Cash received from customers
Cash payments to purchase a non-current asset
Issue of shares for cash
Short-term cash deposit
Cash received as commission
Cash repayment of a loan
Cash repayment of an overdraft
Cash payment to purchase listed government securities
Note: the following items are non-cash transactions and would not appear in the statement
of cash flows:
– revaluation of land; and
– a bonus issue of shares.
4 Overview of IAS 7 – A Statement of Cash Flows
An illustrative pro forma statement of cash flows is set out below:
Statement of cash flows for the year ended 30 June 2008
CU000 CU000
Cash flows from operating activities
Cash generated from operations 10,000
Interest paid (3,000)
Tax paid (5,000)
Net cash from operating activities 2,000
Cash flows from investing activities
Purchase of property, plant and equipment (1,200)
Proceeds from sales of property, plant and equipment 100
Interest received 200
Dividends received 300
Net cash used in investing activities (600)
Cash flows from financing activities
Issue of ordinary shares 2,000
Issue of preference shares 1,100
Issue of non-current interest-bearing borrowings 2,500
Redemption of non-current interest-bearing borrowings (1,000)
Dividends paid (500)
Net cash used in financing activities 4,100
Net change in cash and cash equivalents 5,500
Cash and cash equivalents brought forward 3,200
Cash and cash equivalents carried forward 8,700
This illustrative example of a statement of cash flows shows interest paid as part of operating
activities because it is part of the profit or loss reported by the entity in the period. However,
IAS 7 also permits interest paid to be reported as part of the entity’s financing or investing
activities. [IAS 7.31]
Interest received and dividends received are shown as part of the investing activities in the
illustration set out above; however, they may be reported as part of the operating or financing
activities as described above for interest paid. [IAS 7.31]
Dividends paid are shown as part of the financing operations of the entity in the illustration because they relate to the cost of obtaining equity finance. An alternative treatment permitted under IAS 7 is to include them as part of the operating activities of the entity. Although dividends paid are not deducted in arriving at the profit or loss for the period in the statement of comprehensive income, this presentation allows a user to assess the entity’s future ability to pay dividends out of its operating activities. The separate line items set out under the required cash flow headings should represent the major classes of gross cash receipts and payments arising for each of the activities. Certain cash flows may be reported on a net basis under the relevant cash flow heading. Items shown net may include, for example, cash that is received by the entity on behalf of a third party and is subsequently paid on to that third party. Cash flows should also be
presented on a net basis where the related inflow and outflow occur within a short space of time, the cash flows are large and the maturity dates are short (within three months). An example is the purchase and sale of the same investment.
5 Cash Flows from Operating Activities
The cash flows from an entity’s operating activities can be presented using two methods:
the direct method, which discloses the major classes of gross cash receipts and gross cash payments; or
the indirect method, where the entity starts with the profit or loss for the period and adjusts it for non-cash transactions, deferrals or accruals of income and expenditure and items that form part of the entity’s investing and financing activities.
5.1 The direct method
The direct method details the actual cash flows that are part of the operating activities of the entity. Such cash flows should therefore include, for example, payments to suppliers, receipts
from customers, payments to employees and other payments and receipts made or received
as part of the entity’s operating activities.
Where this approach is adopted, the information will generally be obtained from the entity’s accounting records directly. An alternative approach under the direct method can be to adjust each line item in the statement of comprehensive income for non-cash transactions that have occurred during the period and for items that fall under the headings of investing and financing activities. The nature of the adjustments using this approach is illustrated in the following table:
Statement of comprehensive income item Examples of adjustments
Revenue Change in trade receivables
Cost of sales Relevant part of depreciation charge
Change in inventories
Change in trade payables on purchases
Operating expenses Relevant part of depreciation charge
Changes in accruals/prepayments
Change in trade payables on operating expenses
Illustration 2
Extracts from the draft financial statements of Delta for the year ended 31 December 2007,
are set out below:
Statement of comprehensive income
CU CU
Revenue 250,000
Cost of sales Opening inventories 30,000
Purchases 218,000
Closing inventories (52,000)
(196,000)
Gross profit 54,000
Other operating expenses (all cash costs except
for depreciation of CU11,000) (21,600)
Profit from operations 32,400
Statement of financial position extracts 31 Dec 2007 31 Dec 2006
CU CU
Trade receivables 68,000 23,000
Trade payables 21,600 42,800
The cash from operations for Delta for the year ended 31 December 2007 using the direct
method is:
Cash from customers (250,000 + (23,000 – 68,000)) 205,000
(Revenue plus the movement in trade receivables)
Cash to suppliers (218,000 + (42,800 – 21,600)) (239,200)
(Purchases plus the movement in trade payables)
Other cash operating expenses (21,600-11,000) (10,600)
(Other cash operating activity expenses adjusted
for non-cash items, i.e. depreciation)
Cash outflow from operating activities (44,800)
Notes: This illustration highlights how an entity can have profits from operating activities but
an outflow of cash from those activities.
5.2 Indirect method
The indirect method of calculating the cash flows from an entity’s operating activities makes
adjustments to the profit or loss for the period. The adjustments are for non-cash transactions,
deferrals or accruals of income and expenditure and for items that will form part of the
investing and financing activities of the entity. [IAS 7.18]
Illustration 3
Using the information from Illustration 2 above, the cash generated from operations for Delta
for the year ended 31 December 2007 using the indirect method is:
CU
Profit from operating activities 32,400
Depreciation charge (adjust for non-cash expenses) 11,000
Increase in inventories (52,000-30,000) (22,000)
(adjust for the movement in inventories)
Increase in trade receivables (68,000-23,000) (45,000)
(adjust for the movement in inventories)
Decrease in trade payables (21,600-42,800) (21,200)
(adjust for the movement in inventories) _______
Cash outflow from operating activities (44,800)
_______
This gives the same solution as the direct method.
The adjustments for movements in inventories, trade receivables and payables are to
reverse out the effect of accruals accounting (recording income when it becomes receivable
rather than when the cash is received).
The presentation of the net cash flows of the entity for its operating activities may be
presented by showing movements during the period in inventories and operating receivables
and payables.
5.3 Taxation
Although profit-based taxes may relate to items throughout the cash flow statement, it may
not be practicable to identify separately the elements of tax which relate to each of the three
components of the cash flow statement. As a result, tax will normally be reported as part of an
entity’s operating activities, although it may be split between the relevant headings where it is
practicable to do so. [IAS 7.35]
The cash flow in relation to tax should be separately identified in the cash flow statement and,
where it has been allocated between the different headings, a total should be disclosed.
[IAS 7.35]
6 Cash Flows from Investing Activities
Cash flows arising from investing activities are important, as they provide information on the
level of investment that an entity has made in assets that it will hold and use in its business on
an ongoing basis.
Examples of cash flows arising from investing activities include:
cash paid to acquire, or a receipt from the sale of, an item of property, plant or
equipment;
cash paid to acquire, or a receipt from the sale of, an intangible asset, such as a
brand or trademark;
cash paid to acquire, or a receipt from the sale of, a separate business;
cash paid to acquire, or a receipt from the sale of, an equity or debt instrument in
another entity, such as a joint venture; and
cash given as an advance or loan to another entity, or the repayment of such items.
Cash inflows or outflows arising from the sale or acquisition of a business should be shown as
a net figure and identified separately in the statement of cash flows. As listed above, such
cash flows form part of an entity’s investing activities. [IAS 7.39]
It is important to remember that when an asset is sold, not only will there be a cash inflow
from the proceeds of the sale, but the entity will also make a profit or loss on the transaction.
The profit or loss itself is not a cash flow and therefore is not reported in the statement of cash
flows. It is the cash proceeds received on the sale that are reported in the statement of cash
flows.
Illustration 4
An item of plant was disposed of for cash proceeds of CU1,000. The carrying amount of the
item of plant at the date of the sale was:
CU
Cost 3,000
Less: Accumulated depreciation 1,300
_____
Carrying amount 1,700
A loss of CU700 (the difference between the proceeds of CU1,000 and the carrying amount
of CU1,700) should be recognised in profit or loss and the non-current asset should be
removed from the statement of financial position. This loss should be excluded when
calculating cash flows from operating activities for the statement of cash flows.
The CU1,000 cash proceeds received should be recognised in the statement of cash flows
as an investing activity – “proceeds from sale of property, plant and equipment”.
The cash flows that occur as a result of making an acquisition of a business, or from disposal
of a business, have a direct impact on the entity’s cash flows reported in the period and its
likely future cash flows. Such information should therefore be separated out, so that a user of
the financial statements is able to make a better assessment about cash flows that are likely
to be ongoing and those that are not. IAS 7 specifically requires the following information to
be disclosed in aggregate for acquisitions and sales of businesses, including subsidiaries,
made during the period: [IAS 7.40]
the total proceeds from a sale of businesses or the consideration paid to acquire
businesses, separately identifying the proportion that is cash;
the amount of cash in the businesses being purchased or sold; and
a summary of the assets and liabilities, other than cash, of the businesses acquired
or disposed of.
7 Cash Flows from Financing Activities
Financing activities change the amount and composition of an entity’s equity capital and
borrowings. Such activities are included under a separate heading in the statement of cash
flows because this analysis provides useful information on the amount of cash generated by
the entity that will be needed to service its financing activities. Examples of financing activities
are:
cash proceeds received from issuing shares in the entity;
cash paid to redeem shares in the entity;
cash proceeds received from issuing debt instruments, such as debentures, bonds or
long-term borrowings;
cash paid to repay debt instruments; and
the capital element in finance lease payments made during the period.
As discussed above, dividends paid by an entity may also form part of an entity’s financing
activities, depending on the analysis chosen.
It is important to remember that it is cash movements that are reflected in the statement of
cash flows, so, for example, where shares are issued above their par value, the amount
recorded in the statement of cash flows is a single figure for the total cash received (being the
par value and any share premium recognised). The same principle applies to dividends paid
by an entity, since dividends recognised elsewhere in the financial statements may include
amounts that have been declared at the end of the reporting period, although not yet paid.
The statement of cash flows only recognises the actual outflow of cash to investors.
Illustration 5
An entity has declared preference dividends for the year of CU7,000 (based on its 7%
CU100,000 irredeemable preference shares in issue).
At the start of the year, there was a balance of CU3,500 for preference dividends payable.
At the end of the year no amount was owing to preference shareholders in respect of
dividends.
The preference dividend paid for the year is not simply the CU7,000 declared, as this
amount needs to be adjusted for any opening and closing balances.
CU
Opening balance 3,500
Declared in the year 7,000
Less: Closing balance -
_____
Dividend paid 10,500
Chapter 21 - Statement of Cash Flows
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8 Sundry Items
8.1 Foreign currency cash flows
Where a cash flow arises from a transaction in a foreign currency, it should be translated into
the entity’s functional currency at the exchange rate on the date that the cash flow occurred.
[IAS 7.25]
Accounting for foreign currency transactions is dealt with in IAS 21 Accounting for the effects
of changes in foreign exchange rates. The translation of foreign currency cash flows should
be consistent with the application of IAS 21. The average exchange rate for the period may
be used as an approximation to the actual exchange rate, although an entity is not permitted
to use the rate at the end of the reporting period to translate foreign currency cash flows.
Where an entity has a foreign subsidiary, its cash flows should be translated to the functional
currency at the exchange rates on the dates that the cash flows occurred. [IAS 7.26]
8.2 Non-cash transactions
Investing and financing transactions that do not impact on cash, for example the conversion
of debt to equity, should not be included in the statement of cash flows. The effect of such
transactions should be disclosed elsewhere in the financial statements as appropriate.
[IAS 7.43]
8.3 Additional disclosures
An entity should disclose the components of cash and provide a reconciliation between this
and the corresponding items in the statement of financial position. [IAS 7.45]
If an entity has any significant cash balances that are restricted in some way and therefore
are not available for use by the entity, this should be explained. [IAS 7.48]
Other disclosures are required where such additional information is relevant to users in their
understanding of an entity’s financial statements. Additional useful disclosures may include,
for example, the amount of an entity’s undrawn borrowings and a split of cash flow
information to identify the flows that are needed to maintain an entity’s current operating
capacity and those which increase its capacity.
9 Chapter Review
This chapter has been concerned with the statement of cash flows. In particular it has focused
on identifying and disclosing the key elements of a statement of cash flows.
This chapter has covered:
the objectives, scope, definitions and disclosure requirements of IAS 7;
cash flows arising from operating activities;
cash flows arising from investing activities; and
cash flows arising from financing activities.
