Where has all the money gone?
This article is relevant for ACCA F7 and P2 plus AAT and CIMA papers.
Students of financial reporting papers will need to develop a sound understanding of the primary statement known as the ‘Statement of Cash Flows’. The statement of cash flows is renowned for causing varying degrees of problems with students because depending on the level of financial reporting paper you are sitting will depend on the level of complexity you are expected to deal with when dealing with this primary financial statement.
This article looks at the key aspects of the statement of cash flows and will also look at how the statement differs depending on which GAAP you are sitting. It will also focus on the purpose of the statement of cash flows in an attempt to illustrate why the statement is prepared because understanding the reasoning behind why we do something assists us greatly in actually performing the task.
The statement of cash flows features in the provisions laid down in IAS 7 Statement of Cash Flows. If you are studying under a UK variant of financial reporting, then you will look to the provisions in FRS 1 Cash Flow Statements. This article will be primarily concerned with the provisions in IAS 7, but throughout we will be referring to some notable differences to its UK FRS 1 counterpart.
The statement of cash flows is a primary financial statement. In view of the fact that it is a primary financial statement, then it must be given the same prominence as the other primary financial statements: the statement of comprehensive income (the income statement), the statement of financial position (the balance sheet) and the statement of changes in equity.
During financial reporting studies, you will have come across the IASB’s ‘accruals concept’. This concept requires that transactions and events are accounted for within the financial statement as they arise, as opposed to when they are paid. The statement of cash flows, however, does not accord to this principle. By definition, the statement of cash flows is prepared on a cash basis, rather than an accruals basis.
The objective of the statement of cash flows is to provide the user of the financial statements with information as to how the reporting entity has generated cash during the reporting period and how the entity has spent that cash during the reporting period. The same objective is also applied in FRS 1. When preparing a statement of cash flows, you will often come across the term ‘cash and cash equivalents’. Cash and cash equivalents are classed as:
- Cash on hand.
- Short-term highly liquid investments.
- Demand deposits.
Sometimes users of financial statements will want to know, for example, how much income tax an entity has paid in the reporting period. The statement of comprehensive income will show the taxation charge on the profits for that reporting period together with any over/under provision from previous periods. The statement of financial position will show the liability owed to the tax authorities as at the reporting date. In today’s economic climate, it is not uncommon for entities to agree an instalment plan with HM Revenue and Customs and therefore, in the UK, as corporate taxes are paid nine months’ and one day after the reporting period, then there could be part of the previous year’s tax liability contained in the current year’s liability. The statement of cash flows, however, will contain the actual tax paid in the year.
As you can see from the examples above, transactions within a complete set of financial statements will often be represented differently, for example if we consider sales revenue from 1 January to 31 December:
Sales revenue contributes to revenue in the statement of comprehensive income
Sales revenue contributes to receipts from receivables in the statement of cash flows
Sales revenue contributes to receivables in the statement of financial position at the period end.
Entities reporting under IFRS are mandatorily required to prepare a statement of cash flows in accordance with IAS 7 principles. This is a notable difference in comparison to current UK GAAP (FRS 1). Under FRS 1, a company that meets the ‘small company’ criteria does not have to prepare such a statement, though the proposal is to make the statement of cash flows a mandatory statement when IFRS for SME’s becomes operational for the rest of the UK.
Entities who prepare a statement of cash flows under IAS 7 are required to prepare such a statement under three headings:
- Operating activities.
- Investing activities.
- Financing activities.
Again, there is a notable difference between IAS 7 requirements and FRS 1 requirements. FRS 1 requires a much more detailed breakdown of headings within the statement by virtue of eight headings, though for the purposes of IAS 7:
Operating activities are the day-to-day revenue-producing activities. See Figure 1 and Figure 2 below.
Investing activities are the acquisition and disposal of long-term assets that are not considered to be cash equivalents. These can comprise:
- Acquisition of property, plant and equipment (PPE).
- Disposals of PPE.
- Investing in long term investments.
- Acquisitions and disposals of subsidiaries/joint ventures/associates.
Financing activities are those activities which change the capital and borrowing structure of the reporting entity. Examples of such financing activities are:
- Loans taken out in the year.
- Proceeds from share issues.
- Buy back of equity shares.
- Redemption of preference shares/debentures.
Entities have the choice of preparing the statement of cash flows under two methods – the ‘direct’ method and the ‘indirect’ method.
The direct method is rarely used in practice, and students are urged to refer to their syllabus to determine whether or not this method is examinable. Certain bodies do not examine this method numerically, but candidates are required to have an awareness of how this method works.
The direct method shows each major class of gross cash receipts and gross cash payments. In other words, it takes such major classes of receipts and payments ‘direct’ from the cash book, hence being referred to as the ‘direct’ method. A typical illustration of this is as follows:
Cash receipts from customers $X
Cash paid to suppliers $X
Cash paid to employees $X
Cash paid for other operating expenses $X
Interest paid $X
Tax paid $X
Net cash from operating activities $X
The indirect method is the most frequently examined, and the most commonly used in practice. The indirect method adjusts operating profit for the effects of non-cash transactions and can be illustrated as follows:
Profit from operations $X
Gain on disposal of PPE ($X)
Operating cash flows before movements
in working capital $X
Increase/decrease in inventories $X/($X)
Increase/decrease in receivables $X/($X)
Increase/decrease in payables $X/($X)
Cash generated by operations $X
Income taxes paid ($X)
Interest paid ($X)
Net cash from operating activities $X
Students often struggle in deciphering when to add and when to subtract increases and decreases in working capital. The key to deciphering when to add and to subtract from operating profit is to determine the effect on the cash flow.
Consider an increase in inventories. An increase in inventories means that we have spent more cash on inventories which have not yet turned into receivables and thus not yet turned into cash. This therefore results in a cash outflow and outflows are deducted from operating profit. Conversely if we had a decrease in inventories, then this would represent an inflow of cash because we have spent less on inventories than in the previous year. The reduction is represented by either an increase in receivables or an increase in cash (inventories turn into receivables and receivables eventually turn into cash); this known as the ‘order of liquidity’.
Increases in trade receivables demonstrate that less cash has been received from trade receivables than the previous year which represents an outflow and thus a deduction from operating profit. Conversely, an increase in payables means that we have paid less to trade payables than in the previous year resulting in more money being kept in our bank meaning an inflow, so an addition to operating profit. In summary:
Cash ‘inflows’ Add to operating profit
Cash ‘outflows’ Deduct from operating profit
For those of you studying more advanced financial reporting papers then cash flows denominated in a foreign currency in respect of a foreign subsidiary should be translated at the rates prevailing when the cash flows took place. Associates and joint ventures can be subjected to the ‘equity’ method of accounting. Where this method is used, then the statement of cash flows should only report the cash flows between the investor and the investee (e.g. advance taken or given or dividend paid or received). Where proportionate consolidation is used then the statement should only include the venturer’s share of cash flows of the investee.
The statement of cash flows should be a ‘gift’ to students of financial reporting papers and as long as a methodical approach to dealing with the statement is adopted then they can be relatively straight forward – even when it comes to dealing with the more complex issues.
In a set of financial statements, the numbers are merely a form of shorthand and in recognition of this, it is also important that students are able to not only prepare the statement of cash flows, but that they are also prepared to be able to write about the statement of cash flows as examiners could ask for commentary about the statement of cash flows (or component parts) to confirm a candidate’s understanding of this primary statement. Interpretation of financial statement information is as important as being able to prepare financial statement information.
Steve Collings is Audit and Technical Manager at Leavitt Walmsley Associates and a partner in AccountancyStudents.co.uk. He also lectures student and qualified accountants on financial reporting and auditing subjects.