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Dear sir,
I’m puzzled about the treatment of the change in the provision for product warranties for cash flow statement in the following scenario:
1) Provision for product warranties on the statement of financial position
b/d: 4000
c/d: 16002) In the statement of Profit or Loss, the movement in the product warranty provision has been included in cost of sales.
Extract of PnL statement:
Revenue 58500
COS (46500)
Gross Profit 12000
Operating expenses (8700)
Investment Income 1100
Finance costs (500)
Profit before tax 3900Extract of Cash flow statement:
Profit before tax 3900
Adjustments for:
Depreciation xxx
xxxx
Increase in inventories xxx
Decrease in receivables xxxx
xxxx
Decrease in warranty provision (4000-1600 = 2400)
Cash used in operations (4900)I think, to correct for point 2), this this reduction of 2.4k should be deducted from cost of sales, or added to profit before tax when preparing CFO. However, the provided answer does not seem to do so, instead it only adjust profit before tax with the decrease of 2.4k, representing a outflow from the cash generated from operating activities.
Can you help? thanks!
Regards
LmThere really should be detail about cash actually paid under the warranty agreements within the question. I see no sign of a credit in the statement of profit or loss for “provision no longer required” amounting to 2,400 soi can only assume that 2,400 has been paid out in cash
In summary, there are only two ways to explain that decrease of 2,400.
1) 2,400 was paid out Dr provision Cr Cash, or
2) there was no need to keep the provision at the level of 4,000 so there was a decrease put through Dr provision Cr statement of profit or loss
In situation 1) the entry on the statement of cash flows will be an outflow of $2,400 cash within operating activities and, in situation 2) there will be a deduction of $2,400 from the figure “profit before tax” as an “add-back” within operating activities
Does that make sense to you?
so that means, because the decrease of 2400 has been included in cost of sales in the question, which effectively translates into an increase of 2400 in profit before tax. When preparing cash flow, because this 2400 is a non cash item, 2400 should be deducted from the profit before tax.
sir, is my way of thinking correct?
thanksLm
No, you’re 180 degrees off target!
If cost of sales increases, what happens to the profit figure?
if cos increases, profit decreases.
I think the question says the COS has accounted for the DECREASE in provision, meaning
-(-2400), which then increases profit ??thanks
LmAsk yourself “What was the effect of crediting the $2,400 to cost of sales?”. It reduced cost of sales and thus increased profits
That’s correct, as a non-cash item within cost of sales that has reduced cost of sales, the cash flow implication of the $2,400 is that we need to deduct it from the profit figure within the operating activities section of the statement of cash flows
Is that any clearer?
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