Preparation of Statements of Cash Flows
This module introduces students to modern corporate financial reporting through the Statement of Cash Flows governed by International Accounting Standard 7 (IAS 7). Learners discover why profitable businesses can still experience liquidity crises and insolvency. Students categorize cash inflows and outflows into three standard business activities: Operating Activities, Investing Activities, and Financing Activities. Learners master both the Direct and Indirect methods of computing cash flows from operating activities and prepare standard Statements of Cash Flows.
🎯 Syllabus Competencies & Learning Objectives
Key Competencies
- Main Competence: 1.0 Prepare basic financial statements
- Specific Competence: 1.3 Prepare basic Statements of Cash flows
Specific Learning Objectives
- Explain the meaning, purpose, and importance of the Statement of Cash Flows under IAS 7.
- Differentiate between cash flow and accounting profit.
- Classify cash receipts and payments into Operating, Investing, and Financing activities.
- Calculate cash generated from operations using the Indirect Method (adjusting Net Profit for non-cash items and working capital changes).
- Prepare a complete Statement of Cash Flows reconciling opening and closing Cash and Cash Equivalents.
📖 Comprehensive Study Notes Summary
**Allocated Periods: 15**
#### 1. Concept and Importance of Cash Flow Reporting (IAS 7)
- **Profit vs. Cash**:
* Profit is calculated on the *Accrual Basis* (revenues earned minus expenses incurred, including non-cash items and unpaid credit sales).
* Cash Flow tracks the actual physical movement of *liquid funds* into and out of the bank and cash till.
* A business can be wildly profitable and yet face immediate bankruptcy due to lack of liquid cash (*overtrading* or slow debtor collection).
- **Core Objectives of the Statement of Cash Flows**:
1. Assesses the ability of the enterprise to generate cash and cash equivalents.
2. Evaluates solvency, liquidity, and ability to repay debts and pay dividends.
3. Explains the difference between Net Profit and Net Change in Cash.
#### 2. The Three Categories of Cash Flow Activities
1. **Operating Activities**:
- The principal revenue-producing activities of the business (cash received from customers, cash paid to suppliers, payments for operating expenses, tax paid).
2. **Investing Activities**:
- Acquisition and disposal of long-term non-current assets and other investments (purchase/sale of property, plant and equipment, purchase/sale of shares, interest/dividends received from investments).
3. **Financing Activities**:
- Activities resulting in changes in the size and composition of the owner's equity and borrowings (issue of shares, long-term bank loans received, repayment of loans, payment of dividends, drawings).
#### 3. Operating Cash Flow: The Indirect Method
Under the Indirect Method, Net Profit is adjusted to convert accrual earnings into operating cash:
```
Cash Flows from Operating Activities:
Net Profit Before Interest and Tax XXX,XXX
Adjustments for Non-Cash / Non-Operating Items:
Add: Depreciation Expense XX,XXX
Add: Loss on Sale of Non-Current Assets X,XXX
Less: Profit on Sale of Non-Current Assets (X,XXX)
OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES XXX,XXX
Working Capital Adjustments:
(Increase) / Decrease in Inventory XX,XXX
(Increase) / Decrease in Trade Receivables XX,XXX
Increase / (Decrease) in Trade Payables XX,XXX
CASH GENERATED FROM OPERATIONS XXX,XXX
Less: Interest Paid (XX,XXX)
Less: Tax Paid (XX,XXX)
NET CASH FROM OPERATING ACTIVITIES (A) XXX,XXX
```
- **Rules of Thumb for Working Capital**:
* Increase in Asset (Inventory/Debtors) = **Cash Outflow (-)** (cash tied up).
* Decrease in Asset = **Cash Inflow (+)** (cash released).
* Increase in Liability (Creditors) = **Cash Inflow (+)** (delayed cash payment).
* Decrease in Liability = **Cash Outflow (-)** (cash paid out).
#### 4. Complete Layout of the Statement of Cash Flows
```
Net Cash from Operating Activities (A) XXX,XXX
Cash Flows from Investing Activities:
Purchase of Plant and Machinery (XX,XXX)
Proceeds from Sale of Motor Vehicle XX,XXX
Net Cash from / (used in) Investing Activities (B) (XX,XXX)
Cash Flows from Financing Activities:
Capital Introduced / Proceeds from Loan XX,XXX
Repayment of Bank Loan (XX,XXX)
Drawings Paid (XX,XXX)
Net Cash from / (used in) Financing Activities (C) XX,XXX
NET INCREASE / (DECREASE) IN CASH & CASH EQUIVALENTS (A+B+C)XX,XXX
Cash and Cash Equivalents at Beginning of Year XX,XXX
CASH AND CASH EQUIVALENTS AT END OF YEAR XXX,XXX
```
💡 Key Concepts & FAQs (Exam Questions)
Q: What are the three main activity categories in a Statement of Cash Flows under IAS 7?
Answer: Operating Activities, Investing Activities, and Financing Activities.
Q: Why is depreciation added back to Net Profit in operating cash flows?
Answer: Because depreciation was deducted as an expense in calculating profit, but involved zero cash outflow.
Q: How does an increase in Inventory affect cash flow?
Answer: It is treated as a cash outflow (deduction), because cash was spent to acquire the extra stock.
Q: Under which category is the repayment of a long-term bank loan recorded?
Answer: Financing Activities (cash outflow).