Reporting cash flows

BEA1007 Accounting II

Dr Petros Vourvachis
p.vourvachis@exeter.ac.uk
Office (STC 0.18) hours:
Fridays 11-1

About today
Well discuss the 8th
Accounting II topic with
particular objectives to:
Understand the
importance of cash to a
business, and,
appreciate the need for
a statement of cash
flows and prepare it!
2

We have a date for the

exam!
It will take place on
Wednesday 23 May,
between 14.15 and 16.15.
Held in the Great Hall, but
also a number of smaller
venues (e.g. PCC 1.1, PCC
1.5) please check your
exams timetable to find your
room!
Well revise for it in the last
lecture in three weeks time.
3

Definitions
This lectures focus on reporting cash flows.
According to IAS 7 (the relevant standard):
Cash is notes and coins in hand and deposits in
banks and similar institutions that are accessible
on demand
Cash equivalents is short-term, highly liquid
investments, readily convertible into known
amounts of cash, subject to insignificant risk of
change in value, held for the purpose of meeting
short-term cash commitments rather than for
4
investment

Cash & cash equivalents

Examples include:
Notes/Coins
Bank deposits (withdrawable
on demand)
Overnight money market
deposits (virtually cash)
repayable the following
morning (UK)
Month-long deposits
(International)

Key feature: low risk of loss

of value (in the short term)
5

Importance of cash

The ability to generate cash is

essential for a companys survival

Employees and creditors normally only accept

cash payment (or cash equivalents)
Analysts focus primarily on cash position when
assessing strength of business!
Liquidity problems (no cash to pay expenses as
they fall due) are the primary cause of business
failure, even for profitable businesses
6

Cash vs. profit

The ability to earn profits does not necessarily

result in a healthy cash balance
Essential a business can generate enough
cash to meet short term commitments
7

Relationship with BS and

IS

Balance sheet states the assets and

liabilities at a specific point in time
The income statement shows revenues
and expenses rather than cash receipts
and payments
Limited relationship to the cash generated
CFS needed to show cash position!

Relationship with BS and

IS
Equity

Income statement

Statement of
financial position
at the start of the
accounting period

Cash and
cash
equivalents

Equity
Statement of
financial position
at the end of the
accounting period

Statement of
cash flows

Cash and
cash
equivalents

CFS development

In July 1977 the IASC originally approved

IAS 7 Statement of Changes in Financial
Position via a statement of sources and
use of funds
IAS 7 was revised in 1992 and renamed
the Cash Flow Statement
Mandatory for financial periods from
1 January 2005
10

CFS development

In September 2007 IAS 7 was

retitled Statement of Cash
Flows as a consequential
amendment resulting from
revisions to IAS 1
Aim: give users a basis on
which to evaluate the ability of
a business to generate cash
and cash equivalents
11

CFS: things to consider

The following do not have an impact on the

cash flow:
Depreciation

Represents a charge for using fixed assets

How about amortisation? Impairment? Revaluation?

Disposal of fixed assets

Loss on sale is deducted from the profit figure

Profit on sale is added to the profit figure
It is the actual cash received from the disposing of
the assets that will have an impact on cash
12

CFS: things to consider

The following have an impact on the CF:

Inventory

Debtors

If inventory increases/decreases this would

result in a decrease/increase of cash
If debtors take longer to pay then this will
have a negative impact on the cash flow

Creditors

If creditors are increasing, the business is

retaining cash

13

CFS breakdown

Cash Flows within a business can be

categorised as arising from three main
activities:

Operating activities
Investing activities
Financing activities

14

CF from operating
activities

Net cash inflow/outflow from day-to-day trading

activities, after tax and financing costs:
Cash receipts from customers less cash payments to
suppliers, rent, wages and all other cash expenses

Not the same as revenue and expenses in the income

statement
Depreciation/ amortisation/ impairment expenses are not included in
the CF from operating activities
In contrast, revenue/expenses in the IS include sales and purchases
on credit
CF only considers interest and tax paid

15

16

CF from investing
activities
Shows the net cash flows from making
new investments and disposing of
existing ones:
Cash payments to acquire non-current assets
Cash receipts from disposal of non-current
assets
Receipts from investments made outside the
company
Interest received on loans
Dividends received from equity investments
16

17

CF from financing
activities
Shows the net cash flows of raising and
paying back long-term finance:
Cash received from borrowing obtained
Cash repaid to redeem borrowings
Cash received from share issues made
Can include dividend payments made by the
business here, or under operating activities

The standard layout of CFS is thus as

follows
17

Standard layout of CFS

Cash flows
from operating activities

Cash flows
from investing activities

plus or
minus

plus or
minus

Cash flows
from financing activities
equals

Net increase (or decrease) in

cash and cash equivalents
over the period

18

Direction of cash flows

Normal operating (trading) activities increase

cash resources giving positive cash flows

Cash generated from trading is most important

source of finance for 80% of UK firms

Investing decreases cash resources but

increases non-current assets giving net negative
cash flows
Financing activities give rise to either positive or
negative cash flows. However, since firms seek
to raise capital by issuing shares or borrowing
tendency is for positive cash flows
19

Direction of cash flows

Operating
activities

Cash and
cash
equivalent
balances

Investing
activities

Financing
activities

20

1. Press the Ch or Go button

2. Enter the channel number (02)
3. Press the Ch or Go button
4. Press and release the "1/A" button.
The light should flash amber to
confirm.

21

Lets check if it works

- Has the e-book helped your revision?
1.
2.
3.
4.

Not much
A bit
A lot
I bought a
paper copy

22

Which one of the following features of cash

equivalents is incorrect?

1. Held for meeting shortterm commitments

2. Highly liquid
3. Held for long-term
investment purposes
4. Subject to insignificant
risks of changes in value

23

The essential difference between the statement

of cash flows and the income statement is that:

1.

2.

3.
4.

IS is based on the accruals

concept, whereas CFS reports
cash received or paid
CFS is a forecast of the future,
whereas IS reports historical
events
IS is prepared for external users,
whereas CFS for internal users
CFS only deals with items
measurable in monetary terms,
whereas IS also includes nonmonetary items
24

In a statement of cash flows, the cash generated

from day-to-day trading activities is known as
which one of the following?
1.
2.
3.
4.

Cash flows
activities
Cash flows
Cash flows
Cash flows

from operating
from normal activities
from trading activities
from ordinary activities

25

A business may incur an operating loss for the

year yet have more cash at the end of the year
than at the beginning. A reason for this could be
that:
1.
2.
3.
4.

Trade receivables were allowed a

longer period of credit
Non-current assets were sold for
cash
Dividends paid were lower than in
the previous year
Payments to trade payables were
made more promptly

26

Which one of the following will appear in the

statement of cash flows?

1.
2.
3.
4.

A transfer of profits to reserves

The return of faulty goods
purchased on credit
A bonus issue of shares
A rights issue of shares

27

Which one of the following will not appear in the

statement of cash flows?

1.
2.
3.
4.

Issue of loan notes

Share repurchase
Increase in share premium reserve
Increase in revaluation reserve

28

Methods of calculation

There are two methods of determining the cash flow

from operating activities, the Direct and the Indirect
method
Direct or gross method

Involves an analysis of the cash records of the business

for the period picking out all payments and receipts
relating to operating activities

Indirect or net method

It involves starting with the operating profit and adjusting

it for non-cash charges and cash inflows & outflows so
that one figure of operating cash flow is shown
29

Direct vs. indirect method

Each has its advantages and disadvantages

The direct method gives a clearer picture of cash flows and provides
details that are not available under the indirect method but (although a
matter of routine when computers are used, it still) needs more work to
identify all the operating flows form the cash records through detailed
analysis of bookkeeping records.
The indirect method takes the approach that, while the profit (loss) for
the year is not equal to the net inflow (outflow) of cash from
operations, they are fairly closely linked to the extent that appropriate
adjustment of the figure for profit (loss) for the year will produce
the correct figure for cash flow. It is easier to prepare and highlights
the effects of working capital on cash flows

The indirect method is more popular since firms must prepare

an IS and BS anyway, and figures in the CFS must reconcile
with these statements focus of the lecture on this method
30

The indirect method

Requires the following:

Balance sheet at the start of the period

Balance sheet at the end of the period
Income statement for the period

Because the Income Statement is prepared on an

accruals basis, some adjustments must be made
Most complicated adjustments concern estimating
the net cash flows from operating activities!

This needs to take into consideration the changes in

working capital items (current assets & current liabilities)
but also any dividend /taxation / interest paid)
31

The indirect method

Profit before taxation
plus
Depreciation expense
Interest expense
Increase (minus) or decrease (plus) in
inventories
Increase (minus) or decrease (plus) in
trade receivables
Increase (plus) or decrease (minus)
in trade payables

plus
plus or minus
plus or minus
plus or minus
less

Interest paid
less
Taxation paid
Dividend paid

less
equals

Net cash flows from operating activities

32

The indirect method

Easier to determine the net cash flows from

investing and financing activities!

Net cash flows from investing activities usually involve

calculating payments to acquire non-current assets
(NBV of non-current assets at the start - depreciation of
the year - NBV at the end)
Net cash flows from financing activities usually involve
adjusting for changes in loans and share capital /
premium (add increase / deduct decrease)

33

A template CFS

34

When deriving cash flows from operating

activities, the direct method will produce a
different figure than the obtained from using the
indirect method
1.
2.

True
False

35

When using the indirect method to determine

cash flows from operations in a profitable
company, which one of the following is shown as
the first entry under the heading cash flows from
operating activities?
1.
2.
3.
4.

Profit after taxation and after

interest
Profit before taxation and before
interest
Profit before taxation and after
interest
Profit before taxation and before
interest

36

Starting with the profit before taxation (after

interest), it is necessary to .. the annual
depreciation charge when working towards the
cash flow from operating activities
1.
2.
3.
4.

Reduce
Ignore
Add
Deduct

37

During an accounting period, profit before

taxation (after interest) will not normally equal
the cash flows from operating activities. Which
one of the following could not account for any
difference between the two?
1.
2.
3.
4.

Depreciation
Issue of loan notes
Credit sales
Credit purchases

38

Which one of the following groups of items will be

added back to profit before taxation (after
interest) when calculating the cash flows from
operating activities?
1.
2.
3.
4.

A decrease in inventories and a

decrease in trade receivables
A decrease in inventories and an
increase in trade receivables
An increase in inventories and a
decrease in trade payables
A decrease in inventories and a
decrease in trade payables

39

Which one of the following groups of items will be

deducted from profit before taxation (after
interest) when calculating the cash flows from
operating activities?
1.
2.
3.
4.

A decrease in inventories and an

increase in trade payables
An increase in inventories and a
decrease in trade receivables
A decrease in inventories and a
decrease in trade receivables
An increase in inventories and a
decrease in trade payables

40

Which one of the following items would be shown

under the heading cash flows from financing
activities in a statement of cash flows?
1.
2.
3.
4.

Tax paid
Loan interest paid
Depreciation of non-current assets
Repayment of loan notes

41

A simple example Torrent

plc

42

Torrent plc

43

Torrent plc
Cash flow from operating activities

Profit before taxation (after interest)

----

Adjustments for:
Depreciation

----

Interest expense

----

Increase in trade receivables

----

Decrease in trade payables

----

Decrease in inventories

----

Cash generated from operations

----

Interest paid

----

Taxation paid

----

Dividend paid

----

Net cash from operating activities

---44

Torrent plc
Cash flows from investing activities
Payments to acquire tangible non-current assets

----

Net cash used in investing activities

----

Cash flows from financing activities

Repayments of loan notes

----

Issue of ordinary shares

----

Net cash used in financing activities

----

Net increase in cash and cash equivalents

----

Cash and cash equivalents at 01/01/2010

----

Cash and cash equivalents at 31/12/2010

---45

Torrent plc

46

Torrent plc

47

Independent study for next

week
Study Chapter 6, pages
186-208.
Homework question is
from a past exam! See
next couple of slides
(also uploaded on ELE)

48

Homework question

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Homework question

50