This article considers the statement of cash flows, including how to calculate cash flows and where those cash flows are classified and presented in the statement of cash flows. Both the direct and indirect methods of preparing a statement of cash flows will be addressed in this article.
Cash flows are either receipts (ie cash inflows) and so are represented as a positive number in a statement of cash flows, or payments (ie cash outflows) and so are represented as a negative number in a statement of cash flows.
Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.
Common cash flow calculations include the tax paid (which is an operating activity cash outflow), the payment to buy property, plant and equipment (PPE) (which is an investing activity cash outflow), and dividends paid (which is a financing activity cash outflow). The following examples illustrate all three of these cases.
EXAMPLE 1 – Calculating the tax paid
Crombie Co had a tax liability of $500 at 1 January 20X1. The tax liability at 31 December 20X1 is $900 and the tax charged in the statement of profit or loss was $1,000.
Required: Calculate the tax paid by Crombie Co for the year ended 31 December 20X1.
Solution
It is necessary to reconcile the opening tax liability to the closing tax liability to reveal the cash flow – the tax paid – as the balancing figure.
Tax liability | $ | Explanation |
|---|---|---|
Opening balance at 1 January 20X1 | 500 | Credit balance |
Tax charge for the year 20X1 | 1,000 | The tax charged in the statement of profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to the tax liability account reflects the increase in the tax liability |
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Sub-total | 1,500 | This sub-total represents the amount of the tax liability at the reporting date in the event that no tax had been paid |
Cash flow – the payment of tax | (600) | This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end tax liability is smaller than the sub-total |
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Closing balance at 31 December 20X1 | 900 | This is the closing balance of the tax liability |
This simple technique of taking the opening balance of an item (in this case the tax liability) and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.
EXAMPLE 2 – Calculating the payments to buy PPE
At 1 January 20X1, Crombie Co had PPE with a carrying amount of $10,000. The carrying amount of PPE at 31 December 20X1 is $30,000. During the year, depreciation charged was $2,000, a revaluation surplus of $6,000 was recorded and PPE with a carrying amount of $1,500 was sold for $2,000.
Required: Calculate the cash paid by Crombie Co to buy new PPE during the year ended 31 December 20X1.
Solution
Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in the period that are not cash flows. The balancing figure is the cash paid to buy new PPE.
PPE | $ | Explanation |
|---|---|---|
Opening balance at 1 January 20X1 | 100,000 | Debit balance |
Deprecation | (2,000) | Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to statement of profit or loss to reflect the expense and to credit the asset to reflect its consumption. |
Revaluation surplus | 6,000 | The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and to debit the asset to reflect its increase |
Disposal | (1,500) | The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account |
| _____ |
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Sub-total | 12,500 | This sub-total represents the balance of the PPE if no PPE had been bought for cash |
Cash flow – the payment to buy PPE | 17,500 | This is the last figure written in the reconciliation. This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total |
| _____ |
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Closing balance at 31 December 20X1 | 30,000 |
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| _____ |
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Note that the cash proceeds from the disposal of PPE ($2,000) would be shown separately as a positive cash inflow under investing activities. The profit on disposal of PPE of $500 ($2,000 – $1,500) would be adjusted for as a non-cash item under the operating activities (see later).
EXAMPLE 3 – Calculating the dividend paid
At 1 January 20X1, Crombie Co had retained earnings of $5,000. Profit for the year was $4,500 and retained earnings at 31 December 20X1 are $7,000.
Required: Calculate the dividend paid by Crombie Co during the year ended 31 December 20X1.
Solution
As before, to work out the cash flow – in this case dividends paid – we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity
Retained earnings | $ | Explanation |
|---|---|---|
Opening balance at 1 January 20X1 | 5,000 | Credit balance |
Profit for the year 20X1 | 4,500 | The profit for the year is a credit and increases the retained earnings |
| _____ |
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| 9,500 | This sub-total represents the balance on retained earnings if no dividends have been paid |
Cash flow – the dividends paid | (2,500) | This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is $7,000 rather than $9,500 |
| _____ |
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Closing balance at 31 December 20X1 | 7,000 |
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| _____ |
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IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flows classifies and presents cash flows under three headings:
(i) Operating activities;
(ii) Investing activities; and
(iii) Financing activities.
Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and employees. The second is the indirect method which reconciles profit before tax to cash generated from operations. Under both of these methods the interest paid and taxation paid are then presented as cash outflows deducted from the cash generated from operations to give net cash from operating activities.
Investing activities cash flows are those that relate to non-current assets, including investments. Examples of cash flows from investing activities include the cash outflow on buying PPE, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.
Financing activities cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings (debt) and cash from shareholders (equity). Examples of cash flows from financing activities include the cash received from new borrowings or the cash repayment of debt. It also includes the cash flows related to shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.
As noted above, IAS 7 permits two different ways of reporting cash flows from operating activities – the direct method and the indirect method.
The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash outflows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally, the payments for interest and tax are deducted.
Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial reconciliation, the profit before tax is adjusted for income and expenses that have been recorded in the statement of profit or loss but are not cash inflows or outflows. For example, depreciation and losses on disposal of non-current assets, have to be added back, and non-cash income such as investment income and profits on disposal of non-current assets are deducted.
The changes in working capital (i.e. inventory, trade receivables and trade payables) do not impact on the profit but these changes will impact cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will not impact profit before tax but will have had an adverse impact on the cash flow of the business. Therefore, in the reconciliation process, the increases in inventory and trade receivables are deducted from profit before tax. Conversely, decreases in inventory and trade receivables are added back to the profit before tax. The opposite is applicable for trade payables.
For each movement in working capital, you must consider whether it has had a favourable or unfavourable cash flow impact on the business. If the impact is favourable, then the movement in the year should be added on to profit before tax as part of the reconciliation. If the impact is unfavourable, then it should be deducted.
Finally, the payments for interest and tax are presented.
The following example illustrates both the direct and indirect methods.
EXAMPLE 4 – The direct and indirect methods
Extracts from the financial statements are as follows
| $ | |
|---|---|
Operating profit | 80,000 |
Investment income | 12,000 |
Finance costs | (10,000) |
Profit before tax | 82,000 |
Tax | (32,000) |
Profit for the year | 50,000 |
Other comprehensive income |
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Revaluation gain | 40,000 |
Total comprehensive income | 90,000 |
| Closing balance $ | Opening balance $ |
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|---|---|---|
Current assets |
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Inventory | 30,000 | 25,000 |
Trade receivables | 20,000 | 26,000 |
Current liabilities |
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Trade payables | 14,000 | 11,000 |
Additional informationDuring the year, depreciation of $50,000 and amortisation of $40,000 was charged to the statement of profit or loss.
Cash receipts from customers, including cash sales, were $800,000. Cash paid to suppliers and employees was $626,000.
Interest paid was $12,000 and taxation paid was $13,000.
Required:
(a) Prepare the operating activities section of the statement of cash flows using the direct method.
(b) Prepare the operating activities section of the statement of cash flows using the indirect method.
Solution (a) direct method
The direct method is relatively straightforward in that all the data are cash flows so it is a case of listing the receipts as positive and the payments as negative.
Cash flows from operating activities – Direct method | $ | |
|---|---|---|
Cash receipts from customers | 800,000 | |
Cash paid to suppliers and employees | (626,000) | |
Cash generated from operations | 174,000 | |
Interest paid | (12,000) | |
Taxation paid | (13,000) | |
| Net cash from operating activities | 149,000 |
Note that the additional information in this example stated figures related to cash receipts from customers and cash paid to suppliers and employees. You may need to determine these for yourself by using the figures in the financial statements and the additional information provided in the question.
You should refer to material from your learning provider to learn more about these calculations.
Solution (b) indirect method
As we start with profit before tax in the indirect method, we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then are the two actual cash flows of interest paid and tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.
Cash flows from operating activities – Indirect method | $ |
|---|---|
Operating activities |
|
Profit before tax | 82,000 |
Investment income | (12,000) |
Finance cost | 10,000 |
Depreciation | 50,000 |
Amortisation | 40,000 |
Increase in inventory | (5,000) |
Decrease in receivables | 6,000 |
Increase in payables | 3,000 |
Cash generated from operations | 174,000 |
Interest paid | (12,000) |
Taxation paid | (13,000) |
| Net cash from operating activities | 149,000 |
Note that, whichever method is used, the same figure is presented as the cash generated from operations and the net cash from operating activities.
Written by a member of the FA/FFA examining team