Chapter Six
Summary
The need for a statement of cash flows
Cash is important because no business can operate without it.
The statement of cash flows is specifically designed to reveal movements
in cash over a period
Cash movements cannot be readily detected from the income statement,
which focuses on revenue and expenses rather than on cash inflows and
outflows.
Profit (or loss) and cash generated for the period are rarely equal.
The statement of cash flows is a major financial statement, along with the
income statement and the statement of financial position.
Preparing the statement of cash flows
The cash flows statement has three major categories of cash flows: cash
flows from operating activities, cash flows from investing activities and
cash flows from financing activities.
The total of the cash movements under these three categories will provide
the net increase or decrease in cash and cash equivalents for the period.
A reconciliation can be undertaken to check that the opening balance of
cash and cash equivalents plus the net increase (or decrease) for the
period equals the closing balance.
Calculating the cash generated from operations.
The net cash flows from operating activities can be derived by either the
direct method or the indirect method.
The direct method is based on an analysis of the cash records for the
period, whereas the indirect method uses information contained within the
income statement and statements of financial position.
The indirect method takes the operating profit for the period, adds back
any depreciation charge and then adjusts for changes in inventories,
receivables and payables during the period.
Problems with IAS 7
IAS 7 has been criticized for being too permissive in the description and
classification of important items and for allowing businesses to adopt the
indirect method for determining net cash from operating activities.
There have also been calls for movements in net debt to be reconciled with
cash flows.
,Definitions
Direct method: an approach to interim profit measurement that treats the
interim period as quite separate and distinct from the annual period.
Indirect method: an approach to deducing the cash flows from operating
activities, in a statement of cash flows, by analyzing the business’s other
financial statements.
Working capital: current assets less current liabilities.
Review Questions
1. The typical business outside the service sector has about 50
percent more of its resources tied up in inventories than in cash,
yet there is no call for a statement of inventories flows, to be
prepared. Why cash is regarded as more important than
inventories?
Cash is normally required in the settlement of claims. Employees, contractors,
lenders and suppliers expect to be paid in cash. When businesses fail, it is their
inability to find the cash to pay claimants that actually drives them under. These
factors lead to cash being the pre-eminent business asset. It is studied carefully
to assess the ability of a business to survive and or to take advantage of
commercial opportunities.
2. What is the difference between the direct and indirect methods of
deducing cash generated from operations?
With direct method, the business’s cash records are analyzed for the period
concerned. The analysis reveals the amounts of cash, in total, that have been
paid and received in respect of each category of the statement of cash flows. This
is not difficult in principle, or in practice if it is done as a matter of routine, or
using a computer.
The indirect method takes the approach that, while the profit (loss) for the
reporting period 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 period will produce the correct figure for cash flow.
The adjustment is concerned with the depreciation charge for, and movements in
relevant working capital items over, the period.
3. Taking each of the categories of the statement of cash flows in
turn, in which direction would you normally expect the cash flow
to be? Explain your answer.
Cash flows from operating activities: this would normally be
positive, even for a business with small profits or even losses. The
fact that depreciation is not a cash flow tends to lead to positive
cash flows in this area in most cases.
, Cash flows from investing activities: normally this would be
negative in cash flows terms since many non-current assets wear
out or become obsolete and need to be replaced in the normal
course of business. This means that, topically old non-current assets
generate less cash on their disposal than must be paid to replace
them.
Cash flows from financing activities: businesses tend either to
expand or to fail. In either case, this is likely to mean that, over the
years, more finance will be raised than will be redeemed.
4. What causes the profit for the reporting period not to equal the
net cash inflow?
There are several reasons and we will discuss some of them below.
Change in inventories, trade receivables and trade payables. For example, an
increase in trade receivables during a reporting period would mean that the cash
received from credit sales would be less than the credit sales revenue for the
same period.
Cash may have been spent on new non-current assets or received from disposals
of old ones; these would not directly affect profit.
Tax charged in the income statement is not normally the same as the tax paid
during the same reporting period.
Chapter Seven
Summary
Provisions, contingent liabilities and contingent assets (IAS 37)
A provision is a form of liability where the timing or amount involved is
uncertain.
Provision is recognized where all of the following criteria are met:
there is an obligation arising from a past event;
an outflow of resources is probably needed to settle the obligation;
a reliable estimate of the obligation can be made
The amount of the provision should be the best estimate of the amount
needed to settle the obligation.
A provision is created by charging the income statement with the amount of
the provision. This amount then appears on the statement of financial position
In the past, provisions have been used for creative accounting purposes.
A contingent liability is defined as:
-A possible obligation arising from past events, the existence of which will only
be confirmed
by future events not wholly within the control of the business.
-A present obligation arising from past events; where it is either not probable
that an outflow of resources is needed, or the amount of the obligation cannot
be reliably measured.
Contingent liabilities are disclosed in the notes to financial statements, unless
the possibility of an outflow of resources is remote.
