Computing cash flows

COMPUTING CASH FLOWS

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 out flows and so are represented as a negative number using brackets 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 out flow, the payment to buy property plant and equipment (PPE) which is an investing activity cash out flow and dividends paid, which is a financing activity cash out flow. The following examples illustrate all three of these examples.

EXERCISE CALCULATING THE TAX PAID

At the start of the accounting period the company has a tax liability of $50 and at the reporting date a tax liability of $90. During the year the tax charged in the statement of profit or loss was $100.

Required: Calculate the tax paid.

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. A vertical presentation of the numbers lends itself to noting the source of the numbers.

Tax liability

$

Explanation

Opening balance

50

Credit balance

Tax charge

100

The tax charged in the 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 effect of increase in the tax liability

 

_____

 

Sub-total

150

This sub-total represents the amount of the tax liability that there would have been at the reporting date in the event that no tax had been paid

Cash flow – the payment of tax

60

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

 

_____

 

Closing balance

90

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.

EXERCISE CALCULATING THE PAYMENTS TO BUY PPE

At the start of the accounting period the company has PPE with a carrying amount of $100. At the reporting date the carrying amount of the PPE is $300. During the year depreciation charged was $20, a revaluation surplus of $60 was recorded and PPE with a carrying amount of $15 was sold.

Required: Calculate the cash paid to buy new PPE.

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 period that are not cash flows. The balancing figure is the cash spent to buy new PPE.

PPE

$

Explanation

Opening balance

100

Debit balance

Deprecation

(20)

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

60

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

(15)

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

 

_____

 

Sub-total

125

This sub-total represents the balance of the PPE if no PPE had been bought for cash

Cash flow – the payment to buy PPE

175

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

 

_____

 

Closing balance

300

 

 

_____

 

EXERCISE CALCULATING THE DIVIDEND PAID

At the start of the accounting period the company has retained earnings of $500 and at the reporting date retained earnings are $700. During the reporting period a profit for the year of $450 was reported.

Required: Calculate the dividend paid.

Solution

As before, to ascertain 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

500

Credit balance

Profit for the year

450

The profit for the year is a credit and increases the retained earnings

 

_____

 

 

950

This sub-total represents the balance on retained earnings in the event that no dividends have been paid

Cash flow – the dividends paid

250

This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is less

 

_____

 

Closing balance

700

 

 

_____

 

CLASSIFICATION OF CASH FLOWS

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 flow 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 staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are presented as cash outflows.

Investing activity cash flows are those that relate to non-current assets. Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.

This topic is examined in much more depth in the F7 examination than it is at F3. For example, in F3, an extract, or the whole statement of cash flow might be required. F7, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using finance leases).  However, that does not mean that F7 will never require the preparation of a complete statement of cash flows so be prepared.

OPERATING ACTIVITIES – THE INDIRECT METHOD AND DIRECT METHOD

There are two different ways of starting the cash flow statement, as IAS 7, Statement of Cash Flows permits using either the 'direct' or 'indirect' method for operating activities.

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 out flows are payments for wages, to suppliers and for other operating expenses are then 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, expenses that have been charged against profit that are not cash out flows; for example depreciation and losses, have to be added back, and non-cash income; for example investment income and profits are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit but will have had an adverse impact on the cash flow of the business. Thus in the reconciliation process the increases in inventory and trade receivables are deducted. Conversely decreases in inventory and trade receivables are deducted. The opposite is applicable for trade payables. Finally the payments for interest and tax are presented.

The following exercise illustrates both the direct and indirect methods operating activities section.

EXERCISE: THE DIRECT AND INDIRECT METHOD

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

 

 

Revaluation gain

40,000

 

Total comprehensive income

90,000

 

  Closing balance

$ Opening balance

$

Current assets

 

 

Inventory

30,000

25,000

Receivables

20,000

26,000

Current liabilities

 

 

Trade payables

14,000

11,000

Additional information

During the year depreciation of $50,000 and amortisation of $40,000 was charged to profit.  

Receipts from customers, combined with cash sales, were $800,000, payments to suppliers of raw materials $400,000, other operating cash payments were $100,000 and cash paid on behalf and to employees was $126,000.

Interest paid is $12,000 and taxation paid is $13,000.

Required:

(a) Using the direct method prepare the operating activities section of the statement of cash flows.

(b) Using the indirect method determine the operating activities section of the statement of cash flows.

Answer (a) direct method

The direct method is relatively straightforward in that all the data are cash flows so it is really just a case of listing the receipts as positive and the payments as negative.

Operating activities – 

Direct method

$

$

Cash received from customers

800,000

 

Cash paid to suppliers

(400,000)

 

Cash paid to staff

(100,000)

 

Other operating payments

(126,000)

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

149,000

Answer (b) indirect method

The indirect method is more commonly examined. Here as we start with profit before tax 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.

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

(30,000 – 25,000)

(5,000)

 

Decrease in receivables 

(20,000 – 26,000)

6,000

 

Increase in payables

(14,000 – 11,000)

3,000

 

Cash generated

174,000

 

Interest paid

(12,000)

 

Taxation paid

(13,000)

 

149,000

Note how whichever method is used that the same cash is generated from operating activities.

FORMAT OF THE CASH FLOW STATEMENT – 

INDIRECT METHOD

You may be asked to prepare a statement of cash flows. The following is a pro forma showing the indirect method.

1. Operating activities

   

Profit before tax

X

 

Investment income

(X)

 

Finance cost

X

 

Depreciation

X

 

Less capital government grant released

(X)

 

Amortisation of intangible assets

X

 

Impairment loss charged in profit or loss

X

 

Loss on disposal of assets (profit)

X / (X)

 

Increase in provisions (decrease)

X / (X)

 

Changes in working capital

 

 

Increase / decrease in inventory

(X) / X

 

Increase / decrease in receivables and prepayments

(X) / X

 

Increase / decrease in trade payables and accruals

X / (X)

 

Cash generated

X

 

Interest paid

(X)

 

Taxation paid

(X)

X

 

2. Investing activities

 

 

Payments to buy PPE / Intangibles / Investments

(X)

 

Proceeds from sale of PPE / Intangibles / Investments

X

 

Dividends received from investments

X

 

Capital government grants received

X

(X)

 

3. Financing activities

 

 

Proceeds from an equity share issue

X

 

Dividends paid

(X)

 

Proceeds from the issue of new debt

X

 

Repayment of debt

(X)

 

Capital repayment of finance lease obligations

(X)

X/(X)

Change in cash and cash equivalents

 

X/(X)

Opening cash and cash equivalents

 

X/(X)

Closing cash and cash equivalents

 

X/(X)

Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value.

Tom Clendon FCCA is a senior lecturer based in Singapore and he lectures for FTMS Global in their South East Asia colleges