Cash Flow Statement: Concept, Classification and Significance

In this article we will discuss about Cash Flow Statement:- 1. Concept of Cash Flow Statement 2. Classification of Cash Flow Statement 3. Presentation 4. Significance 5. Limitations.

Concept of Cash Flow Statement:

A Cash flow statement discloses net increase (or decrease) in cash during an accounting period. As per AS-3 (Revised) the objective of cash flow statement is to provide information about cash flows of an enterprise which is useful in providing the users of financial statements a basis to assess the ability of an enterprise to generate cash and cash equivalents to utilise those cash flows.

The statement deals with the provisions of information about the changes in cash and cash equivalents during the accounting year. It classifies cash flows into operating, investing and financing activities.

Definitions in AS-3:

The following terms are used in this Statement with the meanings specified:

Cash comprises cash on hand and demand deposits with banks.

Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise.

Cash and Cash Equivalents:

1. Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent, it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value.

Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. Investments in shares are excluded from cash equivalents unless they are, in substance, cash equivalents; for example, preference shares of a company acquired shortly before their specified redemption date (provided there is only an insignificant risk of failure of the company to repay the amount at maturity).

2. Cash flows exclude movements between items that constitute cash or cash equivalents because these components are part of the cash management of an enterprise rather than part of its operating, investing and financing activities. Cash management includes the investment of excess cash in cash equivalents.

Classification of Cash Flow Statement:

A cash flow statement focuses on various activities and items which bring about changes in the cash balance between two balance sheet dates. This statement covers all items which increase or decrease the cash of a business enterprise. For example, this statement includes items like receipts from debtors and payments to creditors.

On the contrary, this statement will not cover items which have no immediate effect on cash increase or decrease. For instance, goods purchased on credit and goods sold on credit will not be included in this statement as these transactions have no effect on inflow and outflow of cash.

A cash flow statement aims to determine the effects on cash of different types of cash inflows and outflows. In this process, all cash flows, i.e., activities resulting into cash flows are classified into different categories.

The ICAI’s AS-3 ‘Cash Flow Statement’ has classified cash flows into three categories:

(1) Operating Activities (or Flows).

(2) Investing Activities (or Flows).

(3) Financial Activities (or Flows).

Exhibit 16.4 displays the classification of cash inflows and cash outflows relating to operating activities, investing activities and financing activities.

(1) Operating Activities:

Operating activities are those transactions which are considered in the determination of net income. Examples of cash inflows in this category are cash received from debtors for goods and services, interest and dividend received on loans and investment. Examples of cash outflows in this category are cash payments for goods and services; merchandise; wages; interest; taxes; supplies and others.

Classification of Cash Inflows and Cash Outflows:

Classification of Cash Inflows and Outflows

AS-3 Cash Flow Statement states:

(1) The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external source of financing. Information about the specific components of historical operating cash flows is useful, in conjunction with other information, in forecasting future operating cash flows.

(ii) Cash flows from operating activities are primarily derived from the principal revenue producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss.

Examples of cash flows from operating activities are:

(a) Cash receipts from the sale of goods and the rendering of services;

(b) Cash receipts from royalties, fees, commissions and other revenue;

(c) Cash payments to suppliers for goods and services;

(d) Cash payments to and on behalf of employees;

(e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits;

(f) Cash payments or refunds of income taxes, unless they can be specifically identified with financing and investing activities; and

(g) Cash receipts and payments relating to future contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.

(iii) Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included in the determination of net profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities.

(iv) Cash flows from operating activities are determined according to the activities relating to the business in which the enterprise deals in, e.g., interest and dividend received by financial institutions will be treated as operating cash flow.

Similarly, an enterprise may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. In the same manner, cash advances and loans made by finance enterprises are usually classified as operating activities since they relate to the main revenue-producing activity of that enterprise.

(2) Investing Activities:

Investing activities include acquisition of long-term or fixed assets; disposal of long-term or fixed assets; acquisition and disposal of intangible assets; purchase and sale of shares, debentures and other securities; lending of money and its subsequent collection.

Cash inflows from investing activities generally include cash sales of property, plant, equipment and intangible assets, cash sales of investments in shares, debentures and other securities, cash collection (loan repayments) from borrowers. Cash outflows are purchase of shares, debentures and securities of other enterprises, purchase of property, plant, equipment and other long-term assets, loan given to other firms.

According to AS-3 Cash- Flow Statement:

(i) The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Examples of cash flows arising from investing activities are:

(a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalized research and development costs and self-constructed fixed assets;

(b) Cash receipts from disposal of fixed assets (including intangibles);

(c) Cash payments to acquire shares warrants or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes);

(d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes);

(e) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise);

(f) Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise);

(g) Cash payments from future contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities; and

(h) Cash receipts from future contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities.

(ii) When a contract is accounted for as a hedge of an identifiable position, the cash flows of the contract are classified in the same manner as the cash flow of the position being hedged.

(3) Financing Activities:

Financing activities relate to long-term liability and equity capital. A firm engages in financing activities when it obtains resources from owners, returns resources to owners, borrows resources from creditors and repays amounts borrowed. Cash inflows include proceeds from issue of shares and short-term and long-term borrowings.

Cash outflows include repayment of loans and payments to owners, including cash dividends. Repayments of accounts payable or accrued liabilities are not considered repayment of loans under financing activities but are classified as cash outflows under operating activities.

AS-3 Cash Flow Statement observes:

The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.

Examples of cash flows arising from financing activities are:

(a) Cash proceeds from issuing shares or other similar instruments;

(b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings; and

(c) Cash repayments of amounts borrowed.

Presentation of Cash Flow Statement:

A cash flow statement can be presented in either the direct or indirect format. The investing and financing sections will be the same under either format. However, the operating section will be different.

(i) Direct Method:

Direct method is that method whereby major class of gross cash receipts and gross cash payment are disclosed.

Enterprises that utilize the direct method should report separately the following classes of operating cash receipts and payments:

1. Cash collected from customers, including lessees, licensee, and other similar items

2. Interest and dividends received

3. Other operating cash receipts, if any

4. Cash paid to employees and other suppliers of goods or services, including supplies of insurance, advertising, and other similar expenses.

5. Interest paid

6. Income taxes paid

7. Other operating cash payments, if any

Companies that use the direct method must provide a reconciliation of net income to net cash flow from operating activities in a separate schedule in the financial statements.

According to AS-3 Cash Flow Statement:

The direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method.

Under the direct method, information about major classes of gross cash receipts and gross cash payments may be obtained either:

(a) From the accounting records of the enterprise; or

(b) By adjusting sales, cost of sales (interest and similar income and interest expense and similar charges for a financial enterprise) and other items in the statement of profit and loss for:

(i) Changes during the period in inventories and operating receivables and payables;

(ii) Other non-cash items; and

(iii) Other items for which the cash effects are investing or financing cash flows.

(ii) Indirect Method:

Under the indirect method, the net cash flow from operating activities is determined by adjusting net profit or loss for the effects of:

(a) Changes during the period in inventories and operating receivables and payables;

(b) Non-cash items such as depreciation, provisions, deferred taxes, and unrealized foreign exchange gains and losses; and

(c) All other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the indirect method by showing the operating revenues and expenses excluding non- cash items disclosed in the statement of profit and loss and the changes during the period in inventories and operating receivables and payables.

The indirect method starts with net income and reconciles it to net cash flow from operating activities.

The cash flow from operating activities is found by adjusting net income for:

(i) Changes in current assets and current liabilities and

(ii) Depreciation expense. Depreciation expense is not a cash flow. Because it decreases net income, it is added back to net income, in order to arrive at the operating cash flow.

The following summarizes the process:

Change: ………………………………………………. Adjustment to Net Income:

Decrease in a current asset ………………….. Add

Increase in a current asset …………………… Subtract

Decrease in a current liability ……………….. Subtract

Increase in a current liability …………………. Add

The indirect method is more widely used, since it shows the relationship between the income statement and the balance sheet and therefore aids in the analysis of these statements.

Reporting Cash Flows from Investing and Financing Activities:

An enterprise should report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities.

Comparison between Direct and Indirect Method:

Both the approaches, direct and indirect result in the same amount for cash flow from operations after making necessary adjustments. However, both the approaches have the arguments, pros and cons. The arguments in favour of direct approach are that it identifies the major categories of cash receipts and cash payments arising from operating activities; it provides a more useful basis for estimating future cash flows; and it provides information that is not otherwise available in the balance sheet and profit and loss account.

The direct method is a better indicator of company solvency, has a sounder conceptual framework and reflects accepted business practice. It permits an evaluation of cash flow relating to specific line items of income statement such as sales and cost of goods sold. The empirical evidence indicates that the direct method is superior over the indirect method in predicting future operating cash flows and future net operating cash flows.

On the other hand, followers of the indirect approach argue that indirect method is less costly and more convenient to use by firms. It is argued that the direct approach would require information that is hard to collect and sensitive. One difficulty with the direct approach is that some of the cash flows may have characteristics of more than one category of cash flow.

However, the indirect method has also been criticised on two grounds. First, it contains unnecessary detail and may confuse the users. Another limitation of the indirect method is that the adding of expenses such as depreciation suggests that expenses are a source of cash.

The conceptual and practical problems which underlie the indirect method are as follows:

(i) Ambiguity in the definition of “operations.”

(ii) Diversity in reporting practices.

(iii) Impact of changes in the reporting entity on the non-cash current accounts.

(iv) Use of absorption costing in accounting for manufactured inventory.

(v) Measurement of current portion of long-term leases.

(vi) Reclassifications between current and non-current accounts.

Exhibit 16.5 and 16.6 show respectively direct and indirect method of preparing cash flow statement.

Cash Flow Statement (Direct and Indirect Method) 

Provisions of AS-3 on Treatment of Certain Items:

1. Interest and Dividend:

Cash flows from interest and dividends received and paid should be disclosed separately and classified on the basis of nature of the enterprise as shown below:

For Financial Enterprises:

i. Interest paid and received, dividend received as operating activities.

ii. Dividend paid as financing activities.

For Other enterprises:

i. Interest and dividend received as investing activities.

ii. Interest and dividend paid as financing activities.

2. Extra Ordinary items:

The cash flows associated with extraordinary items should be classified as arising from operating, investing or financing activities as appropriate. It should be disclosed separately.

Few examples of such items are:

(i) Claim for loss of Stock—Operating activity.

(ii) Claims for loss of assets—Investing activity.

(iii) Recovery of bad debts—Operating activity.

(iv) Damages paid/received for breach of contract—Operating activity.

(v) Winnings from lotteries—Investing activity.

(vi) Cost of legal action to protect property title—Investing activity.

3. Taxes on Income:

Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.

For instance:

(i) Provision for Taxation for the current year—Non-cash charge under operating activity

(ii) Tax paid—Operating cash out flow

(iii) Income tax refund—Cash inflow from operating activity

(iv) Capital gains tax—Cash outflow from investing activity

(v) Corporate dividend tax—Cash outflow from financing activity.

4. Foreign Currency Cash Flows:

Foreign currency cash flows should be converted at the exchange rate of the date of cash flow. Exchange gain/loss on cash and cash equivalents held in foreign currency will be reported as part of reconciliation of change in cash and cash equivalents for the period and hence, not reported in cash flow statement.

5. Non-Cash Transactions:

Investing and financing transactions that do not require the use of cash or cash equivalents are not shown in the cash flow statement.

Examples of such non-cash transactions are:

(i) Issue of shares or debentures for a consideration other than cash, i.e., against building, machinery, etc.

(ii) Conversion of debentures into equity shares.

(iii) Purchase of business by issue of shares.

AS-3 (Revised) recommends that such transactions may be disclosed under footnote to cash flow statement.

6. Investments in Subsidiaries, Associates and Joint Venture:

Acquisition of interest in any subsidiary, associates or in any joint venture is treated as “Investing Activity”. Similarly, sale or disposal of such interest and receipt of interest or dividends on such investments is treated as “Investing Activity.

Illustrative Problem 1:

From the following Profit and Loss Account of ABC Ltd. for the year ended 31st March 2007 calculate Cash generated from “Operating Activities” by Direct Method:

Cash Flow Statement with Illustrative Problem 9

Notes:

(1) Non-cash charges such as deprecations, Goodwill written off, Preliminary expenses written off have been ignored as these do not involve any outflow of cash.

(2) Dividend received and profit on Sale of Plant are to be treated under cash flow from ‘Investing activities’.

(3) Commission Accrued does not involve any cash inflow, hence ignored.

(4) Changes in current assets and current liabilities are ignored.

Illustrative Problem 2:

From the following Profit and Loss A/c and additional information of M/s Anurag Enterprises, compute cash flow from operations:

Cash Flow Statement with Illustrative Problem 10

Cash Flow Statement with Illustrative Problem 10

Illustrative Problem 3:

The net income reported on the income statement for the year was Rs. 1,10,000 and depreciation of fixed assets for the year was Rs. 44,000. The balances of the current asset and current liability accounts at the beginning and end of the year are as follows:

Cash Flow Statement with Illustrative Problem 11 

Illustrative Problem 4:

From the following information calculate cash from operations:

Cash Flow Statement with Illustrative Problem 14

Cash Flow Statement with Illustrative Problem 14

Illustrative Problem 5:

The following data are provided for ABC Ltd.:

Cash Flow Statement with Illustrative Problem 15

Cash Flow Statement with Illustrative Problem 15

Significance of Cash Flow Statement:

Cash basis funds flow statement is important for a number of reasons:

(1) First, by focusing on cash flows, it explains the nature of the financial events which have affected the cash positions. This statement explains the reasons for the difference between opening and closing cash balance.

(2) The statement is important for financial planning purposes. For example, budgeted cash statements are crucial element in the process of budget plans. These surpluses and shortfalls are expressed sequentially over the planning period and require management to deal with the forecasted cash surplus or deficit, the former involving a short-term investment of surplus cash, the latter a short-term borrowing arrangement.

(3) This statement brings into sharp focus the enterprise’s earning capacity with its spending and operating activity. Accounting principles restrict the income statement to matching periodic revenues with the cost of earning those revenues. Statement of changes in cash is not restricted in this way; hence, it provides an extended view of the financial inflows and outflows by including both capital and revenue flows.

(4) Cash flow statement provides an insight into the critical areas of financial management by identifying two important classes of cash flows, namely, operating cash flows and financing cash flows. This distinction draws attention to the net cash flows from operations and the net financing cash flows.

The net operating cash flows classify the capability of the firm to support dividend payments to shareholders. It is these net cash flows which are of critical importance to investors and shareholders in predicting the amount of cash likely to be distributed in the future in the form of liquidation distributions or repayment of principal and in the evaluation of risk.

(5) The significance of cash flow statement lies in the increased complexity of business activity. This complexity results in a greater disparity between the time when income and expense items are reported and the time when the related cash flows occur. It may also result in a greater variability of cash flows.

ICAI’s AS-3 Cash Flow Statement contains the following explanations on the utility of cash flow statement:

1. Information about the cash flows of an enterprise is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation.

2. Users of an enterprise’s financial statements are interested in how the enterprise generates and uses cash and cash equivalents. This is the case regardless of the nature of the enterprise’s activities and irrespective of whether cash can be viewed as the product of the enterprise, as may be the case with a financial enterprise. Enterprises need cash for essentially the same reasons, however different their principal revenue-producing activities might be. They need cash to conduct their operations, to pay their obligation, and to provide returns to their investors.

3. A cash flow statement, when used in conjunction with the other financial statements, provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities.

Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.

4. Historical cash flow information is often used as an indicator of the amount, timing and certainty of future cash flows. It is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of charging prices.

Limitations of Cash Flow Statement:

Cash flow can be more precisely measured than can other concepts of funds because the valuation problem of cash are not as great as for other financial resources. However, movement of cash may be easily influenced. For example, payment of liabilities, may be temporarily delayed or marketable securities may be sold, increasing cash flow for a given period.

This statement, since it does not cover non-cash items, is not useful in analysing changes in financial position of an enterprise. Cash and changes in cash are not adequate to measure change in financial position. For instance, an enterprise may possess very satisfactory financial (cash) position during a particular month. But if the firm has to pay creditors next month, or make payments for the plant purchased in the near future, the cash position of the firm will be adversely affected.

In this way statement of changes in financial position measured through cash only has drawbacks and does not indicate accurately the changes in financial position. The statement has utility for making short-term financial planning but for long-term planning this statement would not be useful. Because of the limited usefulness of statement of changes in cash, the preparation of statement of changes in working capital (popularly known as funds flow statement) has been suggested.

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