In this article we will discuss about the Cash Flow Statement:- 1. Introduction to Cash Flow Statement 2. Definition of Cash Flow Statement 3. Classification of Activities 4. Advantages 5. Limitations.
- Introduction to Cash Flow Statement
- Definition of Cash Flow Statement
- Classification of Activities in Cash Flow Statement
- Advantages of Cash Flow Statement
- Limitations of Cash Flow Statement
1. Introduction to Cash Flow Statement:
Income Statement and Balance Sheet are the financial statements most sought after. But many of those who study these statements are, for different reasons, also interested in knowing the inflows and outflows of cash or working capital.
For example, the creditors may be interested in this information to assess the short term ability of the enterprise to pay to its creditor. Hence, many companies presented along with the final accounts, a statement called Funds Flow Statement showing changes in financial position.
In June, 1981 the Institute of Chartered Accounts of India issued Accounting Standard-3: Changes in Financial Position. This accounting standard dealt with the financial statement that summarised, for the period covered by it, the changes in financial position showing the sources from which funds were obtained by the enterprise and the specific uses to which funds were applied.
Funds were defined as cash or cash equivalents or working capital (i.e., current assets minus current liabilities). But funds flow statements suffered from certain limitations. A funds flow statement showed flows of working capital which included items like stock of goods and prepaid expenses which did not contribute to the short term ability of the enterprise to pay its debts.
Flows were not classified under the heads of operating, financial and investing activities. There was no standard format of the statement. There was the need of a cash flow statement in a standard format classifying flows from different activities.
In June, 1995 the Securities and Exchange Board of India (SEBI) amended clause 32 of the Listing Agreement requiring every listed company to give along with its balance sheet and profit and loss account, a cash flow statement prepared in the prescribed format, showing separately cash flows from operating activities, investing activities and financing activities.
In March, 1997 the Institute of Chartered Accountants of India issued A S-3 (Revised): Cash Flow Statements. The revised accounting standard supersedes AS-3: Changes in Financial Position, issued in June, 1981. Cash Flow Statement has replaced Statement of Changes in Financial Position.
2. Definition of Cash Flow Statement:
Cash Flow Statement is a statement which shows inflows (receipts) and outflows (payments) of cash and its equivalents in an enterprise during a specified period of time. According to the revised accounting standard 3, an enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented.
In this context, the terms cash, cash equivalents and cash flows mean the following:
(i) Cash comprises cash on hand and demand deposits with banks. A demand deposit with a bank is a deposit which is repayable by bank on demand by the depositor.
(ii) 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. 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 specific redemption date (provided there is only an insignificant risk of failure of the company to repay the amount at maturity).
Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes.
(iii) Cash flows are inflows and outflows of cash and cash equivalents. An inflow increases the total cash and cash equivalents at the disposal of the enterprise whereas an outflow decreases them. The difference between the cash inflows and cash outflows is known as net cash flow which can be either a net cash inflow or a net cash outflow.
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.
3. Classification of Activities in Cash Flow Statement:
According to AS-3 (Revised), the cash flow statement should report cash flows during the period classified by operating, investing and financing activities.
This classification of activities is described below:
(i) Operating Activities:
Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
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 to pay dividends, repay loans and make investments without recourse to external sources of financing.
Information about the specific components of historical operating cash flows is also useful in forecasting future operating cash flows. Cash flows from operating activities 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, usually forming a major share of cash inflow;
(b) Cash receipts from royalties, fees, commissions, and other revenue;
(c) Cash payments to suppliers for goods and services such as payment of rent, electricity bill, fire-insurance premium, printing charges etc.
(d) Cash payments of salaries and wages to employees and also cash payments made on behalf of employees to others like those of life insurance premium and tax deducted at source.
(e) Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities.
(f) 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.
(g) Cash receipts and payments arising from the purchase and sale of dealing or trading securities.
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.
(ii) Investing Activities:
Investing activities are the acquisition and disposal of long-term assets (such as land, buildings, plant, machinery, furniture, fixtures etc.) and other investments not included in cash equivalents.
It is important to make a separate disclosure of cash flows arising from investing activities 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) like payments made to purchase goodwill, land, buildings, plant, machinery, furniture, fixtures, fittings, trademarks, copy rights etc. These payments include those relating to self-constructed fixed assets;
(b) Cash payments relating to capitalized research and development costs;
(c) Cash receipts from disposal of fixed assets (including intangibles);
(d) 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);
(e) Cash receipts from disposal of shares, warrants, of 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);
(f) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise);
(g) Cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise);
(h) Cash payment for and cash receipts from futures 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.
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 flows of the position being hedged.
(iii) Financing Activities:
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. The separate disclosure of cash flows from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both coital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
(a) Cash proceeds from issuing shares 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,
(d) Cash payments to redeem preference shares.
In addition to the cash flows described, AS-3 (Revised) also deals with certain other items as outlined below:—
(a) Interest and Dividends:
Treatment of cash flows from interest and dividends can be described under two heads:
(i) In case of a financial enterprise, cash flows arising from interest paid and interest and dividends received should be classified as cash flows from operating activities. Dividends paid should be classified as cash flows from financing activities.
(ii) In the case of other enterprises, cash flows arising from interest and dividends paid should be classified as cash flows from financing activities while interest and dividends received should be classified as cash flows from investing activities.
In all cases, cash flows from interest and dividends received and paid should each be disclosed separately. Also, the total amount of interest paid during the period is disclosed in the cash flow statement whether it has been recognised as ah expense in the statement of profit and loss or capitalised in accordance with AS-10: Accounting for Fixed Assets.
The following excerpt taken from an annexure to a letter issued by SEBI lists the requirements laid down by SEBI regarding treatment of interest and dividends in cash flow statement:
Interest and Dividends:
35. Cash flows from interest and dividends received and paid should each be disclosed separately. Each should be classified in a consistent manner from period to period as either operating, investing or financing activities.
36. The total amount of interest paid during the period is disclosed in the cash flow statement whether it has been recognised as an expense in the income statement or capitalised.
37. Interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution. However, there is no consensus on the classification of these cash flows for other companies.
Interest paid and interest and dividends received may be classified as operating cash flows because they enter into the determination of net profit or loss. Alternatively, interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows, respectively, because they are costs of obtaining financing resources or returns on investments.
38. Dividends paid may be classified as financing cash flows because they are cost of obtaining financial resources. Alternatively, dividends paid may be classified as a component of cash flows from operating activities in order to assist users to determine the ability of a company to pay dividends out of operating cash flows.
It may be noted that although SEBI allows dividends paid to be classified as a component of cash flows from operating activities, companies invariably treat dividends paid as a component of cash flows from financing activities.
(b) 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.
Taxes on income arise on transactions that give rise to cash flows that are classified as operating, investing or financing activities in a cash flow statement. While tax expense may be readily identifiable with investing or financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transactions.
Therefore, taxes paid are usually classified as cash flows from operating activities.
However, when it is practicable to identify the tax cash flow with an individual transaction that gives rise to cash flows that are classified as investing or financing activities, the tax cash flow is classified as an investing or financing activity as appropriate.
For example, capital gain tax on the sale of land and building is identifiable with the investing activities and hence in the cash flow statement, it should be shown as outflow from investing activities.
When the flows are allocated over more than one class of activity, the total amount of taxes is disclosed.
(c) Extraordinary Items:
The cash flows associated with extraordinary items should be classified as arising from operating, investing or financing activities as appropriate and separately disclosed, winning of a law suit or a lottery and receipt of claim from an insurance company are examples of extraordinary items.
The cash flows associated with extraordinary items are disclosed separately as arising from operating, investing or financing activities in the cash flow statement, to enable users to understand their nature and effect on the present and future cash flows of the enterprise.
These disclosures are in addition to the separate disclosures of the nature and amount of extraordinary items required by AS 5, Net Profit Or Loss For The Period, Prior Period Items, and Changes In Accounting Policies.
(d) Investments in Subsidiaries, Associates and Joint Ventures:
When accounting for an investment in a subsidiary, an associate or a joint venture, the investor should restrict its reporting in the cash flow statement to the cash flows between itself and the investee/joint venture, for example, cash flows relating to dividends and advances.
(e) Acquisitions and Disposals of Subsidiaries and other Business Units:
The aggregate cash flows arising from acquisitions and from disposals of subsidiaries or other business units should be presented separately and classified as investing activities.
An enterprise should disclose, in aggregate, in respect of both acquisition and disposal of subsidiaries or other business units during the period each of the following:
(i) The total purchase or disposal consideration, and
(ii) The portion of the purchase or disposal consideration discharged by means of cash and cash equivalents.
The separate presentation of the cash flow effects of acquisitions and disposals of subsidiaries and other business units as single line items helps to distinguish those cash flows from other cash flows. The cash flow effects of disposals are not deducted from those of acquisitions.
(f) Foreign Currency Cash Flows:
Cash flows arising from transactions in a foreign currency should be recorded in an enterprise’s reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the cash flow.
A rate that approximates the actual rate may be used if the result is substantially the same as would arise if the rates at the dates of the cash flows were used. For example, a weighted average exchange rate for a period may be used for recording foreign currency transactions.
The effect of changes in exchange rates on cash and cash equivalents held in a foreign currency should be reported as a separate part of the reconciliation of the changes in cash and cash equivalents during the period.
Un-realised gains and losses arising from changes in foreign exchange rates are not cash flows. However, the effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency is reported in the cash flow statement in order to reconcile cash and cash equivalents at the beginning and the end of the period.
This amount is presented separately from cash flows from operating, investing and financing activities and includes the differences, if any, had those cash flows been reported at the end-of-period exchange rates.
Transactions which do not involve inflow or outflow of cash or cash equivalents are, for obvious reasons, excluded from a cash flow statement. But significant non-cash investing and financing transactions should be reported in a separate schedule to the cash flow statement.
Examples of non-cash transactions are:
(i) The acquisition of an enterprise by means of issue of shares;
(ii) The acquisition of a fixed asset, say machinery, on credit; and
(iii) The conversion of convertible debentures into equity shares.
AS-3 (Revised) has not prescribed any specific format of cash flow statement. However, suggested format can be inferred from the illustrations appearing in the appendices to the accounting standard.
A widely used format is outlined below:
Cash Provided (Used) by Operating Activities:
A very important piece of information that is made available by cash flow statement is the net cash provided (used) by operating activities. Income statement is prepared on the accrual basis of accounting meaning thereby that revenues are recorded when earned and the expenses are recorded when incurred.
In most cases, earned revenues include credit sales. At the end of the accounting period, there are trade debtors from whom cash is yet to be collected for credit sales.
Also, at the end of the accounting period, there are at least some expenses which have been incurred but which have not yet been paid for.
Thus, net profit disclosed by the income statement does not indicate the net cash provided by operating activities, in order to calculate the net cash provided by (used in) operating activities, revenues and expenses are replaced by actual receipts and payments in cash. There are two methods of converting net income into net cash flows from operating activities: the direct method and the indirect method.
4. Advantages of Cash Flow Statement:
The following are the main advantages of cash flow statement:
(i) Cash flow statement enhances the comparability of the reported performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.
Since it gives the figure of cash inflow from operations, it gives much more reliable picture of the results of operations than the usual profit and loss account. The figure of profit can be easily changed by changing the amount of depreciation. Higher depreciation will mean lower profit and vice versa.
The amount to be charged in respect of depreciation often depends on the management’s decisions and hence the figure of profit revealed in the profit and loss account may sometimes be unreliable. This is not the case with the inflow of cash from operations—this figure is not subject to manipulation though the figure can be marginally increased by postponing payments for goods and services to a certain extent.
(ii) It is useful in checking the accuracy of past assessments of future cash flows. Comparison of cash budget and cash flow statement for the same period will show the extent to which cash budget has been followed.
(iii) It is often used as an indicator of the amount, timing and certainty of future cash flows. It is thus helpful in preparing cash budgets for a subsequent period.
(iv) A study of cash flow statement with other financial statements gives an idea about the ability of the enterprise to meet its short-term commitments in time and to pay dividends.
(v) Cash flow statement provides information of all the investing and financing cash transactions which have taken place during the year. It explains most of the changes in financial statements. Thus, it enables the users to evaluate changes in net assets of an enterprise and its financial structure.
(vi) Cash flow statement, prepared by the indirect method lists reasons for the difference between net profit before tax and net cash generated from operations. Thus, it shows the relationship between profitability and net cash flow.
5. Limitations of Cash Flow Statement:
The following may be said to be the limitations of cash flow statement:
(i) It ignores non-cash charges. For judging the profitability of an enterprise, non-cash charges will also have to be taken into account.
(ii) It ignores one of the basic accounting concepts namely accrual concept.