1 IAS 7 Statement of cash flows C1(a) C1(ii) application
2 Preparing a statement of cash flows C1(a) C1(ii) application
3 Interpretation of statements of cash flows C1(a) C1(ii) application
STATEMENTS OF CASH FLOWS
The importance of the distinction between cash and profit and the scant attention paid to this by the statement of profit or loss has resulted in the development of statements of cash flows. This chapter adopts a systematic approach to the preparation of statements of cash flows in examinations; you should learn this method and you will then be equipped for any problems in the exam itself.
The third section of the chapter looks at the information which is provided by statements of cash flows and how it should be analysed.
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9: Statements of cash flows PART B SINGLE COMPANY FINANCIAL ACCOUNTS1 IAS 7 Statement of cash flows
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Introduction
In this section we look at why statements of cash flows are useful. We also cover the required presentation of a statement of cash flows as per IAS 7.
Exam alert
The preparation of a statement of cash flows featured as a section C question in November 2010, May 2011 and September 2011 exams. In all three sittings, the examiner commented that some candidates ‘didn’t really know what they were doing, suggesting that some had been question spotting and had not prepared for statements of cash flow’. Make sure you work carefully through this chapter and attempt the practice questions in the Practice and Revision Kit as this topic can, and will, be examined.
1.1 Cash flow and profit
It has been argued that 'profit' does not always give a useful or meaningful picture of a company's
operations. Readers of a company's financial statements might even be misled by a reported profit figure. (a) Shareholders might believe that if a company makes a profit after tax, of say, $100,000 then this
is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong.
(b) Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This opinion may not be correct: the ability to pay wages depends on the availability of cash. (c) Survival of a business entity depends not so much on profits as on its ability to pay its debts when
they fall due. Such payments might include 'revenue' items such as material purchases, wages, interest and taxation etc, but also capital payments for new non-current assets and the repayment of loan capital when this falls due (for example on the redemption of debentures).
From these examples, it may be apparent that a company's performance and prospects depend not so much on the 'profits' earned in a period, but more realistically on liquidity or cash flows.
1.2 Funds flow and cash flow
Some countries, either currently or in the past, have required the disclosure of additional statements based on funds flow rather than cash flow. However, the definition of 'funds' can be very vague and such statements often simply require a rearrangement of figures already provided in the statement of financial position and statement of profit or loss. By contrast, a statement of cash flows is unambiguous and provides information which is additional to that provided in the rest of the accounts. It also lends itself to organisation by activity and not by classification in the statement of financial position.
Statements of cash flows are frequently given as an additional statement, supplementing the statement of financial position, statement of profit or loss and other comprehensive income and related notes. The group aspects of statements of cash flows (and certain complex matters) have been excluded as they are beyond the scope of your syllabus.
PART B SINGLE COMPANY FINANCIAL ACCOUNTS 9: Statements of cash flows
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1.3 Objective of IAS 7
The aim of IAS 7 is to provide information to users of financial statements about an entity's ability to generate cash and cash equivalents, as well as indicating the cash needs of the entity. The statement of cash flows provides historical information about cash and cash equivalents, classifying cash flows between operating, investing and financing activities.
1.4 Scope
A statement of cash flows should be presented as an integral part of an entity's financial statements. All types of entity can provide useful information about cash flows as the need for cash is universal, whatever the nature of their revenue-producing activities. Therefore all entities are required by the standard to produce a statement of cash flows.
1.5 Benefits of cash flow information
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The use of statements of cash flows is very much in conjunction with the rest of the financial statements. Users can gain further appreciation of the change in net assets, of the entity's financial position (liquidity and solvency) and the entity's ability to adapt to changing circumstances by affecting the amount and timing of cash flows. Statements of cash flows enhance comparability as they are not affected by differing accounting policies used for the same type of transactions or events.
Cash flow information of a historical nature can be used as an indicator of the amount, timing and certainty of future cash flows. Past forecast cash flow information can be checked for accuracy as actual figures emerge. The relationship between profit and cash flows can be analysed as can changes in prices over time.
1.6 Definitions
The standard gives the following definitions, the most important of which are cash and cash equivalents.
CASH comprises cash on hand and demand deposits.
CASH EQUIVALENTS are short-term, highly liquid investments that are readily convertible to 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 entity and other activities that are not investing or financing activities.
INVESTING ACTIVITIES are the acquisition and disposal of non-current assets and other investments not included in cash equivalents.
FINANCING ACTIVITIES are activities that result in changes in the size and composition of the contributed equity capital and borrowings of the entity. (IAS 7)
1.7 Cash and cash equivalents
The standard expands on the definition of cash equivalents: they are not held for investment or other long- term purposes, but rather to meet short-term cash commitments. To fulfil the above definition, an investment's maturity date should normally be three months from its acquisition date. It would usually be the case then that equity investments (ie shares in other companies) are not cash equivalents. An exception would be where preferred shares were acquired with a very close maturity date.