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Accounting Notes Accounting (Special Edition) Notes

Cash Flow Statement Part 2 Notes

Updated Cash Flow Statement Part 2 Notes

Accounting (Special Edition) Notes

Accounting (Special Edition)

Approximately 126 pages

These notes are specially designed to meet the requirements of the accounting and financial reporting students internationally. These notes are equally relevant for all the regions of the world.

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There are many practice questions to understand how the concept is applied into practical scenarios.

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Cash Flow Statements – Part 2

http://www.youtube.com/watch?feature=player_embedded&v=hkcOqTNPiTo

Upon completion of this lesson you will be able to prepare statement of cash flows for an entity using indirect method and further study the investing and financing activities in detail.

Definition

A cash flow statement shows the change in cash and cash equivalents of a company under the category of operating, investing and financing activities.

Cash and cash equivalents include cash in hand, bank, short-term liquid investments (bonds, securities) that are freely switch into cash.

In other words

Cash flow statement also known as statement of cash flows evaluates the change in cash and cash equivalents during a period, it classifies the cash inflows and outflows in operating, investing and financing activities so that it can be analyzed clearly from which type of activity cash is flowing inwards and outwards, the format of cash flow statement is given later in these notes.

Any Items will not be included in cash flow statement that does not involve cash for e.g. depreciation expense. These are known as Non cash activities.

Why is it important?

The cash flow statement is considered necessary because the accounting profit figures are easy to manipulate. There are many items in the income statement involving judgment such as depreciation, allowance for bad debts etc.

This makes it difficult to interpret a company's performance with confidence. A statement of cash flows showing cash inflows and outflows is easier to understand and difficult to manipulate.

Lecture Notes

In the earlier lesson we study that direct method of presentation is recommended for cash flows from operating activities, but the indirect method can also be used.

Here we will look at the indirect method to compute operating cash flows.

Again it is important to note that the net cash flows from any of the method (direct or indirect) will be the same.

The recommended format for operating cash flows (indirect method) is as follows:

The operating cash flows of the cash flow statement (Indirect Method)

Net Profit/ EBIT

  • xxx

add:

Non-Cash Expenses:

(Depreciation, Amortization Expense)

  • xxx

add:

Non-Operating Losses:

(Loss on disposal of long lived Assets)

  • xxx

less:

Non-Operating Gains:

(Gain on disposal of long lived Assets)

  • (xxx)

add:

Decrease in Current Assets:

(A/c Receivable, Prepaid Expenses, Inventory etc.)

  • xxx

less:

 Increase in Current Assets

  • (xxx)

add:

Increase in Current Liabilities:

(A/c Payable, Accrued Liabilities, Tax Payable etc.)

xxx

less:

 Decrease in Current Liabilities

(xxx)

  • Net cash flow from Operating activities

  • xxx

The Indirect method used above:

  • begins with net profit/ EBIT

  • adjusts for non-cash items

  • adjusts for increase or decrease in working capital

Example: Indirect Method: $

Net Income/ EBIT 7,000

Depreciation Expense 1,000

Increase in Accounts Receivable 4,400

Increase in Prepaid Rent 7,000

Decrease in Prepaid Insurance 1,300

Increase in Accounts Payable 14,000

Increase in Wages Payable 1,000

Decrease in Income Tax Payable 700

Gain on Sale of Equipment 1,800

Solution:

Cash Flow from Operating Activities: $

Net Income/ EBIT 7,000

add: Depreciation Expense 1,000

less: Gain on Sale of Equipment (1,800)

less: Increase in Accounts Receivable (4,400)

less: Increase in Prepaid Rent (7,000)

add: Decrease in Prepaid Insurance 1,300

add: Increase in Accounts Payable 14,000

add: Increase in Wages Payable 1,000

less: Decrease in Income Tax Payable (700)

Net Cash Flow from Operating Activities 10,400

Comparison between Direct and Indirect method:

Method Advantages Disadvantages
Direct

  • Information is shown which can not be found elsewhere in the financial statements

  • It shows the true cash flows in the trading operations of the business.

  • It may be costly in preparing the information

  • Also there may be some cost in obtaining the information.
Indirect

  • By examining the reconciliation between net income and net cashflow from operating activities, the user can easily relate cash flows to profit to understand quality if cash flows

  • Low cost

  • lack of information on the significant elements of trading cash flows

Now we will focus on cash flows from investing and financing activities in detail:

Cash flow from investing activities:

Investing cash flows contains

  • cash paid for purchasing long lived assets

  • cash received on the sale of long lived assets

  • cash paid for investments

  • dividends received on investments

Recommended Format

Cash flow from Investing activities: $
Purchase of long lived assets (x)
Proceeds from sale of long lived assets X
Proceeds from government grants X
Dividends received X
Net cash used in investing activities (x)

Cash flow from financing activities:

financing cash flows contains

  • Receipts from issuing shares or other equity instruments

  • Receipts from issuing debentures, bonds & other long and short term borrowings

  • Repayments of amounts borrowed (other than overdrafts)

  • cash paid for investments

  • The capital element of finance lease rental payments

Recommended Format

Cash flow from Financing activities: $
Purchase from issue of shares X
Proceeds from long term borrowings X
Payment of finance lease liabilities (x)
Dividends paid (x)
Net cash used in Financing activities (x)

Note: In examinations the statement of cash flows is required in its full (means cash flows from all activities must be shown), here the indirect method of cash flow statement is given because examiner normally asks to prepare the cash flow statement by indirect method.

Pro Forma Statement of Cash flows

Cash flows from operating activities: $ $

Net Income/ EBIT XX

Adjustments for:

Investment income (X)

Depreciation X

Profit on sale of noncurrent assets (X)

Increase/decrease in prepayments (X)/X

Increase/decrease in accruals X/(X)

Increase/decrease in inventories (X)/X

Increase/decrease...

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