AAT Level 4 Diploma in Accounting. Financial Statements - Book 3. ü Statement of Cash Flows

AAT Level 4 Diploma in Accounting Financial Statements - Book 3 ü Statement of Cash Flows ü Ratio Analysis and Interpretation of Financial Statements

Published by: Home Learning College 1 Hammersmith Broadway London W6 9DL Home Learning College Ltd 2013 Version 1.0 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any other means, electronic, mechanical, photocopying, recording or otherwise without the written permission of the publisher. All product names and services identified throughout this book are trademarks and registered trademarks of their respective owners. They are used throughout this book in editorial fashion only and are for the benefit of such companies. No such usage, or the uses of any trade names, is intended to convey endorsement or other affiliation with the book. Home Learning College course materials are made available in electronic format for use by students of the College. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to Home Learning College. In using electronic course materials and their contents you agree that your use will be solely for the purposes of completing a Home Learning College course. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of Home Learning College or in accordance with the Copyright, Designs and Patents Act 1988.

Financial Statements (Book 3) Contents Lesson 12 Statement of Cash Flows Introduction Presentation of the statement of cash flows Preparation of the statement of cash flows Interest and dividends received Decrease in long-term borrowings Interest payable Property, plant and equipment Proceeds from the disposal of non-current assets Advantages of using a statement of cash flows Limitations of the statement of cash flows Interpretation of a statement of cash flows Lesson 13 Ratio Analysis and the Interpretation of Financial Statements Introduction Users of ratios The use of ratios Limitations of ratios Types of ratio Calculation of ratios Profitability ratios Liquidity ratios Resource utilisation ratios Financial position ratios Interpreting ratios Communicating ratios Preparing a report Preparing a letter 2 3 9 23 23 23 24 27 31 31 32 36 36 36 37 38 40 41 46 47 55 57 57 57 58

Financial Statements Book 3 LESSON 12 Statement of Cash Flows On completing this lesson you should be able to: Explain the purpose of the statement of cash flows Identify the classification of cash inflows and outflows reported on the statement of cash flows Prepare a statement of cash flows using the indirect method in accordance with the requirements of IAS 7 Appreciate the advantages of using a statement of cash flows and recognise its limitations Interpret a statement of cash flows 1

Home Learning College Introduction IAS1 Presentation of Financial Statements sets out the overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for content. The standard specifies that a set of financial statements comprises: A Statement of Financial Position A Statement of Profit or Loss and Other Comprehensive Income A Statement of Changes in Equity A Statement of Cash Flows Notes including a summary of significant accounting policies. The objective of this lesson is to introduce the preparation, presentation and interpretation of a Statement of Cash Flows covered by IAS 7 Statement of Cash Flows. The Statement of Cash Flows is designed to provide users of financial statements with information about the cash position of the business. It is important for investors to see whether the entity has sufficient cash to meet its liabilities and make dividend and interest payments. The statement shows the inflows and outflows of cash during an accounting period and can explain why, even if the Statement of Profit of Loss and Other Comprehensive Income shows a profit for the period, the bank balance has reduced. The Statement of Cash Flows is linked to both the Statement of Profit or Loss and Other Comprehensive Income and the Statement of Financial Position. It starts by using the operating profit from the Statement of Profit or Loss and Other Comprehensive Income to calculate the net cash flow from operating activities. It ends by reconciling the cash and cash equivalents balance on the Statement of Financial Position at the beginning of the accounting period with the cash and cash equivalents balance at the end of that accounting period. The objective of IAS 7 is to provide information about the historical changes in cash and cash equivalents of an entity by means of a statement which classifies cash flows during the period from operating, investing and financing activities. 2

Financial Statements Book 3 IAS 7 defines cash and cash equivalents as: Cash petty cash, bank current accounts and bank deposit accounts. Cash equivalents short-term highly liquid investments that can be converted into cash quickly (within three months at most). An example is a short-term bond that can be converted into cash with 90 days notice. Note A bank overdraft which is repayable on demand is regarded as a component of cash and cash equivalents. Questions relating to the preparation and/or interpretation of a Statement of Cash Flows appear frequently in AAT Computer Based Tests (CBT s). This is an area that warrants a great deal of practice. However, only unitary Statements of Cash Flows are examinable in this Unit. Students will not be expected to prepare a Consolidated Statement of Cash Flows Presentation of the statement of cash flows The Statement of Cash Flows reports inflows and outflows of cash and cash equivalents during the accounting period and classifies these into three specific areas: 1. Operating activities this is the revenue producing activities of the business and will represent primarily trading revenue, but also includes payments of interest and tax. This section of the cash flow will include all cash flows that are not classified as arising from either investing activities or financing activities. 2. Investing activities this is concerned with the purchase and disposal of non-current assets and investments. 3. Financing activities activities included in this section are receipts from the issue of new shares, repayments of loans, the redemption of loan stock and payment of dividends. 3

Home Learning College A cash inflow is where cash or its equivalent has been received by the entity and a cash outflow is where cash or its equivalent has left the business. An important convention to remember when preparing a Statement of Cash Flows is that cash inflows are positive figures, whereas cash outflows are negative figures. IAS 7 allows two forms of Statement of Cash Flows, that prepared under a method known as the direct method and that prepared under the method known as the indirect method. However, for this Unit you will be required to prepare a Statement of Cash Flows using only the indirect method. The cash generated from operating activities could be calculated by going through all of the banking and cash records, adding up the cash received from customers and deducting all of the cash paid to suppliers in respect of purchases and expenses. This is the direct method and might be possible for a small company but would be virtually impossible for a multinational company, in which case a more indirect method would be acceptable. Under the indirect method the cash generated from operating activities is calculated by adjusting the operating profit for non-cash items and movements in working capital. IAS 7 has an appendix that illustrates the standard layout for a Statement of Cash Flows, but accepts that there may be a need for some entities to adapt the format to suit their own particular needs. If this is the case then management must use its judgement to allocate cash flows to the most appropriate of the three categories. Some companies present a Statement of Cash Flows which incorporates a detailed calculation of the net cash flow from operating activities. Other companies, however, start their Statement of Cash Flows with the net cash flow from operating activities figure preferring to show the calculation of the figure as a note or workings to the main body of the Statement of Cash Flows. The following is an example of a Statement of Cash Flows showing the calculation of net cash flow from operating activities as an integral part of the statement: 4

Financial Statements Book 3 Example Statement of Cash Flows (indirect method) Portland Products Ltd Statement of Cash Flows for the year ended 31 December 20X1 000 000 Cash flows from operating activities Profit from operations 4,700 Adjustments for: Depreciation 500 Loss on disposal of non-current assets 50 Investment income (dividends received) (600) 4,650 Increase in trade and other receivables (480) Decrease in inventories 1030 Decrease in trade payables (1,250) Cash generated from operations 3,950 Interest paid (290) Income taxes paid (1120) Net cash flow from operating activities 2,540 Cash flows from investing activities Payments to acquire property, plant and equipment (900) Proceeds from the sale of property, plant and 30 equipment Interest received 300 Dividends received 300 Net cash used in investing activities (270) Cash flows from financing activities Proceeds from the issue of share capital 500 Proceeds from long-term borrowings 250 Dividends paid (1,200) Net cash used in financing activities (450) Net increase in cash and cash equivalents 1820 Cash and cash equivalents at beginning of 350 period Cash and cash equivalents at end of period 2,170 On the next page is the same example as the one above. This time, however, the net cash flow from operating activities figure of 2,540 is shown as a separate note to the Statement of Cash Flows as follows: 5

Home Learning College Portland Products Ltd Reconciliation of Profit from Operations to Net Cash Flow from Operating Activities for the year ended 31 December 20X1 000 000 Cash flows from operating activities Profit from operations 4,700 Adjustments for: Depreciation 500 Loss on disposal of non-current assets 50 Investment income (dividends received) (600) 4,650 Increase in trade and other receivables (480) Decrease in inventories 1030 Decrease in trade payables (1,250) Cash generated from operations 3,950 Interest paid (290) Income taxes paid (1,120) Net cash flow from operating activities 2,540 Portland Products Ltd Statement of Cash Flows for the year ended 31 December 20X1 000 000 Net cash flow from operating activities 2,540 Cash flows from investing activities Payments to acquire property, plant and equipment (900) Proceeds from the sale of property, plant and 30 equipment Interest received 300 Dividends received 300 Net cash used in investing activities (270) Cash flows from financing activities Proceeds from the issue of share capital 500 Proceeds from long-term borrowings 250 Dividends paid (1,200) Net cash used in financing activities (450) Net increase in cash and cash equivalents 1820 Cash and cash equivalents at beginning of 350 period Cash and cash equivalents at end of period 2,170 6

Financial Statements Book 3 Before working through a detailed example that shows the process for preparing a Statement of Cash Flows, it is worth noting a few points from the example above. The calculation of net cash flow from operating activities begins with operating profit. This figure is obtained from the Statement of Profit or Loss and Other Comprehensive Income and is the profit before interest and tax. Operating profit does not represent the cash generated from the trading activities because there may be some items posted to the Statement of Profit or Loss and Other Comprehensive Income that do not result in a flow of cash, or are used/included in the main body of the Statement of Cash Flows. Common items for which the operating profit is adjusted are: Depreciation as depreciation is deducted from income as an expense when preparing the Statement Profit or Loss and Other Comprehensive Income, it must be added back to the operating profit figure. This is because although the depreciation charge is treated as an expense it does not result in an outflow of cash from the business. Investment income any investment income credited to the Statement of profit or Loss and other Comprehensive Income in the period under review needs to be deducted from operating profit. This is because it is non-trading income, it is then used in the investing activities section of the Statement of Cash Flows where it is treated as a cash inflow. Profit or loss on the disposal of non-current assets operating profit needs to be adjusted for any profit or loss on non-current assets posted to the Statement of Profit or Loss and Other Comprehensive Income in the period under review. Profit on disposal would be deducted from the operating profit figure, whereas a loss on disposal would be added back to the operating profit figure. The profit or loss on disposal is then used when calculating the net proceeds on disposal of non-current assets a figure used in the investing activities section of the Statement of Cash Flows. There are further adjustments to be made before reaching the cash generated from operating activities figure. The first of these is to adjust for movements in working capital. Working capital is the amount of cash held in current assets and current liabilities in various forms. In the Statement of Cash Flows the cash from operating activities is adjusted for 7

Home Learning College increases and decreases between the beginning of the accounting period and the end of the accounting period in respect of changes in the following working capital items: Inventories Trade and other receivables, and Trade and other payables. The easiest way to approach these changes is from the perspective of whether the change has had a positive or negative impact on the cash flow. For example: If the levels of inventory have increased during the accounting period this means that the entity has had to pay cash out. This has a negative effect on cash flow and appears as an outflow on the Statement of Cash Flows. If, however, inventory levels have decreased in the accounting period then this has a positive effect on cash flow. If trade receivables have decreased this means that the entity has reduced the level credit it has given to customers, which has a positive effect on cash flow. This is shown as an inflow on the Statement of Cash Flows. An increase in trade receivables, however, means that the entity is giving more credit to customers, which has a negative effect on cash flow. If trade payables have increased during the accounting period this means that the entity is taking more credit from suppliers, which has a positive effect on cash flows. However, decreasing the trade payables in the accounting period has a negative effect on cash flows and will be shown on the Statement of Cash Flows as an outflow of funds. These adjustments to operating profit have provided the figure for cash generated from operations. If this figure was negative, the description would be cash used in operations. The final adjustment is for payments related to operations. This will include interest paid on loans and payments for tax. It is important to understand that these will be the actual payments made and not necessarily the expense figures shown in the Statement of Profit or Loss and Other Comprehensive Income. IAS 7 does not specify the correct treatment for interest and dividends which means that different entities may choose to classify them, as operating, investing or financing activities. Wherever a company chooses 8

Financial Statements Book 3 to place these items they need to be consistent in the treatment from year to year. In the AAT assessment interest paid should be included in operating activities, dividends and interest received included in investing activities and interest paid included in financing activities. The next section of the Statement of Cash Flows is concerned with cash generated from and used in investing activities. An entity might invest in non-current assets (also referred to as property, plant and equipment) as well as in more traditional forms of investment such as shares in other companies. In this section it is usual to see cash outflows from the purchasing of non-current assets or investments and cash inflows from selling non-current assets, dividends and interest received. The total from these activities will either be cash generated from investing activities or cash used in investing activities. As with investing activities, the cash inflows and outflows associated with financing activities are listed and subtotalled in the financing section of the Statement of Cash Flows. The type of items appearing in this section of the statement are cash inflows from issuing new share capital or new borrowings, and cash outflows from the repayment of loans or payment of dividends. The final section of the Statement of Cash Flows proves whether or not it balances. The total cash generated from, or used in, operating, investing and financing activities is totalled to provide either an increase or a decrease in cash and cash equivalents. This is then added to the value of cash and cash equivalents shown on the Statement of Financial Position at the beginning of the accounting period. The resulting figure should equal the value of cash and cash equivalents shown on the Statement of Financial Position at the end of the accounting period. Note that each of the individual cash flows are given as gross figures, but the net figure of all cash flows are used for the section totals of operating activities, investing activities and financing activities. Preparation of the statement of cash flows The Statement of Cash Flows is easy to prepare if a logical approach is taken. Care needs to be taken when selecting the figures from the Statement of Profit or Loss and Other Comprehensive Income and Statement of Financial Position, and workings will need to be prepared to identify the cash element for certain transactions. The key point is that this statement deals in cash receipts and payments which may not 9

Home Learning College necessarily be the same as the expenses shown in the other financial statements. Work through the following detailed example carefully tracing the origin of every figure. Impact Technologies plc has produced the following draft financial statements for the year ended 31 December 20X1: Detailed example 1 Step-by-step guide Impact Technologies plc Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 December 20X1 000 Revenue 8,432 Cost of sales (5,974) Gross profit 2,458 Distribution costs (340) Administrative expenses (930) Profit from operations 1,188 Finance costs (172) Profit before tax 1,016 Tax (202) Net profit for the period 814 10

Financial Statements Book 3 Impact Technologies plc Statement of Financial Position at 31 December 20X1 000 20X0 000 ASSETS Non-current assets Property, plant and equipment 2,044 1,750 Current assets Inventories 554 530 Trade and other receivables 418 560 Cash and cash equivalents 340 1,312 1,090 Total assets 3,356 2,840 EQUITY AND LIABILITIES Capital and reserves Share capital 300 200 Share premium 120 80 Retained earnings 1,420 1,086 Total equity 1,840 1,366 Non-current liabilities 5% Loan stock 800 640 Current liabilities Bank overdraft 160 Trade and other payables 506 494 Income tax payables 210 180 716 834 Total equity and liabilities 3,356 2,840 The following information is also relevant: 1. During the year Impact Technologies plc sold some non-current assets. The loss on the sale was 28,000 and is included in administrative expenses on the Statement of Profit or Loss and Other Comprehensive Income. 2. The original cost of the non-current assets sold was 480,000. The assets sold had a carrying value of 178,000 at the date of sale. 3. The depreciation charge on property, plant and equipment included in the Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 December 20X1 was 86,000. 11

Home Learning College 4. Dividends of 480,000 were paid by the company to ordinary shareholders in the year ended 31 December 20X1 5. All purchases of non-current assets in the year ended 31 December 20X1 were made for cash. A Statement of Cash Flows for Impact Technologies plc for the year ended 31 December 20X1 can now be prepared in accordance with IAS 7. This is typical of the type of question that might be included in an AAT CBT. Note that the Statement of Profit or Loss and Other Comprehensive Income relates to the same accounting period covered by the Statement of Cash Flows, whereas the Statement of Financial Position is given for both the current and previous accounting periods. This is necessary because the Statement of Cash Flows shows how cash has been generated and used from the beginning to the end of the current accounting period. Many students find it useful to cross each figure out on the Statement of Financial Position as it is used. This ensures that all items have been considered and the Statement of Cash Flows should balance first time. In this detailed example the Statement of Cash Flows is created step-bystep. Extracts from the Statement of Cash Flows are provided to illustrate how each figure is used and additional calculations will be performed as necessary. Finally, a completed Statement of Cash Flows will be produced. 12

Financial Statements Book 3 These pro formas are typical of the ones used in practice: Note: Impact Technologies plc Reconciliation of Profit from Operations to Net Cash Flow from Operating Activities for the year ended 31 December 20X1 Cash flows from operating activities 000 000 Net cash flow from operating activities 13

Home Learning College Impact Technologies plc Statement of Cash Flows for the year ended 31 December 20X1 000 000 Net cash flow from operating activities Cash flows from investing activities Net cash used in investing activities Cash flows from financing activities Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period The first step is to prepare the note reconciling profit from operations to net cash flow from operating activities. The opening figure is profit from operations (operating profit). This can be taken directly from the 14

Financial Statements Book 3 Statement of Profit or Loss and Other Comprehensive Income and inserted into the reconciliation pro forma. 000 000 Cash flows from operating activities Profit from operations 1,188 From the Statement of Profit or Loss The next step is to adjust for non-cash items such as depreciation and the profit or loss on the disposal of non-current assets. In this example both the depreciation charge and the loss on the disposal of non-current assets have been provided so these can be inserted into our reconciliation. In some questions these figures may need to be calculated as will be seen in a later example. 000 Cash flows from operating activities Profit from operations 1,188 Adjustments for: Depreciation 86 Loss on disposal of non-current assets 28 1,302 000 From the additional information The loss on disposal is added back to the operating profit because, although it does not represent an outflow of funds, it was charged as an expense in the Statement of Profit or Loss and Other Comprehensive Income. If a profit had been generated on the disposal of the non-current assets then the adjustment would have been a reduction to operating profit because the original entry would have increased profit in the Statement Profit or Loss and Other Comprehensive Income. In this example there are no other non-cash items to adjust for, nor is there any income from non-operating activities to be considered. The next adjustments to be made are for changes in the working capital items. Remember that here it is the impact on cash that is important. The cash impact will be measured as the difference between the opening and closing balances on these working capital items. This information is found on the Statement of Financial Position. 15

Home Learning College 000 000 Cash flows from operating activities Profit from operations 1,188 Adjustments for: Depreciation 86 Loss on disposal of non-current assets 28 1,302 Decrease in trade and other receivables 142 (to 418 from 560) Increase in inventories (to 554 (24) from 530) Increase in trade payables (to 506 12 from 494) Cash generated from operations 1,432 From the Statement of Financial Position The reduction in trade and other receivables is a cash inflow because there are now fewer receivables meaning that monies have been collected more quickly and so improved the cash flow of the company. A similar result is achieved from an increase in trade payables. The company has obtained more goods and services on credit terms and thus kept cash within the entity rather than paying it to out to suppliers. The increase in inventories has resulted in a cash outflow. The cash generated from operations has now been calculated using the indirect method. The final part of this section of the reconciliation concerns cash paid out for interest and for taxes. Remember that this may not be the same figure as the expense in the Statement of Profit or Loss and Other Comprehensive Income. The way to test this is to look at the Statement of Financial Position and see if there are any accruals at either year-end relating to interest and tax. In this question there is no additional information regarding finance costs and so it can be assumed that the expense in the Statement of Comprehensive Profit or Loss and Other Comprehensive Income equates to the actual payments made during the year. This figure can be inserted into the reconciliation as interest paid without any further calculations being necessary. This is not the case, however, for income tax. There are three pieces of information for income tax. The Statement of Financial Position shows an accrual both at the beginning and at the end of the accounting period, and there is also an income tax expense on the Statement of Profit or Loss and Other Comprehensive Income. The easiest way to calculate the 16

Financial Statements Book 3 actual cash payment that was made during the year is to create a general ledger account for Income Tax Payables. DR Income Tax Payables CR Date Details 000 Date Details 000 31/12/X1? 01/01/X1 Balance b/d 180 31/12/X1 Balance c/d 210 31/12/X1 Income tax (SPL) 202 382 382 31/12/X1 Balance b/d 210 The opening and closing tax liability balances ( 180 and 210) can be taken from the Statement of Financial Position and inserted into the ledger account. Just remember to ensure that they are entered on the correct side of the ledger account. The income tax expense from the Statement of Profit or Loss and Other Comprehensive Income can also be entered on the credit side of the ledger account (it will be a debit in the Statement of Profit or Loss and Other Comprehensive Income). The general ledger account does not yet balance and the missing figure must be the tax that has actually been paid during the year. DR Income Tax Payables CR Date Details 000 Date Details 000 31/12/X1 Cash paid 172 01/01/X1 Balance b/d 180 31/12/X1 Balance c/d 210 31/12/X1 Income tax (SPL) 202 382 382 31/12/X1 Balance b/d 210 The tax paid can now be entered onto the reconciliation and the reconciliation of profit from operations to net cash flow from operating activities is complete. 17

Home Learning College 000 Cash flows from operating activities Profit from operations 1,188 Adjustments for: Depreciation 86 Loss on disposal of non-current assets 28 1,302 Decrease in trade and other 142 receivables Increase in inventories (24) Increase in trade payables 12 Cash generated from operations 1,432 Interest paid (172) Income taxes paid (172) Net cash flow from operating activities 000 1,088 From the Statement of Profit or Loss From workings Impact Technologies plc have generated a cash inflow of 1,088 from their operating activities and this figure can be transferred to the first line of the Statement of Cash Flows. The next section of the Statement of Cash Flows is concerned with the cash generated from or used in investing activities. The most common transactions that will need to be dealt with here are those associated with the purchase and disposal of non-current assets, although some examination questions may include the acquisition or sale of investments, and any investment income received. The first figure required is the payment made to acquire non-current assets. In some questions this figure may be given but in this question it needs to be calculated. Again the most straightforward way is to re-create the movements in the year on the ledger account for property, plant and equipment. The balancing figure will be the additions during the year. This ledger account will be more complicated to reconstruct than the one for tax paid. Since the information provided in the question shows the carrying amount of the non-current assets, the ledger account will include adjustments for disposals and depreciation charged during the year. Again the starting point is the opening and closing balances which are taken from the Statement of Financial Position. 18

Financial Statements Book 3 DR Property, Plant and Equipment (Carrying Amount) CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 1,750 31/12/X1 Balance b/d 2,044 31/12/X1 Balance c/d 2,044 During the year the company disposed of non-current assets with a carrying value of 178,000 and depreciation for the year was 86,000. These information can also be inserted into the general ledger account. DR Property, Plant and Equipment (Carrying Amount) CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 1,750 31/12/X1 Disposal 178 31/12/X1? 31/12/X1 Dep n charge 86 31/12/X1 Balance c/d 2,044 2,308 2,308 31/12/X1 Balance b/d 2,044 Once the figures have been inserted the ledger account can be balanced off. The missing figure will be the cash paid for additions to property, plant and equipment during the year. DR Property, Plant and Equipment (Carrying Amount) CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 1,750 31/12/X1 Disposal 178 31/12/X1 Additions 558 31/12/X1 Dep n charge 86 31/12/X1 Balance c/d 2,044 2,308 2,308 31/12/X1 Balance b/d 2,044 The additions figure can now be inserted into the Statement of Cash Flows as a cash outflow. Cash flows from investing activities 000 000 Payments to acquire property, plant and equipment (558) The additional information in the example says that Impact Technologies plc sold some non-current assets and incurred a loss. The actual proceeds received have not been given and, therefore, need to be calculated. 19

Home Learning College The relevant calculation is made by deducting the loss on disposal from the carrying value of the assets sold: 178,000 28,000 = 150,000 (proceeds received) This figure can be entered into the Statement of Cash Flows and this section is complete because the company has not received any dividends or interest. Cash flows from investing activities 000 000 Payments to acquire property, plant and equipment (558) Proceeds from the sale of property, plant and 150 equipment Net cash used in investing activities (408) The next section of the Statement of Cash Flows relates to financing activities such as the issue of shares and loan stock, the repayment of loans and the payment of dividends. There are no complicated calculations involved here. For the issue of shares and changes in loans the movement for the year can be taken from the Statement of Financial Positions. In the example the balances of share capital and share premium have increased; this means that the company issued additional shares during the year and therefore received an inflow of funds. For the purposes of the Statement of Cash Flows, the balances on these two accounts (Share Capital and Share Premium) can be added together, with the balance at the end of the previous accounting period being deducted from the balance at the end of the current accounting period. Cash flows from financing activities Proceeds from the issue of share capital (( 300 + 120) ( 200 + 80)) 000 140 000 The company has increased its loan stock during the year. This represents an inflow of funds. Again, the calculation is simply the difference between the balance at the beginning and end of the accounting period, with the information being taken from the Statement of Financial Position. 20

Financial Statements Book 3 Cash flows from financing activities 000 000 Proceeds from the issue of share capital 140 Proceeds from long-term borrowings 160 ( 800 640) The final figure to insert here is dividends paid. This figure was given within the example question additional information. Remember that this will be a cash outflow. This section of the Statement of Cash Flows is now complete. Cash flows from financing activities 000 000 Proceeds from the issue of share 140 capital Proceeds from long-term borrowings 160 Dividends paid (480) Net cash used in financing activities (180) From the additional information The final figure to be inserted is cash and cash equivalents at the beginning of the year. The Statement of Financial Position shows that the opening figure was an overdraft. This is shown as a negative figure. The overdraft is deducted from the net increase in cash and cash equivalents to arrive at the positive cash and cash equivalents figure of 340. This is the figure of cash and cash equivalents on the Statement of Financial Position at 31 December 20X1 and indicates that the Statement of Cash Flows balances. 21

Home Learning College The completed Statement of Cash Flows will be as follows: Note: Impact Technologies plc Reconciliation of Profit from Operations to Net Cash Flow from Operating Activities for the year ended 31 December 20X1 000 000 Cash flows from operating activities Profit from operations 1,188 Adjustments for: Depreciation 86 Loss on disposal of non-current assets 28 1,302 Increase in trade and other receivables 142 Increase in inventories (24) Decrease in trade payables 12 Cash generated from operations 1,432 Interest paid (172) Income taxes paid (172) Net cash flow from operating activities 1,088 22 Impact Technologies plc Statement of Cash Flows for the year ended 31 December 20X1 000 000 Net cash flow from operating activities 1,088 Cash flows from investing activities Payments to acquire property, plant and equipment (558) Proceeds from the sale of property, plant and 150 equipment Net cash used in investing activities (408) Cash flows from financing activities Proceeds from the issue of share capital 140 Proceeds from long-term borrowings 160 Dividends paid (480) Net cash used in financing activities (180) Net increase in cash and cash equivalents 500 Cash and cash equivalents at beginning of (160) period

Financial Statements Book 3 Cash and cash equivalents at end of period 340 It is usual to disclose a note which shows the components of the cash and cash equivalents balances. 20X1 000 20X0 000 Cash on hand and balances with banks 340 (160) Short-term investments 340 (160) This is a comprehensive example demonstrating how to prepare a Statement of Cash Flows but there are other ways that the information given in the question could be presented and this will require different calculations to those seen so far. Interest and dividends received Where an entity receives interest and/or dividends from an investment during the accounting period, the amounts received will appear in the Statement of Profit or Loss and Other Comprehensive Income under other income. These amounts will reflect the interest or dividends actually received during the accounting period and therefore can be transferred into the Statement of Cash Flows without having to perform any additional calculations. They form part of the cash flows from investing activities. Decrease in long-term borrowings In the above example the increase in loan stock was shown as an inflow of cash under cash flows from financing activities. If there has been a decrease in the long-term borrowings or the loan stock it can be assumed that the entity has repaid part of the loan. This will be an outflow under the section for cash flows from financing activities. Interest payable An entity accounts for interest payable on an accruals basis. This may result in a difference between the interest expense in the Statement of Comprehensive Income and the actual interest paid. In this case the amount of interest paid will need to be calculated using a ledger account. The procedure is the same as that used to calculate tax paid in the previous example. 23

Home Learning College Example Calculating interest paid Assume that the Statement of Financial Position at 31 December 20X0 shows an accrual for interest of 58,000, the Statement of Financial Position at 31 December 20X1 shows an accrual for interest of 70,000 and the interest expense in Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 December 20X1 is 296,000. The procedure for calculating the interest actually paid during the year to 31 December 20X1 is as follows: 1. Open a ledger account for Interest Payable and enter the opening and closing accruals from the Statement of Financial Position. 2. Enter the interest expense for the year from the Statement of Profit or Loss and Other Comprehensive Income. Remember that it will be a credit entry in the ledger account. 3. Balance off the ledger account and calculate the interest paid this is the missing figure. DR Interest Payable CR Date Details 000 Date Details 000 31/12/X1 Interest paid? 01/01/X1 Balance b/d 58 31/12/X1 Balance c/d 70 31/12/X1 Interest expense (SPL) 296 354 354 31/12/X1 Balance c/d 70 The interest paid in this example is 284. ( 58 + 296 70) DR Interest Payable CR Date Details 000 Date Details 000 31/12/X1 Interest paid 284 01/01/X1 Balance b/d 58 31/12/X1 Balance c/d 70 31/12/X1 Interest expense (SPL) 296 354 354 31/12/X1 Balance c/d 70 Property, plant and equipment There are a number of figures that may need to be calculated using a variety of information provided in respect of property, plant and equipment. In the previous example the carrying amount was provided, but it is possible that a breakdown between cost and accumulated depreciation will be given. In this situation the calculations will involve two separate accounts. For example: 24

Financial Statements Book 3 You are provided with the following information relating to non-current assets at the financial year end 31 December 20X1: Property, plant and equipment 20X1 000 20X0 000 Cost 4,576 3,052 Accumulated depreciation 1,526 958 3,050 2,094 Assume that during 20X1 the company sold non-current assets which had originally cost 250,000 and had a carrying value at the date of sale of 94,000. The sale of these non-current assets resulted in a loss of 48,000, which was included in administrative expenses in the Statement of Profit or Loss and Other Comprehensive Income. The key to the calculation of the depreciation and the value of any additions to non-current assets for 20X1 is to reconstruct the movements on the cost and the accumulated depreciation accounts separately. The simplest way is to use ledger accounts inserting the known information. The missing figure in the cost account will represent the additions and the missing figure in the accumulated depreciation account will represent the depreciation charge. Step 1: Enter the opening balances DR Property, Plant and Equipment Cost CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 3,052 31/12/X1 31/12/X1 Balance c/d 4,576 31/12/X1 Balance b/d 4,576 DR Property, Plant and Equipment Accumulated Depreciation CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 958 31/12/X1 Balance c/d 1,526 31/12/X1 31/12/X1 Balance b/d 1,526 25

Home Learning College Step 2: Account for the disposal The original cost of the non-current assets disposed of is given in the question data so this can simply be credited to the cost account. The associated accumulated depreciation is not given and will need to be calculated. If the original cost was 250,000 and the carrying value at the date of sale was 94,000 then the accumulated depreciation must be the difference between the two figures: 250,000 94,000 = 156,000 (accumulated depreciation) These figures can now be inserted into the ledger accounts. DR Property, Plant and Equipment Cost CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 3,052 31/12/X1 Disposal 250 31/12/X1? 31/12/X1 Balance c/d 4,576 4,826 4,826 31/12/X1 Balance b/d 4,576 DR Property, Plant and Equipment Accumulated Depreciation CR Date Details 000 Date Details 000 31/12/X1 Disposal 156 01/01/X1 Balance b/d 958 31/12/X1 Balance c/d 1,526 31/12/X1? 1,682 1,682 31/12/X1 Balance b/d 1,526 Step 3: Calculate the missing figures The missing figures can be calculated by balancing off the accounts. DR Property, Plant and Equipment Cost CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 3,052 31/12/X1 Disposal 250 31/12/X1 Additions 1,774 31/12/X1 Balance c/d 4,576 4,826 4,826 31/12/X1 Balance b/d 4,576 26

Financial Statements Book 3 DR Property, Plant and Equipment Accumulated Depreciation CR Date Details 000 Date Details 000 31/12/X1 Disposal 156 01/01/X1 Balance b/d 958 31/12/X1 Balance c/d 1,526 31/12/X1 Dep n charge 724 1,682 1,682 31/12/X1 Balance b/d 1,526 Proceeds from the disposal of non-current assets It may be necessary to calculate the proceeds from the disposal of noncurrent assets to be included in the Statement of Cash Flows. This is the difference between the profit or loss in the Statement of Profit or Loss and Other Comprehensive Income and the carrying value of the non-current asset. If the company has made a loss, as in the previous example, it indicates that the proceeds received were less than the carrying value. To calculate the proceeds received the loss is deducted from carrying value: 94,000 48,000 = 46,000 (proceeds received) If the company had made a profit on the disposal then the profit is added to the carrying value to calculate the proceeds received: 94,000 + 48,000 = 142,000 (proceeds received) Detailed example 2 Typical examination task The financial statements for Midlands Aggregates Ltd are as follows: Midlands Aggregates Ltd Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 December 20X1 000 Revenue 2,950 Cost of sales (1,340) Gross profit 1,610 Interest received 30 1,640 Distribution costs (195) Administrative expenses (204) Profit from operations 1,241 Finance costs (45) Profit before tax 1,196 Tax (120) Net profit for the period 1,076 27

Home Learning College Midlands Aggregates Ltd Statement of Financial Position at 31 December ASSETS 20X1 000 20X0 000 Non-current assets Property, plant and equipment cost 3,915 2,880 Property, plant and equipment acc d 1,590 1,380 dep n 2,325 1,500 Current assets Inventories 288 174 Trade and other receivables 336 342 Cash and cash equivalents 24 15 Total assets 2,973 2,031 EQUITY AND LIABILITIES Capital and reserves Share capital 660 480 Share premium 120 30 Retained earnings 1,373 334 Total equity 2,153 1,244 Non-current liabilities 5% Loan stock 400 490 Current liabilities Trade and other payables 204 195 Interest payable 24 12 Income tax payables 192 90 Total equity and liabilities 2,973 2,031 The following information is relevant to the year ended 31 December 20X1: 1. The company paid dividends of 437,000 in the year ended 31 December 20X1. 2. The company disposed of old property, plant and equipment during the year. The original cost of these non-current assets was 300,000 and they had a NBV of 210,000 at the date of disposal. 3. Included in administrative expenses is a profit on disposal of 30,000. 28

Financial Statements Book 3 4. The finance costs in the Statement of Profit or Loss and Other Comprehensive Income consist of interest payable. The Statement of Cash Flows is to be prepared in accordance with the requirements of IAS7. Working 1 DR Property, Plant and Equipment Cost CR Date Details 000 Date Details 000 01/01/X1 Balance b/d 2,880 31/12/X1 Disposal 300 31/12/X1 Additions 1,335 31/12/X1 Balance c/d 3,915 4,215 4,215 31/12/X1 Balance b/d 3,915 DR Property, Plant and Equipment Accumulated Depreciation CR Date Details 000 Date Details 000 31/12/X1 Disposal* 90 01/01/X1 Balance b/d 1,380 31/12/X1 Balance c/d 1,590 31/12/X1 Dep n charge 300 1,680 1,680 31/12/X1 Balance b/d 1,590 *Accumulated depreciation on disposal 300 210 = 90 Working 2 Disposal proceeds for non-current assets: Working 3 210,000 + 30,000 = 240,000 (proceeds received) DR Interest Payable CR Date Details 000 Date Details 000 31/12/X1 Interest paid 33 01/01/X1 Balance b/d 12 31/12/X1 Balance c/d 24 31/12/X1 Interest expense (SPL) 45 57 57 31/12/X1 Balance b/d 24 Working 4 DR Income Tax Payables CR Date Details 000 Date Details 000 31/12/X1 Cash paid 18 01/01/X1 Balance b/d 90 31/12/X1 Balance c/d 192 31/12/X1 Income tax (SPL) 120 210 210 31/12/X1 Balance b/d 192 29

Home Learning College Note: Midlands Aggregates Ltd Reconciliation of Profit from Operations to Net Cash Flow from Operating Activities for the year ended 31 December 20X1 000 000 Cash flows from operating activities Profit from operations 1,241 Adjustments for: Depreciation (Working 1) 300 Profit on disposal of non-current assets (30) Interest received (30) 1,481 Decrease in trade and other receivables ( 336 342) 6 Increase in inventories ( 288 174) (114) Increase in trade payables ( 204 195) 9 Cash generated from operations 1,382 Interest paid (Working 3) (33) Income taxes paid (Working 4) (18) Net cash flow from operating activities 1,331 Midlands Aggregates Ltd Statement of Cash Flows for the year ended 31 December 20X1 000 000 Net cash flow from operating activities 1,331 Cash flows from investing activities Payments to acquire property, plant and equipment (1,335) Proceeds from the sale of property, plant and 240 equipment (working 2) Interest received 30 Net cash used in investing activities (1,065) Cash flows from Investing activities Proceeds from the issue of share capital ( 660 + 270 120) ( 480 + 30) Repayment of loan stock ( 490 400) (90) Dividends paid (437) Net cash used in financing activities (257) Net increase in cash and cash equivalents 9 Cash and cash equivalents at beginning of 15 period Cash and cash equivalents at end of period 24 30

Financial Statements Book 3 Advantages of using a statement of cash flows Statements of Cash Flows have a number of advantages that make them useful to users of financial statements: 1. The Statement of Cash Flows focuses on cash, the theory being that a business needs to generate cash if it wishes to remain viable. It is possible for the Statement of Profit or Loss and Other Comprehensive Income to indicate high levels of profit but for a business to collapse because of a lack of cash. The Statement of Cash Flows shows the liquidity of the entity and its ability to turn profit into cash. 2. The Statement of Cash Flows gives an indication of financial adaptability. This is the ability of an entity to generate cash by selling assets or raising additional capital. 3. The other financial statements are prepared on an accruals basis and are somewhat subjective since they may be affected by an entity s choice of accounting policies. Cash flows are a matter of fact and are, therefore, difficult to manipulate. 4. Cash flow information may have a predictive value as it is likely to have many common components from year to year. However, care must always be taken when trying to predict future results. 5. Suppliers and lenders are more interested in the ability of an entity to pay its debts than how much profit it makes. This can be seen more easily from the Statement of Cash Flows. 6. Cash is much easier to understand than profit for many investors. Limitations of the statement of cash flows While Statements of Cash Flows have a number of advantages, they also have some limitations. 1. The balance of cash and cash equivalents is measured at a single point in time. It may be possible to manipulate balances by offering customers early settlement discounts or delaying payment to liabilities until after the year end. Users of the Statement of Cash Flows will not be able to see the effect of such manipulations and may believe that the company s cash position is better than it actually is. 31

Home Learning College 2. Ensuring that the company has a healthy cash balance may be done at the expense of much needed long-term investment in the business. A company may have a large bank balance but be making a loss which will not please investors. 3. As with other financial statements, the Statement of Cash Flows uses historical information and shows what has happened in the past. This is not necessarily a good indicator of what may happen in the future. Interpretation of a statement of cash flows The Statement of Cash Flows provides information that is not found so easily in the other financial statements and therefore provides a good analysis tool for interpreting the liquidity of an entity. It is easier to see the relationship between profit and cash. It shows how the company manages its liquid resources. It highlights significant inflows and outflows of cash and investors can see where cash is being spent. Inflows and outflows from financing activities are identified rather than appearing simply as a movement in equity and reserves in the Statement of Financial Position. Comparison of cash flows over a period can be made. Example Interpretation of a Statement of Cash Flows The following is an example of the interpretation of a Statement of Cash Flows. It shows a report based upon information taken from example Statement of Cash Flows prepared on behalf of Midlands Aggregates Ltd shown earlier in this lesson: 32