Cash Flow Statements Chapter Notes | Accountancy Class 12 - Commerce PDF Download

Introduction

•  A cash flow statement is a crucial financial document that tracks the inflow and outflow of cash and cash equivalents within a company. 
•  It helps users understand the sources and uses of cash over a specific period, providing insights into the company's liquidity and financial health. 
•  In recent years, the cash flow statement has gained significant importance due to its practical utility for users of financial information, such as investors, creditors, and analysts. 
•  Companies prepare their financial statements, including the cash flow statement, in accordance with accounting standards prescribed by the Companies Act, 2013. 
•  These standards are mandatory and ensure that financial statements are true and fair. 
•  The cash flow statement is defined in Section 2(40) of the Companies Act, 2013, and is prepared according to Accounting Standard-3 (AS-3). 
•  It categorizes cash flows into operating, investing, and financing activities, providing a clear picture of how cash is generated and used during the accounting period. 
•  Preparing a cash flow statement involves classifying cash flows into three main categories and presenting the statement for each accounting period for which financial statements are prepared. 

Objectives of Cash Flow Statement

• A cash flow statement details the inflow and outflow of cash and cash equivalents from various activities of a company during a specific period.
• The primary objective is to provide useful information about cash flows under different heads: operating activities, investing activities, and financing activities.
• This information helps users assess the enterprise's ability to generate cash and cash equivalents and its need to utilize those cash flows.
• Users' economic decisions rely on evaluating the enterprise's capacity to generate cash, along with the timing and certainty of these cash flows.

Benefits of Cash Flow Statement

• Evaluation of Changes: When used with other financial statements, it helps users evaluate changes in net assets, financial structure (including liquidity and solvency), and the ability to affect cash flows.
• Cash Generation Assessment: Cash flow information is crucial for assessing an enterprise's ability to generate cash and enables users to compare the present value of future cash flows of different enterprises.
• Comparability: It enhances comparability in reporting operating performance by eliminating the effects of different accounting treatments for similar transactions.
• Balancing Cash Flows: It aids in balancing cash inflows and outflows in response to changing conditions, checking the accuracy of past cash flow assessments, and examining the relationship between profitability and net cash flow.

Cash and Cash Equivalents

• According to AS-3, ‘Cash’ includes cash in hand and demand deposits with banks.
• ‘Cash equivalents’ refers to short-term, highly liquid investments that are easily convertible into known amounts of cash with minimal risk of value changes. These investments typically have a maturity of three months or less from the date of acquisition.
• Investments in shares are generally excluded from cash equivalents unless they are substantial cash equivalents, such as preference shares acquired shortly before their redemption date with minimal risk of default.
• Short-term marketable securities that can be quickly converted into cash are also considered cash equivalents.

Cash Flows

• Cash Flows refer to the movement of cash in and out due to non-cash items.
• Cash inflow occurs when cash is received from a non-cash item, while cash outflow happens when cash is paid for such items.
• Examples include cash receipts from trade receivables, payments to trade payables, employee payments, receipt of dividends, and interest payments.
• Cash management involves investing excess cash in cash equivalents.
• Purchasing marketable securities or short-term investments constituting cash equivalents is not considered when preparing the cash flow statement.

Classification of Activities for Cash Flow Statement Preparation

• Activities of an enterprise result in cash flows (inflows or receipts and outflows or payments), which are the focus of a cash flow statement.
• According to AS-3, these activities are classified into three categories: operating, investing, and financing activities.
• This classification helps users assess the impact of these activities on the financial position of an enterprise and its cash and cash equivalents.

Cash from Operating Activities

• Operating activities are the main functions of a business, including:
  1. Buying raw materials
  2. Covering manufacturing costs
  3. Generating sales
• Cash flows from operating activities show how well a company can manage its own finances.
• These cash flows reflect the company's ability to:
  1. Keep its operations running smoothly
  2. Pay dividends to shareholders
  3. Make new investments
  4. Repay loans
• All of this can happen without needing external financing.

Cash Inflows from Operating Activities:

• Cash receipts from the sale of goods and services.
• Cash receipts from royalties, fees, commissions, and other revenues.

Cash Outflows from Operating Activities:

• Cash payments to suppliers for goods and services.
• Cash payments to and on behalf of employees.
• Cash payments to insurance companies for premiums and claims, annuities, and other policy benefits.
• Cash payments of income taxes unless specifically identified with financing and investing activities.

Cash flows from purchasing and selling trading securities are classified as operating activities, as they relate to the main activities of the enterprise. Similarly, cash advances and loans made by financial enterprises are usually classified as operating activities.

Cash from Investing Activities

• According to AS-3, investing activities involve the buying and selling of long-term assets and other investments that are not considered cash equivalents. This includes transactions related to fixed assets such as machinery, furniture, land, and buildings, as well as long-term investments.
• Separately disclosing cash flows from investing activities is crucial because it indicates the extent of expenditures made for resources aimed at generating future income and cash flows.
• Examples of Cash Flows from Investing Activities:

Cash Outflows from Investing Activities:

• Cash payments for acquiring fixed assets, including intangible assets and capitalized research and development costs.
• Cash payments for acquiring shares, warrants, or debt instruments of other enterprises, excluding those held for trading purposes.
• Cash advances and loans made to third parties, excluding advances and loans made by a financial enterprise as part of its operating activities.

Cash Inflows from Investing Activities:

• Cash receipts from the disposal of fixed assets, including intangible assets.
• Cash receipts from the repayment of advances or loans made to third parties, except in the case of financial enterprises.
• Cash receipts from the disposal of shares, warrants, or debt instruments of other enterprises, excluding those held for trading purposes.
• Interest is received in cash from loans and advances.
• Dividends received from investments in other enterprises.

Cash from Financing Activities

• Financing activities involve the long-term funds or capital of an enterprise, such as cash proceeds from issuing equity shares, debentures, long-term bank loans, and repayments of bank loans.
• According to AS-3, financing activities lead to changes in the size and composition of the owners' capital (including preference share capital) and borrowings of the enterprise.
• Separate disclosure of cash flows from financing activities is important as it helps predict future cash flow claims by providers of funds (both capital and borrowings) to the enterprise.

Cash Inflows from Financing Activities:

• Cash proceeds from issuing shares(equity or preference).
• Cash proceeds from issuing debentures, loans, bonds, and other short/long-term borrowings.

Cash Outflows from Financing Activities:

• Cash repayments of amounts borrowed.
• Interest paid on debentures and long-term loans and advances.
• Dividends are paid on equity and preference capital.

Key Points on Cash Flow Classification:

• A transaction may involve cash flows that are classified differently based on their nature.
• For instance, when an instalment for a fixed asset acquired on a deferred payment basis includes both interest and loan components:
• The interest portion is classified under financing activities.
• The loan portion is classified under investing activities.
• Additionally, the same activity may be classified differently by different enterprises.
• For example:
• For a share brokerage firm, the purchase of shares is considered an operating activity.
• For other enterprises, the purchase of shares is classified as an investing activity.

Treatment of Some Peculiar Items

Extraordinary Items:

• Extraordinary items are unusual events like losses from theft, earthquakes, or floods.
• These items are not regular occurrences and are non-recurring.
• Cash flows related to extraordinary items should be classified and disclosed separately as operating, investing, or financing activities.
• This classification helps users understand the nature and impact of these items on current and future cash flows.

Interest and Dividends:

• For financial enterprises (primarily involved in lending and borrowing):
  • Interest paid, interest received, and dividends received are classified as operating activities.
  • Dividend paid is classified as a financing activity.
• For non-financial enterprises:
  • Payment of interest and dividends is classified as financing activities.
  • Receipt of interest and dividends is classified as investing activities.

Taxes on Income and Gains:

• Taxes can include income tax (on normal profit), capital gains tax (on capital profits), and dividend tax (on distributed dividends).
• According to AS-3:
  • Cash flows from taxes on income should be classified as operating activities unless linked to financing or investing activities.
  • Tax on operating profit is classified as operating cash flows.
  • Dividend tax is classified as a financing activity along with dividends paid.
  • Capital gains tax on the sale of fixed assets is classified under investing activities.

Non-cash Transactions:

• AS-3 states that investing and financing transactions not requiring cash or cash equivalents should be excluded from the cash flow statement.
• Examples include:
  • Acquisition of machinery through the issue of equity shares.
  • Redemption of debentures by issuing equity shares.
• Such transactions should be disclosed elsewhere in the financial statements to provide relevant information about these activities.
• Assets acquired through the issue of shares are not included in the cash flow statement due to the non-cash nature of the transaction.

With these three classifications, the Cash Flow Statement is shown:

Ascertaining Cash Flow from Operating Activities

Key Points:

• Operating activities are crucial for a business's revenue and expenses, so understanding cash flows from these activities is important.
• According to AS-3, cash flows from operating activities can be reported using two methods:
• Direct Method: Discloses major classes of gross cash receipts and payments.
• Indirect Method: Starts with net profit or loss and adjusts for non-cash transactions, deferrals or accruals, and items related to investing or financing cash flows.
• In the indirect method, adjustments are made to net profit/loss before taxation and extraordinary items to determine cash flows from operating activities.
• The direct method is useful for estimating future cash flows, while the indirect method is more commonly used by companies.
• The indirect method begins with net profit/loss from the Statement of Profit and Loss, which reflects all operating activities but is prepared on an accrual basis. Adjustments are made for non-operating and non-cash items to arrive at cash flows from operating activities.

• Net Profit Adjustments: Start with the net profit of Rs. 30,000 from the Statement of Profit and Loss and make necessary adjustments to arrive at cash flows from operating activities.
• Depreciation Adjustment: Depreciation of Rs. 5,000 is a non-cash item. Since it does not involve any cash flow, it should be added back to the net profit.
• Finance Costs Adjustment: Finance costs of Rs. 5,000 represent a cash outflow related to financing activities. This amount should also be added back to the net profit when calculating cash flows from operating activities. The finance cost will be shown as an outflow under financing activities.
• Other Income Adjustment: Other income includes profit on the sale of land, which is a cash inflow from investing activities. Therefore, this amount should be deducted from the net profit when calculating cash flows from operating activities.
• Working Capital Adjustments: Changes in working capital, involving current assets and current liabilities, are crucial for converting net profit/loss from an accrual basis to cash flows from operating activities. An increase in current assets or a decrease in current liabilities should be deducted from operating profit, while a decrease in current assets or an increase in current liabilities should be added to operating profit.
• Non-Cash Items: Non-cash items like depreciation, goodwill written-off, provisions, and deferred taxes are added back to the net profit or loss.
• Investing and Financing Cash Flows: Items with cash effects related to investing or financing activities are adjusted based on their nature. Investing and financing incomes are deducted from net profits, while expenses are added back. For example, finance costs (a financing cash outflow) are added back, and investing cash inflows like interest received are deducted.
• Current Asset and Liability Changes: Increases in current assets and decreases in current liabilities are deducted, while increases in current liabilities and decreases in current assets are added to determine net cash flow from operating activities.

The figure shows the proforma of calculating cash flows from operating activities as per the indirect method.

• When calculating cash flow from operating activities, start with 'Net profit before tax and extraordinary items', not 'Net profit as per Statement of Profit and Loss.'
• Deductions for income tax paid are made as the final step to determine net cash flow from operating activities.

Example: Using the data given in Illustration 1, calculate cash flows from operating activities using the indirect method.
Ans: 

Note: You will notice that the amount of cash flows from operating activities are the same whether we use the direct method or indirect method for its calculation.

• The process of determining cash flow from investing and financing activities involves identifying key inflows and outflows associated with these activities. - When preparing the cash flow statement, it is essential to present all significant items of gross cash receipts, gross cash payments, and net cash flows separately under the headings "Cash Flow from Investing Activities" and "Cash Flow from Financing Activities."
• This ensures transparency and clarity in reporting the cash flows related to investing and financing activities.

Example: Welprint Ltd. has given you the following information:

During the year, a Machine costing Rs. 25,000 with Accumulated Depreciation of Rs. 15,000 was sold for Rs. 13,000.
Calculate cash flow from Investing Activities on the basis of the above information.
Ans: 

Preparation of Cash Flow Statement

Example: From the following Balance Sheets of Xerox Ltd., prepare cash flow statement

Additional information:

1. The proposed dividend for 2016-17 is Rs. 2,25,000 and for 2015-16 is Rs. 1,50,000.
2. Income tax paid during the year includes Rs. 15,000 on account of dividend tax.
3. Land and building book value Rs. 1,50,000 was sold at a profit of 10%.
4. The rate of depreciation on plant and machinery is 10%.
5. 9% debentures were redeemed in April 2017, 5% bank loan was opted on March 31, 2017.

Ans: