Preparation - Cash flow statements, Cost Accounting | Cost Accounting - B Com PDF Download

Preparation of a Cash Flow Statement

The following basic informations are required for the preparation of a cash flow statement:

1. Comparative Balance Sheets: Balance sheets at the beginning and at the end of the accounting period indicate the amount of changes that have taken place in assets, liabilities and capital.
2. Statement of Profit & Loss: The Statement of Profit & Loss of the current period enables to determine the amount of cash provided by or used in operations during the accounting period after making adjustments for non-cash, current assets and current liabilities.
3. Additional data: In additions to the above statements additional data are collected to determine how cash has been provided or used e.g. sale or purchase of assets for cash.

The following procedure may be used for the preparation of a cash flow statement:

1. Calculation of net increase (decrease) in cash and cash equivalents accounts. The difference between cash and cash equivalents for the period may be computed by comparing these accounts given in the comparative balance sheets. The results will be cash receipts and payments during the period responsible for the increase or decrease in cash and cash equivalent items.
2. Calculation of the net cash provided (used) by operating activities. It is by the analysis of Statement of Profit & Loss, comparative balance sheet and selected additional information.
3. Calculation of the net cash provided (used) by investing and financing activities. All other changes in the balance sheet item must be analysed taking into account the additional information and effect on cash may be grouped under the investing and financing activities.
4. Preparation of a cash flow statement. It may be prepared by classifying all cash inflows and outflows in terms of operating, investing and financing activities. The net cash flow provided by (used) in each of the three activities may be highlighted.
5. Ensure that the aggregate of net cash flows from operating, investing and financing activities is equal to net increase (decrease) in cash and cash equivalents.
6. Report any significant investing/financing transactions that did not involve cash or cash equivalents in a separate schedule to the cash flow statement. 

Reporting Of Cash Flows from Operating Activities 

Net profit/loss as reported in the Statement of Profit & Loss is different from the net cash flow from operating activities as the financial statements are generally prepared on accrual basis of accounting under which the net income will not indicate the net cash provided by or net loss will not indicate the net cash used in operating activities. In order to calculate the net cash flows in operating activities, it is necessary to replace revenues and expenses with actual receipts and payments in cash. This is done by eliminating the non-cash revenues and/non-cash expenses from given earned revenues and incurred expenses. There are two methods of converting net profit into net cash flows from operating activities:

1. Direct method, and
2. Indirect method.

1. Direct Method

Under direct method, cash receipts from operating revenues and cash payments for operating expenses are arranged and presented in the cash flow statement. The difference between cash receipts and cash payments is the net cash flow from operating activities. It is in effect a cash basis Statement of Profit & Loss. In this case each cash transaction is analysed separately and the total cash receipts and payments for the period is determined. The summarised data for revenue and expenses can be obtained from the financial statements and additional information. We may convert accrual basis of revenue and expenses to equivalent cash receipts and payments. Make sure that a uniform procedure is adopted for converting accrual base items to cash base items. 

The following are some examples of usual cash receipts and cash payments resulting from operating activities:

1. Cash sales of goods and services;
2. Cash collected from debtors (customers);
3. Cash receipts of interest or dividends;
4. Cash receipts of royalties, fees, commission and other revenues;
5. Cash payments to suppliers (creditors);
6. Cash payments for various operating expenses i.e. rent, rates, power etc.
7. Cash payments for wages and salaries to employees;
8. Cash payments for income tax etc.

Under direct method, information about major classes of gross cash receipts and gross cash payments may be obtained either:

(a) from the accounting records of the enterprise; or

(b) by adjusting sales, cost of sales and other items in the statement of profit and loss for:

• Changes during the period in inventories and operating receivables and payables;
• Other non-cash items, and
• Other items for which the cash effects are investing or financing cash flows. 

Some of the items to be shown in the cash flow statement are illustrated below:

Collections from Customers: If a business has only cash sales, the amount of sales revenue in the income statement is the amount of cash collected from the customers. However, when the business has credit sales we have to adjust the amount of sales revenue for changes in debtors and bills receivable. The opening balance of debtors or bills receivable represents uncollected amount from a previous period and it is presumed that cash has been collected during the current accounting period. The closing balance of debtors or bills receivable represents uncollected amount in the current accounting period. Therefore in order to calculate the cash received from debtors, the opening balance (debtors/bills receivable) should be added to the amount of credit sales and closing balance should be subtracted therefrom. 

Alternatively, Cash Collected from Debtors can also be calculated as given below:

Payment to Suppliers: The analysis of cash payments to suppliers begins with cost of goods sold from the Statement of Profit & Loss. The amount of purchases is calculated by adding closing stock and subtracting opening stock form the cost of goods sold. The cash payment made to suppliers is calculated by making adjustments for change in sundry creditors/bills payable.

Payment to Employees:

Rent Received: The analysis of rent received is similar to cash collected from customers.

Interest Paid: The analysis of interest paid is similar to the analysis of payments to employees.

A similar treatment is applied for various other income and expenses to find out the cash inflows or outflows.

Insurance: Different procedure is adopted for insurance expense because insurance is usually purchased (and recorded as an asset) before it becomes an expense. The treatment is as follows:

A similar treatment is applied for other prepaid expenses also.

In direct method of calculating cash flow from operations, the following points should be noted:

1. The necessary adjustments should be made for bad debts, sales returns, purchases returns, discount allowed, discount received etc. while calculating the amount received from the customers or paid to suppliers, as the case may be.
2. Items like depreciation, amortisation of intangible assets (such as goodwill, patent, trade mark etc.) or of debenture discount, preliminary expenses, premium on redemption of debentures and preference shares are ignored from the cash flow statement since the method analyses and includes only cash transactions and therefore, non-cash items are omitted from a statement of cash flows.
3. No adjustment is made for loss or gain on the sale of fixed assets and investments since operating cash receipts and payments are reported directly on the cash flow statement.

2. Indirect Method 

In this method the net profit (loss) is used as the base to calculate net cash provided by or used in operating activities. Non-cash and non-operating charges in the Statement of Profit & Loss are added back to the net profit while non-cash and non-operating credits are deducted to calculate operating profit before working capital changes. It is a partial conversion of accrual basis profit to cash basis profit. Then necessary adjustments are made for increase/decrease in current assets and current liabilities to obtain net cash from operating activities.

A summary of adjustments required to convert the net profit to net cash flow from operating activities through indirect method is as follows:

A. Net profit before tax and extraordinary item

B. Adjustments for non-cash and non-operating items:

Add: Amount written off in respect of depreciation, goodwill, preliminary expenses, underwriting commission etc.

Add/Less: Other non-operating items

C. Adjustment for gains and losses on sale of fixed assets and investments:

Add: Loss on sale of fixed assets/investments

Less: Profit on sale of fixed assets/investments

D. Adjustments for changes in current assets (except cash and cash equivalents) and current liabilities (except bank overdraft)

Add: Decrease in accounts of current assets e.g. debtors, bill receivable, stock, prepaid expenses etc.

Less: Increase in accounts of current assets.

Add: Increase in accounts of current liabilities; e.g., creditors, bills payable, outstanding expenses, etc.

Less: Decrease in accounts of current liabilities.

E. Cash generated from operations

Less: Income tax paid.

F. Adjustments for extra-ordinary items if any

G. Net cash from (used in) operating activities

The computation of net cash inflow or cash outflow from operating activities by the indirect method takes a path that is very different from the computation by the direct method. However, the two methods arrive at the same amount of net cash flow from operations.

The logic behind the treatment of various items are explained as follows:

Adjustment for Depreciation and other Non-cash and Non-operating items

Depreciation, depletion and amortisation of expenses (amortisation of goodwill, preliminary expenses, premium on redemption of debentures, underwriting commission, etc.) do not affect cash and thus should be added back to the net profit in the cash flow statement. When depreciation is provided it has no effect on cash. However, depreciation is deducted from revenues for the computation of income. Therefore, in going from net profit to cash flow from operations, we add depreciation back to net profit. Likewise, all expenses with no cash effects are added back to net profit in the cash flow statement. In the same manner, revenues that do not provide cash are substracted from net profit.

Adjustment for Gains and Losses on Sale of Fixed Assets/Investments

When fixed assets or investments are sold, there may be either profit or loss on sale. Such profit or loss affects the amount of net profit. For instance, when fixed assets, with a book value of Rs 75,000 was sold for Rs 90,000 the actual inflow of cash is Rs 90,000 which would be reflected in the cash flow statement including a profit of Rs 15,000. But this profit on sale of fixed asset has already increased the net profit indicating an inflow of cash from operating activities. In order to avoid this duplication, this profit of Rs 15,000 must be deducted from the net profit. Moreover sale of fixed assets is an investing activity and therefore effect of this profit on sale must be removed from cash flow from operations. Likewise, a loss on sale of fixed assets or investment also require an adjustment to the net profit in the cash flow from operations. This loss is added back to the net profit to compute cash flow from operations.

Changes in Current Assets and Liabilities

Most current assets and current liabilities result from operating activities. Sundry debtors and bills receivable result from sales, inventory generates revenues and prepaid expenses are used in operations. On the liabilities side sundry creditors and bills payable are ordinarily incurred to buy inventory and outstanding liabilities relate to salaries, utilities and other expenses. Changes in these current assets and liabilities are reported as adjustments to net profit on the cash flows statement. The following rules apply:

(a) An increase in current assets other than cash is deducted from net profit to calculate cash flow from operations: For example, when sundry debtors (net) increase during the year, this means that revenues on accrual basis are higher than revenues on cash basis since goods sold on credit are treated as revenues on accrual basis. In other words, the business operations in the period covered resulted in more revenues but not all these revenues resulted in corresponding increase in cash. Some of the revenues resulted in an increase in debtors only. In order to convert the net profit to net cash provided by operating activities the increase in debtors must be deducted from the reported net profit. However, a decrease in current assets has opposite effect and has to be added back to net profit to determine cash provided for the period.

(b) An increase in current liability is added to net profit to arrive at the cash from operation. For example when, sundry creditors increase during the period covered, it means that expenses on accrual basis are more than they are on cash basis because expenses are incurred for which no payment has been made. So this increase must be added to net profit. However, a decrease in a current liability is subtracted from net profit, since more cash has been paid than the expenses recorded on accrual basis.

Format of Cash Flow Statement

Accounting Standard-3 (Revised) has not provided any specific format for the preparation of cash flow statements, but a general idea can be had from the illustration appearing thereof. There seems to be flexibility in the presentation of cash flow statements. However, a widely accepted format under direct method and indirect method is given below:

Cash Flow Statement (Direct Method)

A. Cash flows from operating activities

Cash receipts from customers

Cash paid to suppliers and employees

Cash generated from operations

Income taxes paid

Cash flow before extraordinary item

Proceeds from earthquake disaster settlement

Net Cash from Operating Activities

B. Cash flows from investing activities

Purchase of fixed assets

Proceeds from sale of equipment

Interest received

Dividend received

Net Cash from Investing Activities

C. Cash flows from financing activities

Proceeds from issuance of share capital

Proceeds from long-term borrowings

Repayments of long-term borrowings

Interest paid

Dividend paid

Net Cash from Financing Activities

Net Increase (Decrease) in Cash and Cash Equivalents (A + B + C)

Cash and Cash Equivalents at Beginning of Period

Cash and Cash Equivalents at End of Period

Cash Flow Statement (Indirect Method)

A. Cash flows from operating activities

Net profit before tax and extraordinary items

Adjustments for:

Depreciation

Foreign exchange

Investments

Gain or loss on sale of fixed assets

Interest/dividend

Operating profit before working capital changes.

Adjustments for:

Trade & other receivables

Inventories

Trade payables

Cash generation from operations

Interest paid

Direct taxes

Cash before extraordinary items

Deferred revenue

Net Cash from Operating Activities.

B. Cash flows from investing activities

Purchase of fixed assets

Sale of fixed assets

Sale of investments

Purchase of investments

Interest received

Dividend received

Loans to subsidiaries

Net Cash from Investing Activities

C. Cash flows from financing activities

Proceeds from issue of share capital

Proceeds from long term borrowings

Repayment to finance/lease liabilities

Dividend paid

Net Cash from Financing Activities

Net Increase (Decrease) in Cash and Cash Equivalents (A + B + C)

Cash and Cash Equivalents at the Beginning of the Period

Cash and Cash Equivalents at the End of the Period

Alternatively the Cash Flows from Operating Activities (Indirect Method) may be summarised as below:

Net profit before tax and extra-ordinary items

Adjustments for non-cash and non-operating items

(+) Depreciation

(+) Amortization of intangible assets, preliminary expenses, debenture discount and the like.

(+) or (–) Other non-cash and non-operating items included in net profit

Adjustments for gains and losses on sale of fixed assets and investments

(–) Gains on sale of fixed assets and investments

(+) Loss on sale of fixed assets and investments

Adjustments for changes in current assets and current liabilities

(–) Increases in current assets

(+) Decreases in current assets

(+) Increases in current liabilities

(–) Decreases in current liabilities

(–) Income-tax paid

(–) Extraordinary items

Net Cash Flows from Operating activities

We can summarize the all activities while preparing the cash flow as under: