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IAS 7: Learning Objectives

Statement of Cash Flows At the end of this topic, students should be able
to:-
ACC • Explain the meaning of and purpose of cash
FIN221
623
flow statements and cash flow information
• Explain the difference between cash flow and
Madafu, Elias G. profit
CPA (T), MSc. AF (MU), BSc. AF (TU) • Prepare a cash flow statement for a company
using both methods

Definitions: Cash Flow Definitions: Cash and Cash Equivalent

Cash flow is defined as ‘an increase or decrease IAS 7 defines cash and cash equivalents.
in an amount of cash’. Anything that falls • Cash consists of cash (or other financial
outside this definition is not a cash flow and instruments) that can be withdrawn on
should not appear in the statement. demand.
• Cash equivalents are short-term, highly-liquid
investments that are readily convertible into
known amounts of cash and which are subject
to an insignificant risk of changes in value.

Definitions: Cash and Cash Equivalent Purpose of a statement of cash flows

• Cash and cash equivalents are held in order to IAS 1 states that a statement of cash flows is a
meet short-term cash commitments, rather than part of a complete set of the financial
for investment purposes or other purposes. statements of an entity. It provides information
• Examples of cash equivalents are a bank deposit about the cash flows of the entity during the
where some notice of withdrawal is required; reporting period, and the changes in cash and
short-term investments with a maturity of three cash equivalents during the period.
months or less, such as Treasury bills and short-
term Certificates of Deposit.

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Purpose of a statement of cash flows Benefits of cash flow information

A statement of cash flows groups the sources or A statement of cash flows provides information
uses of cash under three broad headings: about where a business obtained its cash during
 cash from operating activities the financial period, and how it made use of its
 cash used in (or obtained from) investing cash.
activities It also shows whether there was an increase or a
 cash paid or received in financing activities decrease in the amount of cash held by the
entity between the beginning and the end of the
period.

Benefits of cash flow information Profit and Cash flow

• It is useful in assessing the ability of the entity When a business makes a profit of Tshs 1,000,000
to generate cash and cash equivalents. this does not mean that it receives Tshs 1,000,000
• It helps users of accounts to compare the more in cash than it has spent. Profit and cash flow
are different, for several reasons:
performance of different entities because
unlike profits, comparisons of cash flows are There are items of cost in the income statement
not affected by the different accounting that do not represent a cash flow. Examples are:
policies used by different entities. • depreciation and amortisation charges
• the gain or loss on the disposal of non-current
assets.

Profit and Cash flow Profit and Cash flow

There are items of cash flow that do not appear Cash flows relating to financial transactions,
in the income statement. Examples are: such as obtaining cash by issuing shares or
Cash flows relating to the acquisition or disposal obtaining loans, the repayment of loans and the
of investments, such as the purchase of new payment of dividends to ordinary shareholders.
non-current assets, and cash from the sale of
non-current assets.

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Cash flows from Operating

Overview of statements of cash flows
Activities
The content and format of statements of cash These are the cash or cash outflows arising in
flows are specified by IAS 7 statements of cash normal trading activities of the entity.
flows. Entities are required by IAS 7 to report In general, cash flows arising from transactions
cash flows for the period under three headings and other events that enter into the
• Cash flows from operating activities determination of profit or loss are operating
• Cash flows from investing activities cash flows.
• Cash flows from financing activities

Methods of presenting the cash flows

Direct method
from operating activities
• IAS 7 permits two methods of presenting • Reports cash inflows and outflows directly.
cash flows from operating activities which are • Starts with the major categories of gross cash
Direct method and Indirect method receipts and payments.
• These two methods differ only in the way • Cash flows such as receipts from customers
that they present cash flows for cash and payments to suppliers are stated
generated from operations. separately within the operating activities.

Direct method Indirect method

• Starts with gross cash receipts and payments. • Starts with profit before tax.
• Provides more information about sources/uses • Highlights differences between operating
of cash. profit and net cash flow from operating
• Shows operating cash receipts and payments. activities.
• Possibly more useful in assessing future cash • Indicates quality of earnings.
flows.
• Useful in failure prediction models. • Able to estimate future cash flows and adjust
for accruals.

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Cash Flows from Investing Activities Cash Flows from Financing Activities
Investing activities are defined by IAS 7 as the These activities are defined by IAS 7 as activities
acquisition and disposal of long term assets and that resulting changes in the size and
other investments not included in cash composition of the contributed equity and
equivalents. They include both:- borrowing of the entity. They include cash flows
• Investing in new non-current assets e.g from:-
purchase of new PPE
• Issue or buy back of shares for cash
• Disinvesting by disposing of item of PPE
• Include cash received from investments such • The issue of bonds or the redemption of
as interest or dividends received bonds (for cash)

Cash Flows from Financing Activities

• New loans and the repayment of loan Preparing a statement of cash flows:
principal
cash flows from operating activities –
• The payment of dividends to equity
shareholders.
indirect method

Adjustment for depreciation,

Profit before taxation
amortisation and impairment
• The starting point for the statement of cash flows • Depreciation charges and amortisation
for a company is the operating profit after charges are not cash flows. They are expenses
deducting interest but before taxation.
that have reduced profit, but they do not
• Adjustments are then made to this profit figure in
order to calculate the amount of cash received by
represent payments of cash.
the entity (or the amount of cash paid out) as a • In order to obtain a figure for cash flow from
consequence of its trading operations. the figure for profit, the charges for
• The purpose of the adjustments is to work depreciation and amortisation must therefore
toward a figure for cash flow from operating be added back to the profit figure.
activities.

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Adjustment for depreciation,

Adjustment for interest charges
amortisation and impairment
• In the same way, any impairment of non- • Because the accruals concept is applied in
current assets charged as an expense in profit accounting, the amount of interest charges in
profit r loss for the year might differ from the
or loss is not a cash flow, and should be added amount of interest actually paid in the year.
back to the profit before tax figure to arrive at • Since interest charges (in profit or loss) and
a figure for cash generated from operations. interest payments (cash flow) might differ, it is
Class Task necessary in the statement of cash flows to add
back the interest charge for the year, and deduct
How do we calculate depreciation figure? the interest actually paid (= the cash payments of
interest).

Adjustment for gains or losses on

Interest, taxation and dividends
disposal of non-current assets
• Gains or losses on the disposal of non-current IAS 7 states that there is no consensus about
assets are not cash flows. The gain or loss is how to treat interest payments by an entity,
calculated as the difference between the net other than a financial institution such as a bank.
cash received from the disposal, and the Interest payments may be classified as either:
carrying value (net book value) of the asset at • an operating cash flow, because they are
the date of disposal. deducted when calculating operating profit
• Deduct any gains on the disposal of non- before taxation, or
current assets, or add any losses on the • a financing cash flow, because they are costs
disposal of non-current assets of obtaining finance.

Interest, taxation and dividends Interest, taxation and dividends

Interest received and dividends received may be IAS 7 allows dividend payments to be treated as
classified as either: either:
• an operating cash flow, because they are • a financing cash flow because they are a cost
added when calculating operating profit of obtaining financial resources, or
before taxation, or • a component of the cash flows from operating
• an investing cash flow, because they represent activities, in order to assist users to determine
returns on investment. the ability of the entity to pay dividends out of
its operating cash flows.

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Interest paid and tax paid Interest paid and tax paid
• The final items in the operating cash flows • The amount of the payments of interest and
part of a statement of cash flows are the tax can be calculated from figures in the
amount of interest paid and the amount of tax opening and closing statements of financial
paid in the period. position for the period, and the statement of
• As explained earlier, the amount of interest comprehensive income for the period.
paid might not be the amount of interest
expense charged against profit. Similarly, the
cash payments for tax might not be the same
as the tax charge for the year.

Interest paid and tax paid Adjustments for working capital:

• However, the taxation liability should include • With the indirect method of presenting a
the deferred tax liability as well as the statement of cash flows, adjustments should
current tax liability, and the tax charge for be made for changes in working capital during
the year is the total amount of tax charged the year, to arrive at the figure for cash
generated from operations.
against profit (current tax, deferred tax and
adjustment for under- or overprovision of tax • For the purpose of preparing a statement of
cash flows, working capital is defined as
in the previous year). Inventory Plus Trade and other receivables B
Minus Trade payables

Summary of the rules for working

Adjustments for working capital:
capital changes
• Trade and other receivables include any The rules for working capital adjustments in a
prepayments. statement of cash flows (indirect method) may
be summarised as follows:-
• Trade payables include accrued expenses and
other payables, provided that the accrued When the working capital increases (which
means cash outflow), subtract the difference
expenses and other payables do not relate to
other items dealt with separately in the • Increase in trade and other receivables -
Subtract
statement of cash flows, in particular accrued
interest charges and taxation payable. • Increase in inventory - Subtract
• Decrease in trade payables - Subtract

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Summary of the rules for working Which method to use: direct or

capital changes indirect method?
When the working capital decreases (which Library Task
means cash inflow), add the difference Explain the main advantage of the direct
• Increase in trade payables - Add method and indirect method?
• Decrease in trade and other receivables - Add
• Decrease in inventory - Add

Cash from the disposal of non-current

Cash flows from investing activities
assets
• All major classes of gross cash receipts and • The cash received from the disposal of a non-
gross cash payments relating to investing current asset can be calculated from: the
activities should be disclosed separately. profit or loss on disposal (in the statement of
• Investing activities include cash payments to comprehensive income or income statement);
make investments; cash receipts from the cost of the asset and the accumulated
investments, such as cash from the disposal of depreciation or amortisation, and the
non-current assets; interest received on
investments and dividends received from accumulated impairment on the asset at the
investments. date of disposal.

Cash paid to acquire non-current Cash paid to acquire non-current

assets assets
• You might be required by an examination Purchases of non-current assets (normally
question to calculate the amount of cash paid assumed to be the amount of cash paid for
to acquire non-current assets during a these purchases) may be calculated
financial period, given data about noncurrent • When there are no disposals or revaluations
assets in the opening and closing balance of non-current assets during the year
sheets, disposals during the year and possibly • When there are disposals of non-current
also the depreciation charge for the year. assets during the year
• When there are revaluations during the year

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Cash flows from financing activities

The third part of a statement of cash flows, after
Cash from new share issues
cash flows from investing activities, is cash flows
from financing activities. These cash flows include: The cash raised from new share issues can be
• Cash proceeds from issuing new shares established by comparing the equity share
capital and the share premium in the statements
• Cash proceeds from a new loan or issuing new
of financial position at the beginning and the
bonds
end of the year.
• Cash paid to redeem shares or bonds
• Cash paid to redeem a loan
• Dividends paid to shareholders (although these
might be included as operating cash flows instead
of financing cash flows).

Cash from new loans/cash used to Cash from new loans/cash used to
repay loans repay loans
Cash from new loans or cash paid to redeem • Remember to add any loans or bonds
loans in the year can be calculated simply by repayable within one year (current liability) to
looking at the difference between the liabilities the loans or bonds repayable after more than
for loans and bonds at the beginning and the one year (non-current liability) to get the total
end of the year.
figure for loans or bonds.
• An increase in loans or bonds means there has
been an inflow of cash.
• A reduction in loans or bonds means there has
been a payment (outflow) of cash.

THE END