J.Welc Module5

MODULE 5:
CASH FLOW REPORTING

Dr Jacek Welc:
jacek.welc@ue.wroc.pl
0
Selected Practical Issues in the Field of Financial Accounting and Auditing: Cash Flow Reporting
PART 1:
PRINCIPLES OF REPORTING
CORPORATE CASH FLOWS
1
WHAT IS A CASH FLOW STATEMENT?
The third primary financial statement (after an income statement and a balance sheet) is a
cash flow statement.
Its purpose is to provide the information about the total change in company’s cash and cash
equivalents in a given period as well as the individual major categories of corporate cash
flows.
A primary reason why a corporate financial reporting is not limited to an income statement
and a balance sheet is their accrual approach.
The accrual basis of accounting means that transactions and other economic events are
recorded in an income statement when they happen, regardless of the timing of related
actual cash inflows or outflows.
2
For example:
sales revenues are recognized when the product or service is provided, while the
related cash may be collected later on (when the customer is granted a trade credit) or
in earlier periods (when the customer pays advance payments),
inventory becomes cost of sales when it is sold while the related cash for purchasing or
manufacturing it may be spent in earlier periods,
the expenditure for new property, plant and equipment may be incurred when it is
purchased, while in an income statement it is expensed as depreciation in future
periods,
the obsolete inventories are written down and expensed as other operating expense
when this impairment occurs, while the actual cash-based losses occurs when they are
sold.
3
The divergences between timing of recognizing revenues and expenses in an income

statement and timing of related cash inflows and outflows create a possibility of significant
deviations of reported earnings from generated cash flows.
It may happen that a company reporting a net loss actually increases its cash balance in a
period or that a company reporting high and fast growing earnings gets drained of its cash
resources.
Thus, it is reasonable to supplement the accrual-based information offered by an income
statement and a balance sheet by a cash-based information from a cash flow statement.
4
THREE TYPES OF COMPANY’S CASH FLOWS
From the point of view of cash flows the company’s total business activities are classified
into three categories:
Operating activity – the primary (core) business operations of a given company, such as
manufacturing and selling vehicles in VW’s case, retailing consumer goods by Tesco or
rendering telecommunication services by T-Mobile,
Investing activity – buying and selling fixed assets (PP&E, intangibles, real-estate
investments, long-term investments in bonds or shares of other entities) or short-term
financial assets, together with all related costs and benefits (i.e. interest earned,
dividends received or profits and losses on sales of these assets),
Financing activity – the activity related to obtaining sources of funds (other than from
operating liabilities), including issue of equity capital, buy-backs of equity capital and
dividends paid as well as borrowing debt, repaying debt and paying interest.
The operating, investing and financing cash flows sum up to the company’s total cash flows
in a given period.
5
THREE TYPES OF COMPANY’S CASH FLOWS
Most accounting standards allow for applying one of the two alternative formats of a cash
flow statement. It may be prepared and presented under direct or indirect method.
However, reporting differences between these two approaches affect only cash flows from
operating activity (investing and financing cash flows are identical under both methods).
Under the direct method the gross amounts of individual items of operating cash flows (e.g.
inflows of cash from sales revenues or payments to suppliers for purchases of inventories)
are presented directly.
In contrast, under the indirect method the operating section begins with a company’s profit
as reported in its income statement (that is resulting from an accrual-based accounting)
which is then reconciled to the company’s operating cash flows by a series of adjustments.
However, huge majority of corporations present their cash flows under the indirect format.
Thus, in this presentation only the indirect method will be discussed.
6
OPERATING CASH FLOWS
Under IAS/IFRS the operating section of a cash flow statement begins with the company’s
pre-tax earnings, which are then adjusted to arrive at the operating cash flows (also labeled
as cash flows from operating activities).
Under some other accounting standards the operating section begins with net earnings
(instead of pre-tax earnings).
However, these differences do not significantly affect the general comparability and
usefulness of the cash flow statements.
Generally speaking, there are three broad groups of factors responsible for differences
between pre-tax earnings reported in an income statement (i.e. resulting from accrual-based
accounting) and operating cash flows.
7
These are:
non-cash revenues, expenses, gains and losses, included in a computation of the

company’s earnings (e.g. depreciation, provisions, gains or losses on disposals of fixed
assets, profits or losses from equity-accounted investments in associated companies),
cash revenues, expenses, gains and losses, affecting pre-tax earnings but relating to
investing or financing activities (e.g. interest paid, interest received, dividends received,
realized foreign currency gains and losses),
changes of non-cash operating assets (inventories, operating receivables, pre-paid

expenses) and operating liabilities (including deferred revenues).
8
Usually the most significant (in monetary terms) adjustments of pre-tax earnings to
operating cash flows include:
depreciation and amortization – these are operating expenses, which lower reported
earnings without any cash outflows. The actual cash outflow related to a fixed asset
occurs when the asset is purchased, not when it is depreciated. Thus, depreciation and
amortization charges must be added back to reported earnings to arrive at cash flows,
unrealized gains and losses from foreign currencies – if a company holds foreign
currencies or if it has receivables or liabilities denominated in foreign currencies, it
revalues their balances periodically to account for the changes of exchange rates. These
revaluations result in unrealized gains (e.g. when a carrying value of a liability
denominated in a foreign currency falls as a result of the exchange rate depreciation) or
unrealized losses (e.g. when a carrying value of a foreign currency receivable increases
as a result of the exchange rate appreciation) which are reported in an income
statement. However, these are non-cash gains and non-cash losses, so they must be
subtracted and added back, respectively, to reported earnings to arrive at cash flows,
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realized gains and losses from foreign currencies which are unrelated to operating
activity – a company may report foreign currency gains or losses which were already
cashed (e.g. when a receivable was collected or a liability settled) but which are not
related to its operating activities (instead, they may be related to investing or financing
activity). For example, a company may issue corporate bonds denominated in foreign
currencies. Realized gains or losses related to interest and principal payments do affect
the company’s cash flows. However, these are realized gains and losses related to
financing activities, so they must be subtracted and added back, respectively, to
reported earnings to arrive at operating cash flows,
share of profits or losses of associated companies – if a company applies an equity-
method of accounting for its investments in associates, it reports non-cash profits or
losses attributable to its shareholdings in these companies. However, these are non-
cash items and they are related to the company’s investing activities, so they must be
excluded from operating cash flows,
10
interest earned and interest paid – similarly as in the case of foreign currency gains and
losses, a company may report unrealized or realized interest revenues or interest
expenses. Unrealized interest earned or interest paid must be subtracted and added
back, respectively, to reported earnings to arrive at cash flows. Realized interest earned
or interest paid may be, in turn, related to the investing and financing activities,
respectively, so it must be excluded from operating cash flows (and reclassified to either
investing or financing cash flows),
gains and losses on disposals of fixed assets - if a company sells a fixed asset (e.g. an
office building or production machinery), it reports gain or loss resulting from a
difference between the proceeds from sale and an asset’s carrying value. Such gains or
losses are unrelated to the operating activity, so they must be excluded from operating
cash flows (only actual cash proceeds from an asset’s sale are reported in investing cash
flows),
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changes in provisions for liabilities – provisions for expected liabilities are expenses,
which lower reported earnings without any current cash outflows. Their reversals, in
turn, boost reported earnings without any current cash inflows. Thus, reported earnings
must be adjusted for changes in provisions to arrive at cash flows,
changes in write-downs of assets – similarly as provisions, write-downs of assets (e.g.
for obsolete inventory, doubtful receivables or impaired fixed assets) are expenses,
which lower reported earnings without any current cash outflows. The reversals of
write-downs, in turn, increase reported earnings without any current cash inflows. Thus,
reported earnings must be adjusted for changes in write-downs of assets to arrive at
cash flows,
changes in inventories, operating receivables and pre-paid expenses – increases in
balances of non-cash operating current assets tie up a company’s cash (without
affecting reported current earnings), while their decreases release cash. Thus the
changes in these non-cash operating assets must be accounted for when adjusting
reported earnings to operating cash flows,
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changes in operating liabilities and deferred revenues – in contrast to non-cash
operating current assets, increases in operating liabilities and deferred revenues boost
the company’s cash balances, while their decreases drain a company’s cash. Thus the
changes in operating liabilities and deferred revenues must be accounted for when
adjusting reported earnings to operating cash flows.
13
REAL-LIFE EXAMPLE – OPERATING CASH FLOWS OF
VOLKSWAGEN GROUP
Table 1: Consolidated operating cash flows of Volkswagen Group in 2007 and 2008.
In millions of EUR 2008 2007
Profit before tax 6 608 6 543
Income taxes paid -2 075 -1 172
Depreciation and amortization expense 5 191 5 435
Amortization of capitalized development costs 1 392 1 843
Impairment losses on equity investments 32 180
Depreciation of leasing and rental assets and investment property 1 823 1 780
Gain on disposal of noncurrent assets 347 32
Share of profit or loss of equity-accounted investment -219 -71
Other noncash income/expense 765 -11
Change in inventories -3 056 -1 856
Change in receivables (excluding financial services) -1 333 -942
Change in liabilities (excluding financial liabilities) 815 2 244
Change in provisions 509 1 657
Cash flows from operating activities 10 799 15 662
Source: Volkswagen Group Annual Report 2008.
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VOLKSWAGEN GROUP
As might be seen, VW’s total operating cash flows (abbreviated to OCF further in this presentation)
amounted to 10.799 million EUR in 2008, after falling by 31% from a preceding year. In both periods
under investigation the OCF exceeded the company’s consolidated profit before tax by a substantial
margin.
The main items responsible for the excess of the OCF over the reported profit were depreciation and
amortization charges (totaling 8.406 million EUR in 2008), included in three separate line items:
• depreciation and amortization expense,
• amortization of capitalized development costs,
• depreciation of leasing and rental assets and investment property.
In turn, the main items decreasing the company’s OCF were:
• income taxes paid,
• change in inventories,
• change in receivables.
The impact of other line items on the company’s total OCF may be considered weak to moderate.
15
VOLKSWAGEN GROUP
It is worth noting that the company presents amortization of capitalized development costs separately
from amortization of other intangible assets.
Capitalized development costs are very specific and “soft” intangible assets and their amortization has
significant weight in the VW’s total OCF. Thus, reporting it in a separate line item is justified.
It is also worth noting that the company excludes financial services receivables from change of its
receivables reported in the OCF.
This means that the company treats its financial services receivables as non-operating (i.e. not resulting
from its core business operations), despite their significant share in the company’s total assets. This issue
of whether it is legitimate to treat financial services receivables as non-operating ones (for cash flow
reporting) will be discussed with more details later on.
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INVESTING CASH FLOWS
From an economic point of view, investing cash flows (also labeled as cash flows from
investing activities) cover three types of business activities:
long-term investments in non-financial assets related to the company’s core business
operations, such as property, plant and equipment and intangible assets,
long-term equity investments related to the company’s core business operations, such
as controlling interests in other entities (mergers and acquisitions) or non-controlling
interests (investments in associated entities),
long-term and short-term equity, debt or non-financial investments unrelated to the

company’s core business operations, such as investments in Treasury bonds, corporate
bonds, loans granted to other entities, short-term equity investments or investment
properties.
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A distinction between the above three categories is important for the analysis of the level
and breakdown of company’s cash flows.
The first two categories of investing cash flows are related to the company’s core business
and are incurred to maintain or develop its future operations, either by direct investments in
tangible and intangible fixed assets (aimed at enabling future organic growth) or through
business combinations or non-controlling investments in strategically related entities (e.g.
takeovers of competitors of suppliers).
Thus, these investments are usually incurred to boost future operating cash flows.
In contrast, a third category of investing cash flows is much more discretionary and reflects a
company’s policy toward investing its excessive cash balances (into assets unrelated to its
core business operations).
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Investing cash outflows usually include:
expenditures on purchases, construction and assembly of new PP&E, intangible assets

and investment properties,
expenditures on improvements of already held PP&E, intangible assets or investment

properties,
loans granted to other entities or private persons, if they are unrelated to the
company’s operating activities,
expenditures on purchases of shares in other companies,

investments in other securities (e.g. bonds or derivatives).
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Investing cash inflows usually include:
proceeds from disposals of PP&E, intangible assets and investment properties,

collected repayments of loans granted to other entities or private persons,
proceeds from disposals of shares in other companies,
proceeds from disposals of other financial instruments,
dividends received,
interest received (e.g. from bank accounts or investments in bonds),
other investment income (e.g. received rental fees related to investment properties).
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However, it must be noted that under IAS/IFR companies have a choice to include dividends
received and interest received either in operating cash flows or investing cash flows.
Thus, it is important to be aware that various companies may include the same type of cash
inflows (related to received dividends and interest) in different sections, with distorting
impact on inter-company comparability of cash flow statements.
21
REAL-LIFE EXAMPLE – INVESTING CASH FLOWS OF
VOLKSWAGEN GROUP
Table 2: Consolidated investing cash flows of Volkswagen Group in 2007 and 2008.
Acquisition of property, plant and equipment, and intangible assets -6 883 -4 638
Additions to capitalized development costs -2 216 -1 446
Acquisition of equity investments -2 597 -1 238
Disposal of equity investments 1 14
Change in leasing and rental assets and investment property -3 055 -2 763
Change in financial services receivables -5 053 -3 588
Proceeds from disposal of noncurrent assets (excluding leasing
93 185
and rental assets and investment property)
Change in investments in securities 2 041 -1 742
Change in loans -1 611 -596
Investing activities -19 280 -15 812
22
VOLKSWAGEN GROUP
As might be seen, VW’s total investing cash flows (abbreviated to ICF further in this presentation) were
negative in both years. This is typical for healthy and growing companies, which invest more than they
receive from disinvestments.
A breakdown of VW’s investing cash flows informs us that:
• majority of line items have negative values, with change in investments in securities being the
only significant item with a positive contribution (only in 2008),
• the company does not obtain any significant cash inflows from disinvestments related to its
noncurrent assets and equity investments,
• the most significant (in monetary terms) investments are related to PPE& and intangible assets,
• the company incurs significant expenditures on other tangible and intangible fixed assets, such
as capitalized development costs, leasing and rental assets and investment properties,
• the second largest item of the company’s investing outflows were financial services receivables
(which may seem surprising),
• the company is engaged in a lending activity (loans) other than resulting from its financial
services.
23
VOLKSWAGEN GROUP
Again, it is worth noting that the company presents expenditures on capitalized development costs
separately from other intangible assets. Additions to capitalized development costs constituted more
than 10% of the VW’s total ICF aggregated for 2007 and 2008. Thus, reporting it in a separate line item is
clearly justified.
It is also worth noting that the company’s investments related to its financial services receivables have
significant weight (almost 25%) in its total ICF aggregated for 2007 and 2008. The company excludes
these enigmatic (at this moment) receivables from its operating receivables and thus treats them as
unrelated to its core business operations.
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FINANCING CASH FLOWS
Financing cash flows (also labeled as cash flows from financing activities) are associated with
company’s sources of capital, other than its operating liabilities.
Generally speaking, the cash inflows and outflows related to two broad categories of capital
fall into this section of a cash flow statement:
cash flows resulting from changes in shareholder’s equity,
cash flows resulting from changes in financial (non-operating) liabilities.
Financing cash inflows usually include:
proceeds from issues of company’s shares,
proceeds from bank loans and other borrowings,
proceeds from issues of corporate bonds.
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FINANCING CASH FLOWS
Financing cash outflows usually include:
payments to shareholders for buy-backs of company’s shares,
dividend payments to shareholders,
repayments of bank loans and other borrowings,
payments for redemptions of issued corporate bonds,
repayments of financial lease liabilities,
interest paid and other expenditures (e.g. bank commissions) related to company’s
financial debt.
Under IAS/IFRS companies have a choice to include interest paid in either operating cash
flows or financing cash flows. Thus, similarly as in the case of interest and dividends
received, it is important to be aware that various companies may include the same type of
cash outflows (interest payments) in different sections, with distorting impact on inter-
company comparability of cash flow statements.
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REAL-LIFE EXAMPLE – FINANCING CASH FLOWS OF
VOLKSWAGEN GROUP
Table 3: Consolidated financing cash flows of Volkswagen Group in 2007 and 2008.
Capital contributions 218 211
Dividends paid -722 -497
Capital transactions with minority interests -362 -
Other changes -3 -12
Proceeds from issue of bonds 7 671 9 516
Repayment of bonds -8 470 -8 484
Change in other financial liabilities 9 806 93
Finance lease payments -15 -40
Cash flows from financing activities 8 123 787
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REAL-LIFE EXAMPLE – FINANCING CASH FLOWS OF
VOLKSWAGEN GROUP
As might be seen, VW’s total financing cash flows (abbreviated to FCF further in this presentation) were
positive in both periods under investigation, with huge increase in 2008.
By far the most significant cash flows were related to company’s financial liabilities, particularly its
corporate bonds (with considerable proceeds from bond issues as well as bond repayments) and other
financial liabilities.
In contrast, cash flows related to VW’s shareholders (capital contributions and dividends paid) had much
more moderate impact on the company’s total financing cash flows.
In 2008 the company also reported some payments related to capital transactions with minority
interests (i.e. with non-controlling shareholders of VW’s subsidiaries), probably related to the company’s
purchases of shares in its subsidiaries from their minority shareholders.
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NET CASH FLOWS
In theory, a change in cash and cash equivalents reported in a company’s balance sheet
(between two periods) should be equal to the sum of its operating, investing and financing
cash flows.
In practice, however, these numbers may differ (although they should be reconciled in the
cash flow statement or in a respective notes to financial statement).
There might be several reasons for such discrepancies, of which the most commonly met
relate to effects of currency translation and to inclusion of some cash and cash equivalents in
assets held for sale.
This will be illustrated by Example 1.
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NET CASH FLOWS
EXAMPLE 1: IMPACT OF CURRENCT TRANSLATION ON REPORTED NET CASH FLOWS
Suppose that a company reports its financial results in EUR but deposits all its cash on bank
accounts denominated in USD. Suppose also that total amount of cash held on bank account
at the end of two consecutive periods was intact and amounted to 1.000 USD, but in the
meantime the EUR/USD exchange rate changed from 1,00 EUR to 1,20 EUR.
In such a circumstance, a company would report in its balance sheet a cash balance of 1.000
EUR (1.000 USD times 1,00 EUR) at the end of the first period and 1.200 EUR (1.000 USD times
1,20 EUR) at the end of the following period. Thus, a period-to-period change in cash and
cash equivalents, inferred from a company’s balance sheet, would amount to 200 EUR.
However, there were not any cash inflows of that amount. Instead, an increase in a reported
cash balance results purely from a currency translation.
Because the purpose of a cash flow statement is to provide a breakdown of company’s cash
inflows and outflows, it is adjusted for such non-cash currency translation effects.
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NET CASH FLOWS
Second common reason for discrepancies between changes of cash reported in a balance
sheet and in a cash flow statement is inclusion of some cash and cash equivalents in assets
held for sale.
EXAMPLE 2: ASSETS HELD FOR SALE AND REPORTED NET CASH FLOWS
Suppose that a company intends to dispose of its controlling interests in one of its
subsidiaries. In such a case it reclassifies all of the assets and liabilities of that subsidiary to
one line item of a consolidated balance sheet, labeled as assets held for sale. Thus, if a
subsidiary holds any cash and cash equivalents, they will be excluded from consolidated cash
and cash equivalents and included in assets held for sale.
However, a decrease in a reported consolidated cash balance results purely from a
reclassification of a subsidiary to assets held for sale and not from any cash outflows.
Because the purpose of a cash flow statement is to provide a breakdown of company’s cash
inflows and outflows, it is adjusted for such non-cash reclassification effects.
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REAL-LIFE EXAMPLE – NET CASH FLOWS OF VOLKSWAGEN
GROUP
Table 4: Net cash flows of Volkswagen Group in 2007 and 2008.
Cash and cash equivalents at beginning of period 9 914 9 367
Cash flows from operating activities 10 799 15 662

Investing activities -19 280 -15 812
Cash flows from financing activities 8 123 787
Effect of exchange rate changes on cash and cash equivalents -113 -90
Net change in cash and cash equivalents -471 547
Cash and cash equivalents at end of period 9 443 9 914
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REAL-LIFE EXAMPLE – NET CASH FLOWS OF VOLKSWAGEN
GROUP
As might be seen, net change in cash and cash equivalents was positive in 2007 and negative in 2008. In
both years the company spent significant amounts on its investing activities. Also, in both years its cash
generated by operating activities was insufficient to cover all its investing expenditures (particularly in
2008). However, positive cash flows from financing activities (primarily from increasing the company’s
indebtedness) enabled investing more than earning (in cash terms) on operations, without significant
drainage of a company’s total cash balances.
It is also worth noting that net change in cash and cash equivalents in 2008, reported in a company’s
cash flow statement (-471 millions of EUR) differs from a change in cash and cash equivalents, inferred
from its balance sheet (not presented here).
The cash and cash equivalents reported in a VW’s balance sheet amounted to 10.112 millions of EUR at
the end of 2007 and 9.474 millions of EUR at the end of 2008. Thus, a balance-sheet-based change in
cash and cash equivalents equaled -638 millions of EUR.
The discrepancy of 167 millions of EUR does not stem from any exchange rate effects, because they are
already accounted for in a bottom part of a cash flow statement. Perhaps its cause may be found in
notes to the financial statement, which may provide some information about the composition of assets
classified by a company as held for sale.
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PART 2:
SELECTED PROBLEMS WITH
RELIABILITY AND
COMPARABILITY OF REPORTED
CASH FLOWS
34
HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS
EXAMPLE 3: IMPACT OF COST CAPITALIZATION ON REPORTED CASH FLOWS
This example is an extension of the Example 5 from Module 2 (Treating Routine Maintenance
Costs as Investments in Fixed Assets).
At the end of 2009 the small airline purchased several new airplanes for 10.000 thousands
EUR. The operations (charter flights) were started at the beginning of 2010. The useful lifes of
all those assets were estimated to be 10 years and for simplicity let’s assume that the
residual values are zero. The company assumed linear depreciation, so the annual
depreciation (reflected in income statement) is 1.000 thousands EUR (10.000.000 EUR / 10
years). The company’s annual net sales (from charter flights) are 3.000 thousands EUR.
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EXAMPLE 3 (CONT.): IMPACT OF COST CAPITALIZATION ON REPORTED CASH FLOWS
In order to ensure reproduction of fixed-assets the company incurs in each year the capital
expenditures equaling annual depreciation of those assets. However, each year the company
must spend another 1.000 thousands EUR associated with the obligatory safety control (this
is necessary to have permission for flights within the European Aviation Area). These are
typical current expenditures that should be classified as necessary for maintaining the
current state of the asset (and not extending the future benefits from the asset, as compared
to the current benefits). Therefore, those expenditures should be expensed (in operating
costs) as incurred. However, the company’s accounting policy states that those expenditures
are separate investments (into fixed assets) and are depreciated or amortized through 5
years.
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Computation of depreciation and balance-sheet carrying values of the initial fixed assets
(airplanes) and following true capital expenditures related to reproduction of those assets.
2009 2010 2011 2012 2013
1) Gross value of fixed assets* 0 11.000 12.100 13.310 14.641
2) Depreciation of initial fixed assets** 0 1.000 1.000 1.000 1.000
3) Reproduction expenditures*** 0 1.000 1.100 1.210 1.331
4) Depreciation of reproduction expenditures**** 0 0 100 210 331
expenditures incurred in 2010 0 0 100 100 100
5) Total depreciation (2 + 4) 0 1.000 1.100 1.210 1.331
6) Net (balance-sheet) value of fixed assets***** 10.000 10.000 10.000 10.000 10.000
* initial 10.000 + cumulative reproduction expenditures **10% from the initial value of fixed assets (airplanes)
***equaling annual depreciation (in order to ensure full reproduction of the assets’ usage)
****assuming linearity, 10 years and depreciation starting at the beginning of the next year
*****net value of fixed assets at the end of the previous year + reproduction expenditures – total depreciation
37
The carrying amount of these “assets” grows steadily, because in each
period the routine safety control expenditures exceed the annual
depreciation of the expenditures capitalized in the past
Computation of depreciation and balance-sheet carrying values of the capitalized (as fixed
assets) expenditures on obligatory safety control
2009 2010 2011 2012 2013
1) Routine safety control expenditures 0 1.000 1.000 1.000 1.000

2) Depreciation of safety control expenditures* 0 0 200 400 600
3) Net (balance-sheet) value of
0 1.000 1.800 2.400 2.800
capitalized safety control expenditures**
* assuming linearity, 5 years and depreciation starting at the beginning of the next year
**net value of capitalized safety control expenditures at the end of the previous year + routine safety
control expenditures in a given year – depreciation of safety control expenditures
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Computation of total carrying (net) amount of fixed assets, including the “true” assets as well
as the capitalized (as fixed assets) expenditures on obligatory safety control
2009 2010 2011 2012 2013
Net value of „true” fixed assets 10.000 10.000 10.000 10.000 10.000
Capitalized routine safety control expenditures 0 1.000 1.800 2.400 2.800
Total net (balance-sheet) value of fixed assets 10.000 11.000 11.800 12.400 12.800
The carrying amount of total fixed assets grows steadily

because of the unjustified repeated capitalization of
routine safety control expenditures. The longer it is
continued, the higher is the resulting “asset bubble”
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Capitalization of the routine safety control
expenditures brings about the repeated
overstatements of reported earnings
Selected income statement data with and without the capitalization (as intangible assets) of
routine safety control expenditures
Incorrect income statement 2009 2010 2011 2012 2013
Net sales 0 3.000 3.000 3.000 3.000
Depreciation and amortization 0 1.000 1.300 1.610 1.931
Costs of routine safety control 0 0 0 0 0
Profit before income taxes 0 2.000 1.700 1.390 1.069
Correct income statement 2009 2010 2011 2012 2013

Net sales 0 3.000 3.000 3.000 3.000
Depreciation and amortization 0 1.000 1.100 1.210 1.331
Costs of routine safety control 0 1.000 1.000 1.000 1.000
Profit before income taxes 0 1.000 900 790 669
NOTE THAT IN EACH YEAR THE DIFFERENCE BETWEEN PROFIT WITH CAPITALIZATION AND PROFIT WITHOUT
CAPITALIZATION EQUALS THE DIFFERENCE BETWEEN THE SAFETY CONTROL EXPENDITURES INCURRED IN A GIVEN YEAR
AND DEPRECIATION OF THE PREVIOUSLY CAPITALIZED SAFETY CONTROL EXPENDITURES. FOR EXAMPLE, IN 2013 THIS
DIFFERENCE EQUALS 400 (1.069 – 669) AND EQUALS THE DIFFERENCE BETWEEN SAFETY CONTROL EXPENDITURES
INCURRED IN 2013 (1.000) AND DEPRECIATION OF PRIOR SAFETY CONTROL EXPENDITURES (600)
40
Carrying (balance sheet) value of fixed assets with and without the capitalization (as
intangible assets) of routine safety control expenditures
Incorrect balance sheet 2009 2010 2011 2012 2013
"True" fixed assets 10.000 10.000 10.000 10.000 10.000
Capitalized safety control expenditures 0 1.000 1.800 2.400 2.800
Total fixed assets 10.000 11.000 11.800 12.400 12.800
Correct balance sheet 2009 2010 2011 2012 2013
"True" fixed assets 10.000 10.000 10.000 10.000 10.000
Capitalized safety control expenditures 0 0 0 0 0
Total fixed assets 10.000 10.000 10.000 10.000 10.000
NOTE THAT THE CARRYING VALUE OF CAPITALIZED SAFETY CONTROL EXPENDITURES AT THE END OF 2013 (2.800)
EQUALS THE DIFFERENCE BETWEEN THE CUMULATIVE EXPENDITURES (4.000) AND CUMULATIVE AMORTIZATION OF
THOSE “ASSETS” (1.200 = 200 IN 2011 + 400 IN 2012 + 600 IN 2013). IF THIS IS FICTITIOUS ASSET, THE REVERSAL MUST
OCCUR SOONER OR LATER (USUALLY AFTER THE AUDITOR’S INTERVENTION). IF THE COMPANY WRITES-OFF THOSE
IMPROPERLY CAPITALIZED “ASSETS” AT THE END OF 2013 (EXPENSING THEIR CARRYING VALUE AS OTHER OPERATING
COSTS), THE RESULT WOULD BE REPORTED SEEMINGLY ONE-OFF (!!!) OPERATING LOSS OF 1.731 (1.069 – 2.800) IN
2013.
41
The “side-effect” of such illegitimate cost capitalization is an overstatement of operating
cash flows and understatement of investing cash flows. This is so because these safety
control expenditures, treated as investments in fixed assets, will be shown in cash flow
statement in investing cash flows.
Overstatement of operating cash flows results from the fact that operating expenditures
(that should decrease current earnings) are artificially treated as capital expenditures
(investments in fixed assets).
If those expenditures were properly expensed as incurred, they would decrease earnings and
operating cash flows (because earnings are part of operating cash flows). Instead, they are
treated as expenditures incurred on fixed assets and are shown in cash flow statement as
investing cash outflows.
42
Capitalization of the routine safety control expenditures brings about
the repeated overstatements of reported operating cash flows and
repeated understatements of reported investing cash flows
Cash flow statement data under two alternative treatments of routine maintenance costs
Incorrect cash flows 2009 2010 2011 2012 2013
profit before income taxes 0 2.000 1.700 1.390 1.069
depreciation and amortization 0 1.000 1.300 1.610 1.931
Net operating cash flows: 0 3.000 3.000 3.000 3.000
expenditures on "true" fixed assets 0 -1.000 -1.100 -1.210 -1.331
expenditures on capitalized safety control expenditures 0 -1.000 -1.000 -1.000 -1.000
Net investing cash flows: 0 -2.000 -2.100 -2.210 -2.331
Total net cash flows 0 1.000 900 790 669
Correct cash flows 2009 2010 2011 2012 2013
profit before income taxes 0 1.000 900 790 669
depreciation and amortization 0 1.000 1.100 1.210 1.331
Net operating cash flows: 0 2.000 2.000 2.000 2.000
expenditures on "true" fixed assets 0 -1.000 -1.100 -1.210 -1.331
expenditures on capitalized safety control expenditures 0 0 0 0 0
Net investing cash flows: 0 -1.000 -1.100 -1.210 -1.331
Total net cash flows 0 1.000 900 790 669
43
NOTE THAT:
TOTAL cash flow (sum of operating and investing cash flow) is the same under both scenarios;
this confirms the contention that “cash is king” and cannot be manipulated, but unfortunately this is
true only as regards TOTAL cash flows (which is generally rather meaningless number from the
analytical point of view),
operating cash flows in the capitalization-scenario are PERMANENTLY higher than in non-
capitalization scenario (by 1.000 which is exactly equal to the amount spent annually on routine
safety control),
investing cash flows in capitalization-scenario are PERMANENTLY lower than in non-capitalization
scenario (again, by 1.000 which is exactly equal to the amount spent annually on routine safety
control),
by capitalizing routine safety control expenditures the company not only overstates the reported
earnings but also FALSELY seems to be much healthier as free-cash-flow generator (many analysts
would say that “the company invests a lot, as compared to competition, but these investing outflows
are quickly transformed in high positive cash flows from operations”).
44
EXAMPLE 4: DISTORTING REPORTED OPERATING AND INVESTING CASH FLOWS BY
ARTIFICIAL TRANSACTIONS WITH NON-CONSOLIDATED FIRMS
The company PC is a public company, but controlled by a private person, John, who holds
70% share in PC’s equity (the remaining 30% is free floating on the stock market). John has
also controlling (100%) equity interest in other company (OC), but this is private company,
not listed on any stock exchange. These relationships look as follows.
John
Free Float OC
(minority investors) 100% (a “friendly”
70%
30% company, owned by
John or his relatives
PC (public company) or his friends)
45
EXAMPLE 4 (CONT.): DISTORTING REPORTED OPERATING AND INVESTING CASH FLOWS
BY ARTIFICIAL TRANSACTIONS WITH NON-CONSOLIDATED FIRMS
John serves also as CEO at PC. All this means that OC is related-party to PC. However, from the
accounting point of view, the results of OC are not consolidated with the results of PC (because the
results and dividends of OC are not associated with the shareholders of PC).
Suppose that PC regularly incurs significant expenditures (1 EUR million annually) on intangibles
(e.g. new clothing collections, new models of ceramic tiles, etc.) which, according to IFRS, should
be expensed as incurred (with no any capitalization). If John intends to boost PC’s earnings and
operating cash flows, through capitalization of its expenditures on those new products, he may
arrange the following transactions:
• PC grants to OC a loan on financing specified works (expenditures) on new products (let’s
suppose that PC, two years in a row, „outsources” to OC the works on new products, with a
related expenditure equaling 1 EUR million in each of those years),
• afterwards PC „purchases” from OC the results obtained from those works (e.g. in the form
of patents, licenses, copyrights, etc.), for the amount, which ensures the financial neutrality
of those artificial transactions for OC.
46
Suppose that John arranges the following transactions:
• in each of those two years PC „outsources” to OC the works on new products,
amounting to 1 EUR million annually (thus 2 EUR million altogether), and grants OC a
loan (payable in the same year) necessary to finance those works,
• after completion of those works PC re-purchases their results (e.g. as licenses, technical
documentation, product formulas) from OC, for 1 EUR million at the end of each of
those two years,
• according to IFRS, such „externally purchased” intangibles, if they have finite useful
lives, are subject to periodic amortization (suppose that PC applies to them a five-year
straight-line amortization with zero residual value),
• suppose for simplicity that amortization of those „assets” commences with the
beginning of the year following their purchase.
47
Thus, the transactions are arranged as follows:
2) PC purchases the results of works completed by OC

(e.g. as licenses or product formulas), for 1 EUR million
OC
(a “friendly”
PC (public company)
company, owned by
John or his relatives
1) PC grants a loan to OC, amounting 1 EUR million, to finance or his friends)
the OC’s works on new products, “outsourced” to OC by PC
48
As a result of such “outsourcing” transactions, the expenditures on new
products are treated as investments in intangibles (and then amortized), and
reported under investing cash flows (instead of operating ones)
Impact of those „outsourcing” transactions on PC’s reported results*:

Period t Period t+1 Period t+2
Fixed assets (BS) / 1.000 / Fixed assets (BS) / 1.000 / Fixed assets (BS) / 0/
Cash (BS) -1.000 Cash (BS) -1.000 Cash (BS) 0
Fixed assets (BS) / 0/ Fixed assets (BS) / -200 / Fixed assets (BS) / -400 /
amortization (IS) 0 Amortization** (IS) 200 Amortization*** (IS) 400
Operating profit (IS) 0 Operating profit (IS) -200 Operating profit (IS) -400
Operating cash flows 0 Operating cash flows 0 Operating cash flows 0

Investing cash flows -1.000 Investing cash flows -1.000 Investing cash flows 0
Total cash flows -1.000 Total cash flows -1.000 Total cash flows 0
* the interest costs related to a loan granted to OC were omitted for simplicity
** amortization of intangible „assets” purchased in the previous year (1.000 EUR / 5 years)
*** amortization of intangible „assets” purchased in the previous two years (200 EUR x 2)
49
In contrast to the “outsourcing” scenario, when expenditures on new products are
incurred internally (with no capitalization as intangibles), they are expensed as
incurred and also reported as operating cash outflows (instead of investing ones)
PC’s reported results* without those “outsourcing” transactions:

Period t Period t+1 Period t+2
Cash (BS) / -1.000 / Cash (BS) / -1.000 / Cash (BS) / 0/
Operating costs (IS) 1.000 Operating costs (IS) 1.000 Operating costs (IS) 0
Operating profit (IS) -1.000 Operating profit (IS) -1.000 Operating profit (IS) 0
Operating cash flows -1.000 Operating cash flows -1.000 Operating cash flows 0
Investing cash flows 0 Investing cash flows 0 Investing cash flows 0
Total cash flows -1.000 Total cash flows -1.000 Total cash flows 0
* the interest costs related to a loan granted to OC were omitted for simplicity
50
NOTE THAT:
the effect of those artificial transactions is a capitalization of fictitious „assets” (which are de facto
PC’s operating costs), and as a result an overstatement of PC’s reported earnings for both years,
when the works on new products were conducted,
the side-effect is an overstatement of fixed assets (intangibles), by 1 EUR million in Period t and 1,8
EUR million in Period t+1 (1.000 + 1.000 – 200),
the overstatement of earnings lasts as long as the cost capitalization is continued (and capitalized
amounts exceed the amortization of previously capitalized costs) – after the “outsourced” works on
new products are ceased (in Period t+2) the prior overstatement of earnings begins its reversal (in
this period the profit under scenario with cost capitalization is lower than profit with no
capitalization, by 0,4 EUR million, which results from amortization of previously capitalized costs),
the result of those transactions is also irreverseable overstatement of operating cash flows reported
in periods t and t+1 (by 2 EUR million altogether) and accompanying understatement of investing
cash flows reported for the same periods (by the same 2 EUR million).
51
EXAMPLE 5: DISTORTING REPORTED OPERATING AND FINANCING CASH FLOWS BY
ARTIFICIAL TRANSACTIONS WITH NON-CONSOLIDATED FIRMS
This example is an extension of the Example 14 from Module 4 (Off-Balance-Sheet Financing
Under the Equity Method).
Suppose that Company A borrows 800 EUR (a bank loan) to invest in its operating assets (e.g.
property, plant and equipment), with the following impact on its balance sheet:
Pre-borrowing balance sheet Post-borrowing balance sheet
Total assets (A) 1.000 Total assets (A) 1.800
Total equity (E) 500 Total equity (E) 500
Total liabilities (L) 500 Total liabilities (L) 1.300
Indebtedness ratio 50% Indebtedness ratio 72%

(L / A) (500 / 1.000) (L / A) (1.300 / 1.000)
52
EXAMPLE 5 (CONT.): DISTORTING REPORTED OPERATING AND FINANCING CASH FLOWS
Assume now that A arranges the alternative set of transactions, as presented below:
4) A loan granted by Bank to B (guaranteed
by A) is transferred to A via artificial Company B
transactions (e.g. artificial sale of services (A’s associate, with
from A to B) A’s share of e.g.
Company A
20%)
2) Company A invests into the shares of
allegedly non-controlled entity B (which is
a shell company, with no any business
2) Company A gives to the operations) 3) After getting a guarantee
Bank a guarantee of from Company A, Bank may
repayment of a loan lend 800 EUR to B (which
borrowed by B would otherwise not qualify
Bank for any loan, due to its poor
credit quality)
53
In order to keep a loan of 800 EUR out of A’s balance sheet (but still be able to use it), and
obtain additional boost to A’s reported earnings and operating cash flows, the following
sequence of transactions may be arranged:
• Company B borrows 800 EUR from Bank (a loan which is guaranteed by A, given that B
lacks any assets and any business operations),
• A loan of 800 EUR, granted by Bank to Company B, is transferred to Company A through
artificially arranged sale transactions (e.g. sale of services with a profit of 800 EUR),
possibly involving some intermediate “friendly” non-related firm, to which A sells and
from which B purchases (to obtain an additional effect of avoiding consolidation
adjustments as well as other disclosures, which would be required if A transacts directly
with B),
• In the following periods, Company A re-transfers (in regular transactions) to Company B
funds necessary to enable repayments of B’s bank debt.
54
Such artificial arrangements cause not just the maintenance of A’s
indebtedness at pre-borrowing level (50%) and avoidance of its growth,
but even bring the LOWERING of its reported indebtedness

Such arrangements have the following impact on A’s balance sheet and income statement:
Pre-borrowing balance sheet Post-borrowing balance sheet
Total assets (A) 1.000 Total assets (A) 1.800
Total equity (E) 500 Total equity (E) 1.300 (500+800)
Total liabilities (L) 500 Total liabilities (L) 500
Indebtedness ratio 50% Indebtedness ratio 28%

(L / A) (500 / 1.000) (L / A) (500 / 1.800)
Post-borrowing income statement
Pre-borrowing of 500 EUR + post-borrowing
“profit” from transactions between A and B (not A’s net earnings 800
eliminated on consolidation)
55
Such artificial arrangements cause not only overstatement of A’s earnings and
understatement of its indebtedness, but also an overstatement of A’s operating
cash flows (with corresponding understatement of its financing cash flows)

Such arrangements have the following impact on A’s cash flow statement:
Cash flow statement when A Cash flow statement when A
borrows directly from a bank borrows through non-consolidated entity
Operating cash flows 0 Operating cash flows 800
Investing cash flows -800 Investing cash flows -800
Financing cash flows 800 Financing cash flows 0
Total cash flows 0 Total cash flows 0
Post-borrowing income statement

A’s net earnings 800
56
EXAMPLE 6: DISTORTING REPORTED OPERATING AND INVESTING CASH FLOWS BY
CUSTOMER FINANCING SCHEMES
Suppose that company ABC (an IT company) sold a software and some IT services to
company XYZ for 100 million EUR on December 31, 2009, and gave to the customer
the payment term of 30 days.
Such a transaction should be neutral for operating cash flows in 2009, because the
revenues and profits (of 100 million EUR) would be offset by „Change of receivable
accounts” of the same amount (-100 million EUR). In contrast, when the related
payment is collected (in 2010) the operating cash flows would be increased (again
under the item „change of receivable accounts”) by 100 million EUR.
57
BY CUSTOMER FINANCING SCHEMES
However, if ABC is interested in artificially boosting its operating cash flows
reported for 2009, it might arrange the following allegedly unrelated transactions:
• grant to the customer (XYZ) a loan, before a sale of services, of 100 million
EUR,
• sell its software and IT services for 100 million EUR, paid immediately in cash.
The loans granted to other entities (and their repayments) are normally treated as
non-operating cash flows (that is, resulting from investing excess cash rather than
from operating transactions). As such, they may be reported as part of investing
cash flows (although their substance may suggest that they support the operating
business, despite their allegedly non-operating form).
58
If, despite its substance (which is a customer financing receivable), a
loan is treated as a financial investment, the operating cash flows for
2009 are overstated (while investing cash flows are understated)

Impact of such customer-financing loan on ABC’s reported cash flows:
Cash flows from: 2009 2010
Operating activities*, including: 100 0
Operating profit* 100 0
Change in receivable accounts 0 0
Investing activities, including: -100 100
Loans granted and paid back -100 100
Financing activities 0 0
Net cash flows 0 100
* impact of income taxes omitted for simplicity
59
Impact of a customer-financing on ABC’s reported cash flows, if the customer credit
is treated as routine receivable account:
Cash flows from: 2009 2010
Operating activities*, including: 0 100
Operating profit* 100 0
Change in receivable accounts -100 100
Investing activities, including: 0 0
Loans granted and paid back 0 0
Financing activities 0 0
Net cash flows 0 100
60
EXAMPLE 7: DISTORTING IMPACT OF BUSINESS COMBINATIONS ON REPORTED
CONSOLIDATED OPERATING AND INVESTING CASH FLOWS
Increases of a working capital (i.e. receivable accounts, inventories and prepaid expenses,
less operating liabilities), resulting from normal operating activities, are reported in a cash
flow statement as decreases of operating cash flows. Decreases of a working capital, in turn,
boost operating cash flows.
In contrast, increases of a working capital, stemming from business combinations (mergers

and acquisitions), are reported as investing expenditures (and not operating ones). However,
in the following periods (after an acquisition date), decreases of the same working capital
(i.e. purchased on business combination) are reported as operating cash inflows.
61
EXAMPLE 7 (CONT.): DISTORTING IMPACT OF BUSINESS COMBINATIONS ON REPORTED
Suppose that in 2010 Company A purchased inventory for 1.000 EUR million. Those
inventories were then sold in 2011 also for 1.500 EUR million (paid in cash).
In contrast, Company B increased in 2010 its inventories also by 1.000 EUR million, by taking
the control over another entity, which on acquisition date held inventories valued at 1.000
EUR million. Similarly as in A’s case, in 2011 B sold those inventories for 1.500 EUR million
(paid in cash).
62
In A’s case, both an increase in inventory (in 2010) as well as its decrease (in 2011) are
reported as operating cash flows. In contrast, B reports its expenditure under investing
cash outflows, while the following sale of inventory is reported as operating cash inflow.

EXAMPLE 7 (CONT.): DISTORTING IMPACT OF BUSINESS COMBINATIONS ON REPORTED
Impact of those events on A’s and B’s consolidated cash flow statements:
Company A Company B
Cash flows:
2010 2011 2010 2011
Operating, including: -1.000 1.500 0 1.500
Operating profit* 0 500 0 500
Change in inventories -1.000 1.000 0 1.000
zmianaInvesting
stanu zapasów 0 0 -1.000 0
Financing 0 0 0 0
Net cash flows -1.000 1.500 -1.000 1.500
63
EXAMPLE 8: SALE OF INVENTORY TO TARGET JUST BEFORE A MERGER
Company acquiring controlling interest in another company starts to consolidate the
financial statements of this subsidiary (target) after obtaining control. This means that there
may be a temptation for the parent company to artificially boost its income BEFORE the
merger by selling the inventory to the target just before the merger (hence recognizing
income that is not adjusted on consolidation).
However, because this is an artificial acceleration of recognized income, the result is an
overstatement of the parent company’s consolidated financial results just BEFORE the
merger, at the cost of its FUTURE consolidated results.
The side-effect is also an overvaluation of the balance-sheet value of inventory and an
overstatement of the acquirer’s pre-merger reported operating cash flows (the decrease of
the same inventory is reported twice: before and after the business combination!).
64
EXAMPLE 8 (CONT.): SALE OF INVENTORY TO TARGET JUST BEFORE A MERGER
Suppose that Acquirer purchased 100% shares in Target’s equity on December 31, 2009. Few
days before that acquisition Target was a typical „shell company”, with no any assets and
liabilities. At the beginning of 2009 Acquirer did not have any inventories. However, until the
end of the year, its inventories grew by 100 EUR million (as a result of a shrinking demand).
On December 30 Acquirer arranged the following artificial transactions:
• Acquirer granted to Target a loan on 100 EUR million,
• Acquirer sold all its inventories for 100 EUR million to Target (paid in cash) and then
purchased Target’s shares for Target’s net assets (equaling zero = inventory valued at
100 EUR million minus a liability to Acquirer of 100 EUR million).
In 2010 Target sold all those inventories to a third party for 100 EUR million (i.e. for a price
equal to their carrying amount). The money collected from this sale was used as a repayment
of the prior borrowing from Acquirer (with no interest costs, for simplicity).
65
Without this pre-merger sale of inventories, Acquirer would report in 2009
negative operating cash flows of -100 (reflecting increased inventories). Thus, a
transaction causes an overstatement of operating cash flows by 100. In 2010,
however, the sale of this inventory boosts operating cash flows once again.

Impact of those transactions on Acquirer’s stand-alone and consolidated cash flows:
Acquirer Target Consolidated
Cash flows:
2009 2010 2009 2010 2009* 2010**
Operating, including: 0 0 -100 100 0 100
Change in inventories 0 0 -100 100 0 100
Investing, including: -100 100 0 0 -100 0***
Loans granted and collected -100 100 0 0 -100 0***
Financing, including: 0 0 100 -100 0 0***
Loans borrowed and paid back 0 0 100 -100 0 0***
Net cash flows -100 100 0 0 -100 100
* equal to Acquirer’s stand-alone cash flows
** equal to the sum of Acquirer’s and Target’s cash flows
*** repayment of a loan in 2010 is adjusted on consolidation as an intra-group transaction
66
In the absence of such pre-merger transaction, Acquirer reports negative
operating cash flows in 2009. In 2010, the sale of this inventory (directly
from Acquirer to a third party, with no Target’s involvement), is reported as
an increase of Acquirer’s stand-alone operating cash flows.

Acquirer’s stand-alone and consolidated cash flows without the pre-merger sale of inventory:
Acquirer Target Consolidated
Cash flows:
2009 2010 2009 2010 2009* 2010**
Operating, including: -100 100 0 0 -100 100
Change in inventories -100 100 0 0 -100 100
Investing, including: 0 0 0 0 0 0
Loans granted and paid back 0 0 0 0 0 0
Financing 0 0 0 0 0 0
Net cash flows -100 100 0 0 -100 100
* equal to Acquirer’s stand-alone cash flows
** equal to the sum of Acquirer’s and Target’s cash flows
67
NOTE THAT:
the loan granted by Acquirer to Target is reported in 2009 under Acquirer’s investing cash flows (and
as financing cash inflows by Target), but its repayment in 2010 is not reported at all in Acquirer’s
consolidated cash flow statement (because it is eliminated on consolidation as an intra-group
transaction),
the result of the pre-merger sale of inventory is an irreverseable overstatement of Acquirer’s
consolidated pre-merger operating cash flows,
this stems from the fact that in 2009 consolidated operating cash flows are overstated by 100 EUR
million as a positive „change in inventories” (because a pre-merger transaction in not adjusted for
on consolidation),
in the following year, after the new subsidiary sells the inventory to a third party, consolidated cash
flows statement once again shows the decrease of inventory (by the same 100 EUR million).
68
EXAMPLE 9: DISTORTING IMPACT OF NON-CONTROLLING INTERESTS ON RELIABILITY OF
REPORTED CASH FLOWS
In consolidated financial statements, when a parent holds less than 100% share in a
subsidiary’s equity, the adjustments for the non-controlling interests (in subsidiary’s equity)
impact only one item of the consolidated balance sheet (i.e. shareholder’s equity) and only
two items of the consolidated income statement (i.e. net earnings and total comprehensive
income).
All the other items of the consolidated balance sheet and the consolidated income statement,
and particularly the whole cash-flow statement, are distorted and may significantly limit the
usefulness of the consolidated financial statement in the company’s analysis and valuation.
Suppose a hypothetical group structure as presented below:
69
Controlling entity A
Share in equity
of 57,7%
Subsidiary B (a „shell” company*) The resulting share of

Share in equity the controlling entity A
of 51% in the shareholders equity
of its subsidiary D:
Subsidiary C (a „shell” company**) 57,7% x 51% x 51% = 15%
Share in equity
of 51%
Subsidiary D
* the only assets held are shares in C
** the only assets held are shares in D
70
Company A fully consolidates D’s cash flows, despite being entitled to extract
(e.g. from dividends) only 15% of economic benefits generated by D. Under
assumptions taken in this example, A’s reported consolidated cash flows are
significantly distorted (because they include 100% of D’s cash flows).
Suppose a now that A’s and D’s stand-alone and consolidated cash flow reports look as
presented below:
Parent Subsidiary D
Full Proportional
CASH FLOW STATEMENT Company (owned in
consolidation* consolidation
A 15%)
Operating profit 1 000 2 500 3 500 1 375
Income tax -200 -500 -700 -275
Gains from sale of land -3 000 0 -3 000 -3 000
Change of inventory -2 000 2 500 500 -1 625
Net operating cash flows -4 200 4 500 300 -3 525
Gains from sale of land 3 000 0 3 000 3 000
Net investing cash flows 3 000 0 3 000 3 000
Interest on debt -1 500 0 -1 500 -1 500
Net financing cash flows -1 500 0 -1 500 -1 500
NET CASH FLOWS -2 700 4 500 1 800 -2 025
* provided that there are no any intra-group transactions between companies A and D (which would
have to be adjusted for on consolidation)
71
THANK YOU
FOR YOUR ATTENTION
Dr Jacek Welc:
jacek.welc@ue.wroc.pl
72

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MODULE 5:

CASH FLOW REPORTING

The divergences between timing of recognizing revenues and expenses in an income

non-cash revenues, expenses, gains and losses, included in a computation of the

changes of non-cash operating assets (inventories, operating receivables, pre-paid

long-term and short-term equity, debt or non-financial investments unrelated to the

expenditures on purchases, construction and assembly of new PP&E, intangible assets

expenditures on improvements of already held PP&E, intangible assets or investment

expenditures on purchases of shares in other companies,

proceeds from disposals of PP&E, intangible assets and investment properties,

This will be illustrated by Example 1.

Cash and cash equivalents at beginning of period 9 914 9 367

Cash flows from operating activities 10 799 15 662

1) Routine safety control expenditures 0 1.000 1.000 1.000 1.000

2009 2010 2011 2012 2013

The carrying amount of total fixed assets grows steadily

Correct income statement 2009 2010 2011 2012 2013

2) PC purchases the results of works completed by OC

Impact of those „outsourcing” transactions on PC’s reported results*:

Operating cash flows 0 Operating cash flows 0 Operating cash flows 0

PC’s reported results* without those “outsourcing” transactions:

Indebtedness ratio 50% Indebtedness ratio 72%

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

Indebtedness ratio 50% Indebtedness ratio 28%

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

Total cash flows 0 Total cash flows 0

Post-borrowing income statement

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

In contrast, increases of a working capital, stemming from business combinations (mergers

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

HYPOTHETICAL EXAMPLES OF DISTORTED CASH FLOWS

Suppose a hypothetical group structure as presented below:

Subsidiary B (a „shell” company*) The resulting share of

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