FINACC 2

(Conceptual Framework and Accounting standards)

Topic – 4 : Statement of Cash Flows
Introduction
PAS 7 prescribes the requirements in the preparation of statement of
cash flows.
PAS 7 Statement of Cash Flows requires an entity to present a
statement of cash flows as an integral part of its primary financial
statements.
The statement of cashflows provides information about the sources
and utilization (i.e., historical changes) of cash and cash equivalents
during the period.
 Cash flows are classified and presented into operating activities
(either using the “direct” or “indirect” method), investing activities
or financing activities, with the latter two categories generally
presented on a gross basis.
Definition of terms
Cash comprises cash on hand and cash in bank.
Cash equivalent are “short-term, highly liquid investments that
are readily convertible to known amounts of cash and which are
subject to an insignificant risk of changes in value.”
Only debt instruments acquired within 3 months or less before
their maturity date can qualify as cash equivalents.
 Examples of cash equivalents:
a. 1-year treasury bill acquired 3 months before maturity date
b. 90-day market instruments or commercial paper
c. 3-month time deposit
Cash flows include inflows (sources) and outflows (uses) of cash
and cash equivalents.
When used in conjunction with the rest of the financial statements, the
statement of cash flows helps users assess:
a. the ability of the entity to generate cash equivalents,
b. the timing and certainty of the generation of cash flows, and
c. the need of the entity to utilize those cash flows.
 Because cash is the most liquid of all assets, it is also the one that
needs to be safeguarded the most.
Cash comprises cash on and cash in bank.
Cash includes checks, bank drafts and money orders because these
are acceptable by the bank for deposit or immediate encashment.
Post dated checks are not considered as cash yet because these
checks are unacceptable by the bank.
Cash must be unrestricted meaning cash must be readily available in
the payment of current obligations and not be subject to any
restrictions, contractual or otherwise.
CASH AND CASH EQUIVALENTS
In accounting cash includes money and any other negotiable
instrument that is payable in money and acceptable by the bank for
deposit and immediate credit.
Cash is important because it provides the basis for measurement and
accounting for all other items.
Another reason why cash should be given due attention is that
business, individuals and even government must maintain adequate
liquidity position if they are to remain viable operating entities.
The IASB has identified the need to report information on cash and
liquidity as one of the key objectifies of financial reporting.
This emphasis led to the requirement of providing a Statement of
Cash Flows as one of the primary financial statements.
Cash items included in cash
a. Cash on hand –includes deposited cash collections and other cash
items awaiting deposit such as customers’ check, cashier’s or
manager’s checks., travelers checks, bank drafts and money
orders.
b. Cash in bank – includes demand deposit or checking account and
savings deposit which are unrestricted as to withdrawal.
c. Cash fund – set aside for current purpose such as petty cash fund,
payroll fund and dividend fund.
Only highly liquid investments that are acquired three months before
maturity can qualify as cash equivalents, 3-month BSP treasury bill,
3-month time deposit, 3-month money market instrument or
commercial paper.
There are several money market instrument, including treasury
bills, commercial paper, banker's acceptances, deposits, certificates
of deposit , bills of exchange, repurchase agreements, and short-lived
mortgage - and asset-backed securities.
Commercial paper is a money-market security issued (sold) by large
corporations to obtain funds to meet short-term debt obligations
(for example, payroll) and is backed only by an issuing bank or
company promise to pay the face amount on the maturity date
specified on the note.
 Investments in time deposit, money market instruments and
treasury
bills should be classified as follows:
a. If the term is 3 months or less included as cash and cash
equivalent
b. If the term is more than 3 months but with in one year classified
as short-term financial assets or temporary investment
c. If the term more than one year classified as noncurrent or long-
term investments.
Cash in foreign currency should be translated to Philippine pesos
using the current exchange rate.
Cash fund for certain purpose used in current operations or payment
of current obligations included as part of cash and cash equivalent,
examples petty cash fund, payroll fund, travel fund interest fund
among others.
Used for noncurrent purpose shown as long-term investments, examples,
sinking fund, contingent fund and others.
Statement of Cash Flows
Statement of cash flows is a component of financial statements
summarizing the operating, investing and financing activities of an
entity.
Statement of cash flows provides information about the cash receipts
and cash payments of an entity during a period.
The primary purpose of a statement of cash flows is to provide
relevant information about cash receipts and cash payments of an
entity during a period. Stop A 9/4
Cash flow information is useful in assessing the ability of the entity to
generate cash and cash equivalents and the needs to the entity to
utilize those cash flows.
PAS 7 Statement of Cash Flows sets out requirements for the
presentation and disclosure of cash flow information.
Classification of cash flows
Cash flows are inflows and outflows of cash and cash equivalents.
The statement of cash flows shall report cash flows during the period
classified as operating, investing and financing activities.
1. Operating activities (affect profit or loss)
Operating activities are the cash flows derived primarily from the
principal revenue producing activities of the entity.
In other words , operating activities generally results from
transactions and other events that enter into the determination of
net income or loss.
 Examples of cash flows from operating activities:
a. Cash receipts from sale of goods and rendering of services
b. Cash receipts from royalties, rental, fees, commission and other
revenue
c. Cash payments to suppliers for goods and services
d. Cash payments for selling, administrative and other expenses
Special items in operating activities
Cash flows from buying and selling held trading securities
(whether financial assets or financial liabilities) are classified as
operating activities.
Held for trading securities are similar to inventories in the
sense that they are acquired specifically for resale.
For example, when an invoice is issued on the sale of goods on credit,
the entity that has sold the goods has a financial asset – the receivable –
while the buyer has to account for a financial liability – the payable.
Another example is when an entity raises finance by issuing equity
shares.
A financial asset is a liquid asset that gets its value from a contractual
right or ownership claim.
Cash, stocks, bonds, mutual funds, and bank deposits are all are
examples of financial assets.
Examples financial liabilities include loans, bonds, accounts payable,
and derivatives.
 Some entities, in the ordinary course of their activities, routinely
manufacture or acquire items of property , plant and equipment
to be held for rental to others and subsequently transfer these assets
to inventories when they cease to be rented out and become held
for sale.
For these entities, cash flows from the acquisition, rental and
subsequent sale of such assets are considered operating activities.
The proceeds from the sale of such assets are recognized as
revenue.
Loan transactions of financial institutions (e.g., banks) are
operating activities because they relate to the main revenue
producing activity of a financialinstitution.
2. Investing activities (affect noncurrent assets and other investments)
Investing activities are the cash flows derived from the acquisition
and disposal of long-term assets and other investments not included
in cash equivalent. These are activities include cash flows from
transactions involving nonoperating assets.
Examples of cash flows from investing activities:
a. Cash payments to acquire property, plant and equipment,
intangibles and other long-term assets.
b. Cash receipts from sale of PP&E, intangibles and other long-
term assets
c. Cash payments to acquire equity or debt instruments of other
entities
d. Cash receipts from sale of equity or debt instruments of other
entities.
 3. Financing activities (affect borrowings and equity)
Financing activities are the cash flows derived from the equity
capital and borrowings of the entity.
Examples of cash flows from financing activities:
a. Cash receipts from issuing shares or other equity
instruments (from example issuance of ordinary and
preference shares).
b. Cash payments to owners to acquire or redeem the
enterprise’s shares (payment of treasury stock).
c. Cash receipts from issuing dentures, loans, notes, bonds
mortgages, and other short or long term borrowings.
d. Cash payments for amount borrowed
.
Interests and Dividends
Entities (except financial institutions) may classify cash flows on
interests and dividend as flows:
Cash flows Option 1 Option 2
1. Interest income received Operating activity Investing activity
2. Interest expense paid Operating activity Financing activity
3. Dividend income received Operating activity Investing activity
4. Dividend paid to owners Financing activity Operating activity
Option 1
Interest income, interest expense and dividend income are classified
as operating activities because they enter into the determination of
profit or loss.
Dividend paid is classified as financing activity because it is a
transaction with the owners and alters the equity structure.
Option 2 activities
Interest income and dividend income are classified as investing
activity because they result from investments.
Interest expense is classified as financing activity because it results
from borrowing .
Dividends paid is classified as operating activity in order to assist
users in assessing the entity’s ability to pay dividends out of operating
cash flow.
Cash flows from operating activities shall be reported using either
the direct method or indirect method.
Direct method
The direct method shows in detail or itemizes the major classes of
gross cash receipts and gross cash payments.
In essence, the direct method is the cash basis income statement.
Indirect method
The indirect method means that the net income or loss is adjusted for
the effects of transactions of a noncash nature, any deferral or
accruals of past or future operating cash receipts and payments, and
items of income or expense associated with investing and financing
activities.
Indirect method
The indirect method means that the net income or loss is adjusted for
the effects of transactions of a noncash nature, any deferral or
accruals of past or future operating cash receipts and payments, and
items of income or expense associated with investing and financing
activities.
The indirect method of presenting the cash flow from operations
begin with the accrual basis net income and applies a series of
adjustments to convert the income to a cash basis.
 The following general guidelines are offered for the adjustments of
net income to cash basis:
1. All increases in trade noncash current assets are deducted from
net income.
2. All decrease in trade noncash current assets are added to net
income
3. All increases in trade current liabilities are added to net income.
4. All decreases in trade current liabilities are deducted from net
income.
5. Depreciation, amortization and other noncash expenses are added
back to net income to eliminate the effect they had on net income.
 6. Any gain on disposal of property or gain on early retirement of
nontrade liabilities is included in net income but it is a
nonoperating item.
While loss on disposal of property is deducted from net income.
How to Prepare the Statement of Cash Flows Using the Indirect
Method
The statement of cash flows is prepared by following these steps:
Step 1: Determine Net Cash Flows from Operating Activities
Using the indirect method, operating net cash flow is calculated as
follows:
Begin with net income from the income statement.
Add back noncash expenses, such as depreciation, amortization, and
depletion.
Remove the effect of gains and/or losses from disposal of long-term
assets, as cash from the disposal of long-term assets is shown under
investing cash flows.
Adjust for changes in current assets and liabilities to remove accruals
from operating activities.
Step 2: Determine Net Cash Flows from Investing Activities
Investing net cash flow includes cash received and cash paid relating
to long-term assets.
Step 3: Present Net Cash Flows from Financing Activities
Financing net cash flow includes cash received and cash paid
relating to long-term liabilities and equity.
Step 4: Reconcile Total Net Cash Flows to Change in Cash Balance
during the Period
To reconcile beginning and ending cash balances:
The net cash flows from the first three steps are combined to be total
net cash flow.
The beginning cash balance is presented from the prior year balance
sheet.
Total net cash flow added to the beginning cash balance equals the
ending cash balance.
Step 5: Present Noncash Investing and Financing Transactions
Transactions that do not affect cash but do affect long-term assets,
long-term debt, and/or equity are disclosed, either as a notation at
the bottom of the statement of cash flow, or in the notes to the
financial statements.
Illustration
The following data are provided information for Carmen Company :
2017 2016
Cash and cash equivalents 600,000 200,000
A/R (net of allowance) 1,100,000 1,040,000
N/R trade 150,000 200,000
Inventory 1,200,000 1,360,000
Prepaid expenses 110,000 120,000
Investment in equity securities 300,000 500,000
Property, plant and equipment 3,400,000 2,000,000
Accumulated depreciation (900,000) (600,000)
Patent _ 0- 80,000
5,960,000 4,900,000
Accounts payable 880,000 840,000
Notes payable - trade 60,000 240,000
Accrued expenses 100,000 330,000
Notes payable – bank (short term debt) 400,000 -0-
Share capital, P100 par 3,000,000 2,400,000
Share premium 530,000 400,000
Retained earnings 990,000 790,000
Treasury shares, at cost __-0-__ (100,000)
5,960,000 4,900,000
The statement of retained earnings for the year ended December 31, 2017 showed the following:
Retained earnings - Jan. 1 790,000
Net income for 2017 1,000,000
Total 1,790,000
Cash dividend paid (800,000)
Retained earnings – December 31 990,000
Additional information
a. The entity sold an investment in equity securities for P240,000 cash. There
were no other transactions affecting the investment in equity securities.
b. Land was purchased in the current year for P1,200,000, paying P1,000,000
cash and issuing P200,000 share capital at par value.
c. Equipment costing P200,000 and having a carrying amount of P80,000 was
sold for P60,000 cash.
d. Equipment of P400,000 was purchased for cash.
e. The entity borrowed P400,000 from a bank to be paid June 30, 2018.
f. Share capital with par value of P400,000 was issued for cash at a premium of
P100,000.
g. The treasury shares were reissued for P130,000 cash.
h. The patent was fully amortized.
 Carmen Company
Statement of Cash Flows (Indirect Method)
Year ended December 31, 2017
Cash flows from operating activities:
Net income 1,000,000
Increase in accounts receivable ( 60,000)
Decrease in notes receivable 50,000
Decrease in inventory 160,000
Decrease in prepaid expenses 10,000
Gain on sale of investment ( 40,000)
Loss on sale of equipment 20,000
Depreciation 420,000
Amortization of patent 80,000
Increase in accounts payable 40,000
Decrease in notes payable (180,000)
Decrease in accrued expenses (230,000)
Net cash provided by operating activities 1,270,000
Cash flows from investing activities:
Sale of investment 240,000
Sale of equipment 60,000
Purchase of land (1,000,000)
Purchase of equipment (400,000)
Net cash used in investing activities (1,100,000)
Cash flows from financing activities:
Cash received from bank loan 400,000
Issuance of share capital 500,000
Reissuance of treasury shares 130,000
Payment of cash dividend (800,000)
Net cash provided by financing activities 230,000
Increase in cash and cash equivalents 400,000
Add: Cash and cash equivalents - Jan.1 200,000
Cash and cash equivalents – Dec. 31 600,000
Analysis:
1. Accounts receivable, P60,000 increase (deduct)
The increase in accounts receivable increased net income but did
not increase cash. Accounts receivable should be analyzed net of
the allowance for doubtful accounts.
2. Notes receivable- trade, P50,000 decrease (add)
The decrease in notes receivable increased cash but did not increase
net income.
3. Inventory, P160,000 decrease (add)
The decrease in inventory increased cost of goods sold and
consequently decreased net income but did not decrease cash.
4. Prepaid expenses, P10,000 decrease (add)
The decrease in prepaid expenses increased expenses and
consequently decreased net income but did not decrease cash.
5. Investment in equity securities, P200,000 decrease (deduct)
The gain on sale of investment is previously included in the
determination of net income but this a nonoperating item.
6. Property, plant and equipment, P1,400,000 increase (deduct)
Land only the P1,000,000 is shown as a deduction under investing
because it is nonoperating assets. The issuance of share capital for
land is both noncash investing and a financing activity, it is only
disclosed
7. Loss on sale of equipment is (add)
The loss on sale of equipment is previously deducted from the net
income but this is a nonoperating item.
 8. Patent, P80,000 decrease (add)
The amortization is a noncash expense.
9. Accounts payable, P40,000 decrease (add)
The increase in accounts payable increased cost of goods sold and
decreased net income but did not decrease cash.
10. Notes payable-trade, P180,000 decrease (deduct)
The decrease in notes payable decreased cash but did not decrease net
income.
11. Accrued expenses. P230,000 decrease( deduct)
The decrease in accrued expenses decreased cash but did not
decrease net income.
12. Note payable –bank, P400,000 increase (add)
The cash received from the bank note payable is added because it
is nontrade liability.
**** END OF PRESENTATION CASH FLOWS ****