CASH FLOW STATEMENT

MEANING OF CASH FLOW AND CASH FLOW STATEMENT

Cash Flows are inflows and outflows, i.e., the movement of cash and cash equivalents.

The Cash Flow Statement is prepared according to Revised Accounting Standard-3

on cash flow statement. The standard requires that cash flow be classified and shown in the cash flow statement under three heads, namely:

1. Cash Flow from Operating Activities 2. Cash Flow from Investing Activities ; and 3. Cash Flow from Financing Activities.

OBJECTIVES OF CASH FLOW STATEMENT

The objectives of cash flow statement are:

To ascertain the sources from activities (i.e., operating/investing/financing activities) from which cash and cash equivalents were generated by an enterprise.

To ascertain the uses by activities (i.e., operating/investing/financing

activities) for which cash and cash equivalents were used by an enterprise.

To ascertain the net change in cash or cash equivalents indicating the

difference between sources and uses from or by the three activities between the dates of two Balance Sheets.

IMPORTANT DEFINITIONS AS PER ACCOUNTING STANDARD-3 (REVISED)

I. Cash comprises of cash in hand and demand deposits with banks.

II. Cash Equivalents are short-term, highly liquid investments that are readily convertible into known amount of cash and which are subject to an insignificant risk of change in value.

An investment normally qualifies as cash equivalent only when it has a short maturity of, say (a) treasury bills,(b) commercial paper,(c)money

market funds and (d)investments in preference shares and redeemable within three months can also be taken as cash equivalents if there is no risk of the failure of the company.

III. Cash Flows are inflows and outflows of cash and cash equivalents.AS-3

requires a cash flow statement to be prepared and presented in a manner that it shows cash flows from business transactions during a period

classifying the into: (I)Operating Activities; (ii) Investing Activities; (III) Financing Activities.

IV. Operating Activities: operating activities are the principal revenue producing activities of the enterprise and other activities that are not

investing or financing activities.

V. Investing Activities: Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. These activities include transactions involving purchase and

sale of long term productive assets like machinery, land, etc., which are not held for resale.

VI. Financing Activities: Financing activities are the activities that result in change in the size and composition of the owner’s capital (including

preference share capital in the case of a company) and borrowing of the enterprise.

OPERATING ACTIVITIES

CASH INFLOW CASH OUTFLOW

Cash Sales Cash purchase

Cash received from Debtors Payment to creditors

Cash received from commission Cash operating expenses

and Fees Payment of Wages

Royalty. Income Tax

In the case of financial companies In the case of financial companies

Cash received for Interest and Cash paid for interest

Dividends Purchase of Securities

Sale of Securities

INVESTING ACTIVITIES

Cash Inflow Cash Outflow

Sale of Fixed Assets Purchase of Fixed Assets

Sale of Investments Purchase of Investments

Interest received

Dividends received

FINANCING ACTIVITIES

Cash Inflow Cash Outflow

1. Issue of shares in Cash Payment of Loans

2. Issue of Debentures in Redemption of preference shares

Cash Buy-back of Equity shares

3. Proceeds from Long-term Payment of Dividend

Borrowings Payment of Interest

How the amount of Income Tax is paid determined?

If the amount of tax paid is not given, it is calculated by preparing the provision for

Tax Account:

Dr. PROVISION FOR TAX ACCOUNT Cr.

Particulars Rs. Particulars Rs.

To Bank A/c (Tax Paid)

To Balance c/d

……..

……..

By Balance b/d

By Profit and loss A/c (provision made during the

year)

…….

……..

………….. ..……..

NOTE: If only the provision for tax is given in the two Balance Sheets and no information

about tax paid is given, the amount in the previous year’s Balance sheet is treated as tax paid during the current year. It involves an Outflow of cash.

The current year’s provision for tax represents the amount of tax provided for the current year. It is added back to the current year’s profits to calculate net profit

before tax and extraordinary items (under the indirect method). It is merely a book entry and does not involve outflow of cash.

The provision for Tax Account provides information about the tax paid during the current year as well as the tax provided for the current year. Indirect Method of calculating the Cash Flow from Operating Activities.

Under this method, net cash flow from operating activities is calculated by employing the information contained in the Profit and Loss Account and Balance Sheet.

The amount being net profit before tax is the starting point for calculation. It can be calculated as:

Difference between the Closing Balance and the Opening Balance of Profit and Loss A/c

Add: The Proposed Dividend for the current year

Add: The Interim Dividend paid during the year

Add: Transfer to Reserve

Add: The Provision for tax made during the year

Less: Refund for tax credited to the Profit and Loss A/c

Less: Extraordinary items, if any, credited to the Profit and Loss A/c

Net profits before tax and extraordinary items

After having computed the Net Profit before tax and extraordinary items, it is further adjusted to arrive at the net Cash Flow from Operating Activities. These adjustments are classified into two categories:

1. Adjustments for Non-Cash and Non-Operating Items: Non-Cash and non-operating items (such as depreciation, interest on long

term borrowings, discount on issue of shares or debentures written off, goodwill/patents/copyright amortized, loss on sale on assets or

investments, premium payable on redemption of debentures or preferential shares, etc) are added back and non-operating incomes and gains (such as profit on sale on fixed assets and investments, interest, rent or dividend

received, etc) are deducted.

2. Adjustments for Changes in the Current Assets and Current Liabilities

Related to Operating Activities: (e.g., debtors, bills receivable, stock, prepaid expenses, creditors, bills

payable, outstanding expenses, etc) A decrease in current assets (excluding cash and cash equivalents) and increase in current liabilities (excluding bank overdraft) is added and an increase in current assets and a decrease in current liabilities is deducted from operating profit before working capital changes to arrive at cash generated from operation. After that tax paid (the net of refund of tax) is deducted from cash generated

from operations to arrive at the cash flow from operating activities before extraordinary items. After that we add or subtract the proceeds of extraordinary item(s) to get Net cash from (used in) operating activities.

EFFECT OF CHANGE IN CURRENT ASSETS AND CURRENT LIABILITIES.

Current Assets

1) Stock: Change in the level of stock must be considered for

calculating the cash flow from operating activities. A decrease in

stock will increase the cash inflow from operating activities whereas an increase in stock will decrease the cash inflow from

operating activities.

2) Debtors and Bills Receivable: A decrease in debtors or bills will

receivable will increase the cash inflow from operating activities, whereas an increase in debtors or bills receivable will decrease the cash inflow from operating activities.

3) Prepaid Expenses: A decrease in the prepaid expenses will increase the cash inflow from operating activities. Conversely, an

increase in the prepaid expenses will decrease the cash inflow from operating activities.

Current Liabilities

1) Creditors and Bills Payable: A decrease in creditors and bills payable

will reduce cash. Conversely, an increase in creditors/bills payable will effectively increase the cash available to the enterprise.

2) Outstanding Expenses: A decrease in outstanding expenses will reduce cash. Similarly, an increase in outstanding expenses will increase the

cash available to the enterprise.

The general rules that develop from the above discussion are:

1. An increase in current assets leads to decrease in cash. 2. A decrease in current assets leads to an increase in cash.

3. An increase in current liabilities leads to an increase in cash. 4. A decrease in current liabilities leads to a decrease in cash.

Preparation of Fixed Assets Account

1. Fixed Asset Account (on Original Cost Basis): If the Balance

Sheet contains an item of provision for depreciation or accumulated

depreciation, it means that the fixed assets are shown in the balance sheet at their original cost. In such cases, fixed assets fixed assets and provision for depreciation account should be prepared. Fixed asset account will disclose the purchase and sale of the fixes asset during the year and by preparing provision for depreciation account the amount of depreciation charged during the year will be found out.

2. Fixed Asset Account (on the Written Down Value Basis): When the Balance sheet does not contain the item of provision for depreciation or accumulated depreciation for both the years, it means that the fixed assets are shown in the Balance sheet at their written

down value (after depreciation) and hence the fixed asset account will be prepared on the written down value basis. In this case the amount of current year’s depreciation should be

credited to the Asset Account.

Treatment of Depreciation At the time of calculating profit/loss, depreciation is debited to profit and loss account. It does not involve cash but is a book entry. Therefore, depreciation is to be added back to net profit before tax for calculating cash flow.

Treatment of profit or loss on sale of Fixed Assets

For calculating net profit/loss, loss on sale of fixed assets is debited to profit and loss account. Similarly, profit on sale of fixes assets is

credited to profit and loss account. It does not involve cash. Rather cash is involved on sale of fixed assets. Profit or loss is a result of sale. Therefore, loss on sale of fixed assets is added back and profit on

sale of fixed assets is deducted from net profit before tax for arriving at the cash flow from operating activities.

Sale proceeds of fixed assets will, of course, result in a cash inflow but this inflow

will be shown in the cash flow statement under cash flow from investing activities.

CASH FLOW FROM INVESTING ACTIVITIES

Investing activities of an enterprise are acquisition and disposal of

the long term assets and other investments not included in cash

equivalents. Accordingly, the cash inflow and outflow relating to the

fixed assets, shares and debt instruments of other enterprises,

interests in joint ventures, advances and loans to third parties and

also their repayments are shown under investing activities in the

cash flow statement.

Cash flow from investing activities is ascertained by analyzing the

changes in fixed assets and long term investments in the beginning

and at the end of the year.

For getting the missing figure regarding purchase/sale of fixed assets

and depreciation, fixed assets account and provision for depreciation

account is prepared.

Ascertaining Missing Amounts regarding Fixed Assets or

Depreciation.

CASE 1: When the Fixed Asset is shown at the Written down Value.

Under this case, depreciation is charged to the Asset Account and the

balance of the Asset Account shows the written down value of the

asset, which is also called the book value.

Dr. FIXED ASSETS ACCOUNT (AT WRITTEN DOWN VALUE) Cr.

NOTES:

1) Generally, the purchase of fixed assets is a balancing amount on the debit

side of the account and depreciation or the sale of fixed assets on the

credit side of the account.

2) Information regarding depreciation is generally given in the question.

Students are required find out only the sale or purchase of asset.

3) If the sale and depreciation are not given, then assume it is either sale or

depreciation and give your assumptions.

In case of land, it should be assumed sale as depreciation is not charged

on land. In case of patents/goodwill/trade marks, it should be assumed

that the amount is written off.

CASE 2: When the fixed assets are shown at their original cost and

accumulated depreciation (provision for depreciation) is separately

maintained.

Under this case, (in contrast to the above case), depreciation is not directly

charged to the Asset Account. The depreciation for the period is debited to the

depreciation account (transferred to P&L A/c) and credited to Accumulated

Depreciation Account.

In the Balance Sheet, asset appears at its original cost and the accumulated

depreciation is shown either by deducting from Fixed Asset Account or on the

liability side of Balance sheet. In such cases, we prepare separate accounts for

fixed assets and accumulated depreciation. Depreciation for the year can be

ascertained from provision for depreciation account.

Particulars Rs. Particulars Rs.

To Balance b/d

To Bank A/c (purchases)

To Profit & loss A/c

(Profit on sale of Fixed Asset)

By Bank A/c (sale of Fixed Asset)

By Profit & loss A/c

(Loss on sale of Fixed Asset)

By Depreciation A/c

By Balance c/d

……

……

……

Dr. FIXED ASSET ACCOUNT (AT COST) Cr.

NOTE: Normally, the purchase of fixed asset is a balancing amount on the debit

side of the account and the sale of fixed asset on the credit side of the account.

Dr. ACCUMULATED DEPRECIATION ACCOUNT Cr.

Particulars Rs. Particulars Rs.

To Fixed Asset A/c

(Acc. Dep. on Fixed Asset Sold)

To Balance c/d

……

…….

By Balance b/d

By Profit & loss A/c

(Dep. Charged for current year)

…..

……

NOTE: Accumulated depreciation on the fixed asset sold or depreciation charged

for the current accounting year may not be given, which shall be the balancing

amount.

CASH FLOW FROM FINANCING ACTIVITIES

Financing Activities of an enterprise are those activities that result in change in

the size and composition of owner’s capital and borrowing of the enterprise. It

includes proceeds from issue of shares or other similar instruments, issue of

debentures, loans, bonds, other short-term loans or long term borrowings and

repayments of amounts borrowed. Accordingly, receipts and payments on

account of the above are disclosed in the cash flow statement as the cash flow

from financing activities.

Dividends paid (in all enterprises) and interest paid (in case of non-financing

enterprise) is also included in Financing Activities.

It is important to note that an increase in share capital due to bonus issue will not

be shown in the cash flow statement, since it is a capitalization of reserves.

Particulars Rs. Particulars Rs.

To Balance b/d

To Profit & loss A/c

(Profit on sale of Fixed asset)

To Bank A/c

(Purchase of Fixed Asset)

….

….

…..

By Bank A/c (Sale of Fixed Asset)

By Accumulated Dep. A/c

(Accumulated Dep. On fixed asset sold)

By Profit & loss A/c

(loss on sale of Fixed Asset)

By Balance c/d

….

….

…..

…..

When shares are issued at a premium, the cash flow statement reflects the total

cash generated by the issue (i.e., Face Value of shares + Premium).

The cash flow from financing activities is ascertained by analyzing the change in

Equity and Preference share capital, Debentures and other borrowings.

Special Items Treatment thereof in Cash Flow Statement

I. Interest and Dividends: The treatment of interest and dividends received

as well as paid depends on the nature of the business of the enterprise,

i.e., whether the business is of financial or non-financial nature.

II. Proposed dividend:

1. The proposed dividend is proposed by the Board of Directors and

approved by the shareholders in the Annual General Meeting before it

becomes due for payment. Till the time it is approved at the Annual

General Meeting, it is not a liability.

2. The proposed dividend for the current year becomes due and is also

paid in next year. It is an outflow of cash and cash equivalents in the

next year.

3. The proposed dividend of the previous year becomes due and is also paid

in the current year. It is an outflow of cash and cash equivalents in the

current year.

Enterprises

Financial Enterprises Other Enterprises

Cash Flows Arising From Cash Flows Arising From

Interest

Paid and

Received

Dividends

Received

Dividends

Paid

Interest

Paid

Interest

Paid and

Dividends

Received

Dividends

Paid

Operating

Activities

Financing

Activities

Financing

Activities

Investing

Activities

Financing

Activities

4. The accounting treatment of the proposed dividend is:

a) Proposed Dividend (current year): Add back to the current year’s

profits to find out cash from operating activities.

b) Proposed Dividend (Previous year): Net dividend paid (proposed

dividend – dividend still payable) is cash used in financing activities.

III. Interim Dividend:

1. The Interim Dividend is a dividend that is declared by the Board of

Directors in between the financial year provided it is allowed by the

company’s Articles of Association.

2. Declaration of the Interim Dividend does not require the approval at

the General Meeting.

3. Therefore, it becomes due and is paid during the year itself.

4. The accounting treatment of the Interim Dividend shall be as:

a) Add Back to the current year’s profits to find out cash from

operating activities.

b) Show as cash used in Financing Activities in the cash flow

statement.

IV. Extraordinary items:

Extraordinary items are incomes or expenses that arise from transactions

that are distinct from ordinary activities of the business which are material

and are not expected to recur frequently or regularly. Extraordinary items

are classified under appropriate activity, i.e., operating, investing and

financing activities and disclosed separately in the cash flow statement.

Examples of extraordinary items are any claim against loss of stocks from

an insurance company (for operating activities), a claim for the destruction

of building from an insurance company (for investing activities), buy-back

of shares (for financing activities).

V. Discount on Issue of Shares and Debentures:

Discount on the issue of shares and debentures may be written off

through the profit & loss account. It is also possible that discount allowed

is increased due to the new issue during the year. Discount on issue of

shares/debentures account shall appear as:

DISCOUNT ON ISSUE OF SHARES/DEBENTURES ACCOUNT

Particulars Dr. Rs. Particulars Cr. Rs.

To Balance b/d

To Share capital/debentures

…..

…….

By Profit & loss A/c

(Written off)

By Balance c/d

…….

…….

Accounting Treatment

a) Amount of Discount Written Off: Add Back to the current year’s

profits for ascertaining cash from operating activities.

b) Amount of Discount Allowed During the year: Show the net proceeds

of shares/debentures as cash from Financing Activities.

INDIRECT METHOD

FORMAT OF CASH FLOW STATEMENT

For the year ended….

As per Accounting Standard-3 (Revised)

Particulars Rs.

I. Cash Flow from Operating Activities

Net profit as per profit & loss A/c or Difference between Closing balance and

Opening Balance of profit & loss A/c

Add: Transfer to reserve

Proposed dividend for current year

Interim dividend paid during the year

Provision for tax made during the current year

Extraordinary item, if any, debited to the profit & loss A/c

Less: Extraordinary item, if any, credited to the profit & loss A/c

Refund of tax credited to profit & loss A/c

(A) Net profit before Taxation and Extraordinary items

Adjustment for Non-cash and Non-operating items

(B) Add: Items to be added

Depreciation

Preliminary expenses/Discount on issue of Shares & Debentures

Written off

Goodwill/patents/Trade marks Amortized

Interest on borrowings & debentures

Loss on sale of Fixed Assets

(C) Less: Items to be deducted

Interest Income ……

Dividend Income ……

Rental Income …….. ........

Profit on sale of Fixed Assets

(D) Operating Profit before Working Capital changes (A+B-C)

(E) Add: Decrease in Current Assets and

Increase in Current Liabilities

Decrease in Stock/Inventories

Decrease in Debtors/Bills Receivables

Decrease in Accrued Incomes

Decrease in prepaid expenses

Increase in creditors/Bills payables

Increase in outstanding expenses

Increase in Advance incomes

Increase in Provision for Doubtful Debts

(F) Less: Increase in Current Assets and

Decrease in Current Liabilities

Increase in Stocks/Inventories

Increase in Debtors/Bills Receivables

Increase in Accrued Incomes

Increase in Prepaid expenses

Decrease in creditors/Bills payables

Decrease in outstanding expenses

Decrease in Advance Incomes

Decrease in Provision for Doubtful Debts

(G) Cash Generated from Operations (D+E-F)

(H) Less: Income Tax paid (Net of Tax Refund received)

(I) Cash Flow before Extraordinary items

Extraordinary items (+/-)

(J) Net cash from Operating Activities

II. Cash Flow from Investing Activities

Add: Proceeds from Sale of Fixed Assets

Add: Proceeds from Sale of Investments

Add: Proceeds from Sale of Intangible Assets

Add: Interest and Dividend Received

(For non-financial companies only)

Add: Rent Income

Less: Purchase of Fixed Asset

Less: Purchase of Investment

Less: Purchase of Intangible Assets like Goodwill

Extraordinary items (+/-)

Net Cash from Investing Activities

III. Cash Flow from Financing Activities

Add: Proceeds from issue of shares and Debentures

Add: Proceeds from Other Long term Borrowings

Less: Final Dividend Paid

Less: Interim Dividend Paid

Less: Interest on Debentures and Loans paid

Less: Repayment of Loans

Less: Redemption of Debentures/Preference shares

Extraordinary items (+/-)

Net Cash from Financing Activities

IV. Net Increase/Decrease in Cash and Cash Equivalents (I+II+III)

V. Add: Cash and Cash Equivalents in the beginning of the year.

Cash in Hand

Cash at Bank (Less: Bank Overdraft)

Short-term Deposits

Marketable Securities.

VI. Cash and Cash Equivalents at the end of the year

Cash in Hand

Cash at Bank ( Less: Bank Overdraft)

Short-term Deposits

Marketable Securities

Notes:

1. Amounts in brackets indicate negative amounts, i.e., amounts that are to be

deducted.

2. Increase/Decrease in unpaid Interest on Debentures/Loans affects the Cash

Flow from Financing Activities and not Operating Activities.

3. Increase/Decrease in Unclaimed Dividend affects the Cash Flow from

Financing Activities and not Operating Activities.

4. Increase/Decrease in Accrued Interest on Investment affects the Cash Flow

from Investing Activities and not Operating Activities.