1. Financial Accounting II Lecture 40

2. Another area that is to be considered carefully while preparing cash flows is the finance lease. At the time of inception of lease Asset and Liability is recorded in Balance Sheet. However in case of cash flows only payment of Lease Rentals is shown as outflow. Principal portion of lease rentals is shown under investing activities as payments towards addition in fixed assets whereas the markup portion is either shown in financing activities or separately as shown in this example,

3. Cash is not synonymous with profit on an annual basis, but you should also remember that the “behavior” of profit and cash flows will be very different. Profit is smoothed out through accruals prepayments, provisions and other accounting conventions. This does not apply to cash, so the cash flow figures are likely to be lumpy in comparison. You must distinguish between this lumpiness and the trends which will appear over time. Cash Flow Statement

4. The relationship between profit and cash flows will vary constantly. Note that healthy companies do not always have reported profits exceeding operating cash flows. Similarly, unhealthy companies can have operating cash flows well in excess of reported profit. The value of comparing them is in determining the extent to which earned profits are being converted into the necessary cash flows. Cash Flow Statement

5. Cash flow figures should also be considered in terms of their specific relationships with each other over time. A form of cash flow gearing can be determined by comparing operating cash flows and financing flows, particularly borrowing, to establish the extent of dependence of the reporting entity on external funding. Cash Flow Statement

6. A cash flow statement, when used in conjunction with the rest of the financial statement, provides information that enables user to evaluate the changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash Flow Statement

7. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effect of using different accounting treatments for the same transactions and events. Cash Flow Statement

8. Historical cash flow information is often used as an indicator of the amount, timing and certainty of future cash flows. It is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices. Cash Flow Statement

9. The standard offers a choice of method for this part of the cash flow statement. a)Direct Method: Disclose major classes of gross cash receipts and gross cash payments. b)Indirect method: Net profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expenses associated with investing or financing cash flows. Reporting cash flows from operating activities IAS 7

10. The direct method is the preferred method by IAS-7 because it discloses information, not available elsewhere in the financial statements, which could be of use in estimating future cash flows. Reporting cash flows from operating activities

11. There are different ways in which the information about gross cash receipts and payments can be obtained. The most obvious way is simply to extract the information from the accounting records. This may be a laborious task, however, the indirect method is easier than direct method. Using the Direct Method

12. This method is undoubtedly easier from the point of view of the preparer of the cash flow statement. The net profit or loss for the period is adjusted for the following. a)Changes during the period in inventories, operating receivables and payables. Using the Indirect Method

13. b)Non cash items, e.g. depreciation, provisions, profits/losses on the sales of assets. c)Other items, the cash flows from which should be classified under investing or financing activities Using the Indirect Method

14. The direct method is encouraged where the necessary information is not too costly to obtain, but IAS 7 does not require it, and favours the indirect method. In practice, therefore, the direct method is rarely used. It is not obvious that IAS 7 is right in favouring the indirect method. It could be argued that companies ought to monitor their cash flows carefully enough on an ongoing basis to be able to use the direct method at minimal extra cost. Indirect Method VS Direct Method

15. Cash flows from interest and dividends received and paid should each be disclosed separately. Each should be classified in a consistent manner from period to period as either operating, investing or financial activities. Treatment of Interest and Dividend

16. The total amount of interest paid during a period is disclosed in the cash flow statement whether it has been recognised as an expense in the income statement or Capitalised in accordance with the allowed alternative treatment in IAS 23 Borrowing Costs. Treatment of Interest and Dividend

17. Interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution. However, there is no consensus on the classification of these cash flows for other entities. Interest paid and interest and dividends received may be classified as operating cash flows because they enter in to the determination of profit or loss. Treatment of Interest and Dividend

18. Alternatively, interest paid and interest dividends received may be classified as financing cash flows and investing cash flows respectively, because they are costs of obtaining financial resources or returns on investments. Treatment of Interest and Dividend

19. Dividends paid may be classified as a financing cash flow because they are a cost of obtaining financial resources. Alternatively, dividends paid may be classified as a component of cash flows from operating activities in order to assist users to determine the ability of an entity to pay dividends out of operating cash flows. Treatment of Interest and Dividend

20. a)Survival in business depends on the ability to generate cash. Cash flow accounting directs attention towards this critical issue. b)Cash flow is more comprehensive than profit which is dependent on accounting conventions and concepts. The advantages of cash flow accounting:

21. c)Creditors (long and short term) are more interested in an entity’s ability to repay them than in its profitability. Whereas profits might indicate that cash is likely to be available, cash flow accounting is more direct with its message. d)Cash flow reporting provides a better means of comparing the results of different companies than traditional profit reporting. The advantages of cash flow accounting:

22. e)The accruals concept is confusing, and cash flows are more easily understood. f)Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts. g)For shareholders and auditors, cash flow accounting can provide a satisfactory basis for stewardship The advantages of cash flow accounting:

23. All entities should disclose, together with a commentary by management, any other information likely to be of importance, for example: a)Restrictions on the use of or access to any part of cash equivalents. b)The amount of un-drawn borrowing facilities which are available. Other disclosures

24. c)The separate disclosure of cash flows that represent increases in operating capacity and cash flows that are required to maintain operating capacity is useful in enabling the user to determine whether the entity is investing adequately in the maintenance of its operating capacity. An entity that does not invest adequately in the maintenance of its operating capacity may be prejudicing future profitability for the sake of current liquidity and distributions to owners. Other disclosures

25. d)The disclosure of segmental cash flows enables users to obtain a better understanding of the relationship between the cash flows of the business as a whole and those of its components parts and the availability and variability of segmental cash flows. Other disclosures