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. II. Cash comprises of cash in hand and demand deposits with banks. 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. 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. Operating Activities: operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities.

III.

IV.

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. Financing Activities: Financing activities are the activities that result in change in the size and composition of the owners capital (including preference share capital in the case of a company) and borrowing of the enterprise.

VI.

OPERATING ACTIVITIES

CASH INFLOW Cash Sales Cash received from Debtors Cash received from commission and Fees Royalty. In the case of financial companies Cash received for Interest and Dividends Sale of Securities

CASH OUTFLOW Cash purchase Payment to creditors Cash operating expenses Payment of Wages Income Tax In the case of financial companies Cash paid for interest Purchase of Securities

INVESTING ACTIVITIES

Cash Inflow Sale of Fixed Assets Sale of Investments Interest received Dividends received

Cash Outflow Purchase of Fixed Assets Purchase of Investments

FINANCING ACTIVITIES

Cash Inflow
1. Issue of shares in Cash 2. Issue of Debentures in Cash 3. Proceeds from Long-term Borrowings

Cash Outflow
Payment of Loans Redemption of preference shares Buy-back of Equity shares Payment of Dividend 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. Particulars To Bank A/c (Tax Paid) To Balance c/d PROVISION FOR TAX ACCOUNT Rs. Particulars Cr. Rs. . ..

.. 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 years Balance sheet is treated as tax paid during the current year. It involves an Outflow of cash. The current years provision for tax represents the amount of tax provided for the current year. It is added back to the current years 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. 2. 3. 4. An increase in current assets leads to decrease in cash. A decrease in current assets leads to an increase in cash. An increase in current liabilities leads to an increase in cash. 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 years 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.

Particulars
To Balance b/d To Bank A/c (purchases) To Profit & loss A/c (Profit on sale of Fixed Asset)

Rs.

Particulars
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

Rs.

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.

Dr. Particulars

FIXED ASSET ACCOUNT (AT COST) Rs. . . .. Particulars By Bank A/c (Sale of Fixed Asset) By Accumulated Dep. A/c
(Accumulated Dep. On fixed asset sold)

Cr.

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 Profit & loss A/c

(loss on sale of Fixed Asset)

By Balance c/d

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. Particulars To Fixed Asset A/c (Acc. Dep. on Fixed Asset Sold) To Balance c/d ACCUMULATED DEPRECIATION ACCOUNT Rs. . Particulars By Balance b/d By Profit & loss A/c
(Dep. Charged for current year)

Cr. Rs. ..

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 owners 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.

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

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 Investing Activities

Dividends Paid

Operating Activities

Financing Activities

Financing Activities

Financing Activities

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.

I.

4. The accounting treatment of the proposed dividend is: a) Proposed Dividend (current year): Add back to the current years 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 companys 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 years 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 To Balance b/d

Dr.

Rs. .. .

Particulars By Profit & loss A/c (Written off) By Balance c/d

Cr.

Rs. . .

To Share capital/debentures

Accounting Treatment a) Amount of Discount Written Off: Add Back to the current years 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 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

Rs.

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.