1. What is the purpose of a statement of cash flows?

2. How might a statement of cash flows be used?

3. What is the meaning of cash equivalent?
4. Explain the required classifications of cash flows under IAS 7.
5. What sources of information are usually required to prepare a statement of cash flows?
6. Explain the differences between the presentation of cash flows from operating activities
under the direct method and their presentation under the indirect method. Do you consider
one method to be more useful than the other? Why?
7. The statement of cash flows is said to be of assistance in evaluating the financial strength of
an entity, yet the statement can exclude significant non-cash transactions that can materially
affect the financial strength of an entity. How does IAS 7 seek to overcome this issue?
8. An entity may report profits over a number of successive years and still experience negative
net cash flows from its operating activities. How can this happen?
9. An entity may report losses over a number of successive years and still report positive net
cash flows from operating activities over the same period. How can this happen?
10. What supplementary disclosures are required when a consolidated statement of cash flows is
being prepared for a group that has obtained or lost control of a subsidiary?
What is the purpose of a statement of cash flows?
The purpose of a statement of cash flows is to present information about changes in the cash and
cash equivalents of an entity during the period classified by operating, investing and financing
activities.

How might a statement of cash flows be used?

A statement of cash flows may be used by investors, creditors and other users of financial
statements to assist in:

(a) evaluating an entity’s ability to generate cash and cash equivalents

(b) predicting future cash flows and
(c) evaluating the accuracy of past predictions of future cash flows.

Further, when used with other financial statements, the statement of cash flow may help users in:
(i) evaluating an entity’s financial structure and its ability to meet its obligations and to
pay dividends;
(ii) evaluating an entity’s capacity to affect the amount, timing and certainty of future
cash flows and to adapt to changing business opportunities and circumstances;
(iii) evaluating the quality of an entity’s earnings by understanding the reasons for the
difference between an entity’s profit and the cash and cash equivalents generated
from operating activities, which are more readily identified when an entity uses the
indirect method of presenting net cash flows from operating activities
(iv) comparing the operating performance of different entities; this comparison is assisted
by the fact that net operating cash flows reported in a statement of cash flows are
unaffected by different accounting choices and judgments under accrual accounting
(although they may be affected by decisions such as when to pay accounts).

What is the meaning of cash equivalent?

Cash equivalents 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. They are held
for the purpose of meeting short-term commitments and are not for investment or other purposes.

Explain the required classifications of cash flows under IAS 7.

Cash flows must be classified into cash flows from operating, investing and financing activities.

Operating activities are the principal revenue-producing activities of an entity and any other
activities that do not fall within investing and financing activities. Such cash flows include
receipts from customers, and payments to suppliers and employees. Operating cash flows may
also include interest and dividends received (though these items may be classified as investing)
and interest paid (though this item may be classified as financing). Similarly, income tax paid is
classified as operating unless it tax can be specifically identified with financing or investing
activities.
Investing activities are the acquisition and disposal of long-term assets (such as property, plant
and equipment, subsidiaries, businesses and intangibles) and other investments not included in
cash equivalents (such as shares in other entities).

Financing activities are activities that result in changes in the size and composition of the
contributed equity and borrowings of an entity (such as the issue of new shares, buyback of
shares, new borrowings, repayment of borrowings and the payment of dividends, though
payment of dividends is sometimes classified as an operating activity).

What sources of information are usually required to prepare a statement of cash flows?
The required sources of information include the statement of financial position, statement of
profit or loss and other comprehensive income, statement of changes in equity and other
accounting records that provide details such as the composition of account balances and non-
cash financing and investment transactions. A statement of cash flows is usually prepared by
firstly determining the net change in each class of assets, liabilities and equities over the relevant
period from the comparative statements of financial position, and then further analysing the net
amount of change in each to enable the relevant receipts and payments to be identified. For
example, the net change in net plant and equipment needs to be analysed between cash flows for
purchases of new plant and equipment, changes arising from the disposal of plant and equipment
and depreciation charged. Changes in the amount of outstanding accounts payable for the
purchase of plant and equipment also need to be taken into account, together with any
acquisitions or disposals for non-cash consideration (such as the issue of shares or through long-
term borrowings or by way of a finance lease).

Explain the differences between the presentation of cash flows from operating activities
under the direct method and their presentation under the indirect method. Do you
consider one method to be more useful than the other? Why?

Under the direct method of presentation classes of operating cash receipts and payments are
disclosed, such as receipts from customers and payments to suppliers and employees, to arrive at
cash generated from operations. Under the indirect method the starting point is the profit before
tax and this is first adjusted for the effects of transactions of a non-cash nature (such as
depreciation, impairment of non-current assets), and then for any deferrals or accruals of past or
future operating cash receipts or payments (e.g. increases or decreases in the amount of
receivables or payables outstanding, changes in provisions) and items of income or expense
included in the profit before tax that are associated with investing or financing activities (such as
gain or loss on sale of plant and equipment).

Both methods have their advantages and disadvantages. The direct method shows the gross
inflows and outflows that will assist a user in predicting future cash inflows and outflows and
allows a comparison to be made of cash receipts from customers with reported revenues. This
comparison will assist in evaluating the quality of revenues. However, while the indirect method
does not disclose the gross inflows and outflows arising from an entity’s operations, it does
report a complete reconciliation of the operating profit before tax with the cash generated from
operations. This is particularly useful in evaluating the quality of the earnings of an entity,
especially if earnings are being manipulated by management through varying accruals and
provisions, such as a provision for restructuring.

The statement of cash flows is said to be of assistance in evaluating the financial strength of
an entity, yet the statement can exclude significant non-cash transactions that can
materially affect the financial strength of an entity. How does IAS 7 seek to overcome this
issue?
IAS 7 seeks to overcome the problem referred to above by way of disclosure. Entities must
disclose investing and financing transactions that do not involve cash flows, such as the
acquisition of assets by means of a finance lease or by assuming other liabilities, or through an
equity issue, conversion of debt to equity, refinancing of a long-term debt, and the payment of
dividends through a share reinvestment scheme.

In the case of changes in the financial strength of an entity that may arise from the purchase or
sale of subsidiaries or other business units, IAS 7 requires the aggregate cash flows from the
acquisition of subsidiaries and other business units and the aggregate cash flows from the
disposal of subsidiaries and other business units to be reported in the investing section of the
statement of cash flows. This reporting is then required to be supplemented by separate
disclosure in the notes of the aggregate:
 purchase or disposal consideration
 the portion of the purchase or disposal consideration discharged by means of cash or cash
equivalents
 the amount of cash or cash equivalents in the subsidiary or business unit acquired or
disposed of
 the amount of the assets and liabilities other than cash or cash equivalents in the subsidiary
or business unit acquired or disposed of, summarised by each major category.

An entity may report profits over a number of successive years and still experience
negative net cash flows from its operating activities. How can this happen?
This situation is typical of an entity that is growing in size, such that increases in receivables,
inventories and prepayments exceed increases in accounts payable, accrued liabilities and
provisions. The collection of cash from customers usually lags the payment to suppliers for
purchases of goods and services. In a growth phase, this may generate negative operating cash
flows because the entity incurs cash outflows to increase its working capital, particularly
inventories, to accommodate expected increases in the volume of future sales.

An entity may report losses over a number of successive years and still report positive net
cash flows from operating activities over the same period. How can this happen?
This situation is typical of an entity that has large non-cash charges to the statement of profit or
loss and other comprehensive income, such as depreciation, impairment losses and increasing
provisions, including provisions for employee benefits. It may also arise when an entity
decreases in size by reducing the level of inventories where this is not accompanied by large cash
outflows for restructuring or retrenchments.
What supplementary disclosures are required when a consolidated statement of cash flows
is being prepared for a group that has obtained or lost control of a subsidiary?

IAS 7 requires the separate reporting of the aggregate cash flows paid for the acquisition of
subsidiaries, net of cash acquired, and the aggregate cash flows from the disposal of subsidiaries,
net of cash disposed of, in the investing section of the statement of cash flows. This reporting
must be supplemented by separate disclosure in the notes of the aggregate:

 purchase or disposal consideration

 the portion of the purchase or disposal consideration discharged by means of cash or cash
equivalents
 the amount of cash or cash equivalents in the subsidiary acquired or disposed of and
 the amount of the assets and liabilities other than cash or cash equivalents in the
subsidiary acquired or disposed of, summarised by each major category.