C H A P T E R 6:

STATEMENT OF CASH FLOWS Week 6#7

(MFRS 107) BKAR 1013

1
LEARNING OBJECTIVES

1. Describe the purpose of the statement of cash flows.

2. Identify the major classifications of cash flows.
3. Contrast the direct and indirect methods of calculating net cash flow from
operating activities.
4. Determine net cash flows from investing and financing activities.
5. Prepare a statement of cash flows.

2
PURPOSE OF STATEMENT OF CASH FLOWS

Primary purpose:
To provide information about a company’s cash receipts and cash payments
during a period.

Secondary objectives:
 To provide cash-basis information about the company’s operating, investing,
and financing activities.
 Profit is not a reliable indicator of an entity's cash as profits are computed on
the accruals basis, not on the cash basis. It is important for users to focus on
the entity's cash flows to predict future cash flows & to identify cash
problems

3
USEFULNESS OF THE STATEMENT OF CASH FLOWS

Provides information to help assess:

1. Entity’s ability to generate future cash flows.

2. Entity’s ability to pay dividends and obligations.

3. Reasons for difference between net income and net cash flow from
operating activities.

4. Cash and non-cash investing and financing transactions.

4
DEFINITION OF CASH AND CASH EQUIVALENTS

MFRS 107 defines:

Cash:
"cash on hand and demand deposits".
Cash equivalents:
"short-term, highly liquid investments that are readily
convertible to known amounts of cash and which are
subject to insignificant risk of changes in value".
Additionally, businesses may have bank overdrafts as a
result, total of cash & cash equivalents could be negative
-bank overdrafts are classified in current liabilities
5
CLASSIFICATION OF CASH FLOWS

Operating Activities Investing Activities Financing Activities

-‘the principal -‘the acquisition Changes in Long-

revenue-producing and disposal of Term Liabilities and
long-term assets Stockholders’
activities of the entity’
and investments’ Equity
-[Income Statement
Transactions]

6
OPERATING ACTIVITIES
Cash flows arising from operating activities (i.e. from
revenue-producing activities) include:
a) cash receipts from the sale of goods & services
b) cash receipts from royalties, fees, commissions and other revenue
c) cash payments to suppliers for goods & services
d) cash payments to and on behalf of employees
e) cash receipts cash receipts and cash payments of an insurance entity
for premiums and claims, annuities and other policy benefits;
f) cash payments or cash refunds of taxes (unless taxes are specifically
identified with investing or financing activities).
g) cash receipts and payments from contracts held for dealing or trading
purposes.
Overall, revenue – generating activities

7
INVESTING ACTIVITIES
Cash flows arising from investing activities (i.e. from
acquisition & disposal of Non-CA) include:
a) cash payments to acquire PPE, IA/other long-term assets
b) cash receipts from sale of PPE, IA/other long-term assets
c) cash payments to acquire equity or debt instruments
d) cash receipts from the sale of equity or debt instruments of
other entities
e) cash advances and loans made to other parties
f) cash receipts from the repayment of advances and loans
made to other parties.
Overall, long-term asset investments

8
FINANCING ACTIVITIES
Cash flows arising from financing activities (i.e. activities
related with equity & borrowings) include:
a) cash proceeds from issuing shares
b) cash payments to owners to acquire or redeem the entity's
own shares
c) cash proceeds from issuing debentures, loans and other
borrowings
d) cash repayments of amounts borrowed
e) cash payments by a lessee for the reduction of the
outstanding liability relating to a finance lease.
Overall, changes in own equity and borrowings

9
EXAMPLES OF CLASSIFICATION OF CASH FLOWS BY ACTIVITY

10
EXAMPLES OF CLASSIFICATION OF CASH FLOWS BY ACTIVITY
(CONT’D)

11
 INTERESTS, DIVIDENDS AND TAXES (NO CONSENSUS)

Interests, dividends & taxes are disclosed separately

Interest received and dividends received are treated as cash
inflows from investing activities. Alternative: operating activities
However, correct treatment of interest paid and dividends paid is
less clear:
-interest paid on a loan acquired for operating purposes is
classified under operating activities. Alternative: financing activity
-dividends paid might be classified under operating activities or
financing activities.
Tax cash flows are classified under operating activities
-unless associated with investing or financing

12
REPORTING CASH FLOW FROM OPERATING ACTIVITIES
 Cash flows from operating activities may be reported using
either:
-The DIRECT method
• whereby major classes of receipts and payments arising
from operating activities are disclosed individually
-The INDIRECT method
• which begins with the profit or loss for the period (before
tax) and then makes a number of adjustments so as to
calculate the total amount of cash generated from
operations.
 Both methods give the same bottom-line result for operating
activities
13
DIRECT
METHOD

14
THE DIRECT METHOD
 The direct method is a method of creating the cash flow
statement in which actual cash flow information from the
company's operations segment is used, instead of accrual
accounting values.
 Major classes of operating receipts & payments are disclosed
individually and are then aggregated to give the cash generated
from operations.
 Direct method based SCF discloses these classes:
i. cash receipts from customers
ii.cash paid to suppliers
iii.cash paid to employee
CF FROM OPERATING ACTIVITIES: DIRECT
METHOD

Cash flows from operating activities

+ Cash receipts from customers
- Cash paid to suppliers and employees
Cash generated from operations
- Interest paid
- Income taxes paid
Net cash from operating activities

(based on MFRS 107, para18a)

Direct Method: Example

Drogba SA, which began business on January 1, 2019, has the

following selected statement of financial position information.

ILLUSTRATION 23.19
Statement of Financial Position Accounts, Drogba SA

LO 3
Direct Method: Example
Drogba’s December 31, 2019, income statement and additional information are as
ILLUSTRATION 23.20
follows. Income Statement, Drogba SA

Additional Information
(a) Dividends of €70,000 were declared and paid in cash.
(b) The accounts payable increase resulted from the purchase of merchandise.
(c) Prepaid expenses and accrued expenses payable relate to operating expenses.

REQUIRED:
Prepare the operating activities section of the statement of cash flows using the direct LO 3
method.
 Operating Activities — Direct Method

Accounts receivable increased €15,000. Thus, cash receipts from

customers are computed as follows.
Illustration 23-22

Accounts Receivable
1/1/20 Balance 0 Receipts from customers 765,000
Sales revenue 780,000

12/31/20 Balance 15,000

LO 3
Operating Activities — Direct Method

Drogba SA reported cost of goods sold on its income statement of

€450,000. In 2019, Drogba’s inventory increased €160,000. The
company computes purchases as follows.

Cost of goods sold €450,000

Add: Increase in inventory 160,000
Purchases €610,000

Accounts Payable
1/1/20 Balance 0
Purchases 610,000

12/31/20 Balance 60,000

LO 3
 Operating Activities — Direct Method

Drogba determines cash payments to suppliers by adjusting

purchases for the change in accounts payable.

Accounts Payable
1/1/20 Balance 0
Payments to suppliers 550,000 Purchases 610,000

12/31/20 Balance 60,000

ILLUSTRATION 23.23
Formula to Compute Cash Payments to Suppliers
LO 3
 Operating Activities — Direct Method

Drogba reported operating expenses of €160,000 on its income

statement. To determine the cash paid for operating expenses, it
must adjust this amount for any changes in
 prepaid expenses and
 accrued expenses payable.

ILLUSTRATION 23.24
Formula to Compute Cash Payments for Operating Expenses

LO 3
Operating Activities — Direct Method
Prepaid Expenses
1/1/20 Balance 0

12/31/20 Balance 8,000

Accrued Expenses Payable

1/1/20 Balance 0

12/31/20 Balance 20,000

Operating expenses €160,000

Add: Increase in prepaid expenses 8,000
Deduct: Increase in accrued expenses payable 20,000
Cash payments for operating expenses €148,000
LO 3
 Operating Activities — Direct Method

The income statement for Drogba shows income tax expense of

€48,000. Cash paid for income taxes is computed by taking the
expense and adjusting by the change in the payable.

Income Tax Payable

1/1/20 Balance 0
Payments for income tax 48,000 Income tax expense 48,000

12/31/20 Balance 0

LO 3
SOLUTION: DROGBA SA
Drogba SA
Partial Statement of Cash Flows
For the year ended 31 December 2019
Cash flows from operating activities €
Cash received from customer 765,000
Cash paid to suppliers (550,000)
Cash paid for operating expenses (148,000)
Cash generated from operations 67,000
Income tax paid (48,000)
Net cash from operating activities 19,000

 When companies use the direct method they are required to provide in a separate
schedule the reconciliation of net income to net cash provided by operating activities.

25
INDIRECT
METHOD

26
 The Indirect Method Adjustments
This method begins with the profit or loss before tax and then makes the
following adjustments:
i. any non-cash expenses are added back
e.g. depreciation, impairment, losses on disposal of plant
ii. any non-cash income is subtracted
e.g. a decrease in the allowance for doubtful debts
iii. increase/decreases in working capital (e.g. current assets and current
liabilities) are adjusted:
-inventories, trade receivables and prepaid expenses,
-trade payables and accrued expenses.
iv. any items of income or expense which are not derived from operating
activities are adjusted for.
-e.g. interests or dividends
27
 The Impact of the Adjustments
 These adjustments on profit (or loss) before tax remove non-
cash expenses and income
-The main objective is to calculate the total cash generated
from operations
 These adjustments also take account of increases or
decreases in working capital items
-These working capital adjustments are made based on
comparing their opening and closing balances reported in the
SFP

28
(i)Non-cash expenses
 Depreciation have no effect on cash flow, but were
deducted from profit as expense.
-So, depreciation should be added back to profit.
 Loss of sale of non-current assets (e.g. PPE) have
no effect on cash flow, but were deducted from
profit as expense.
-So, this expense (loss of sale of non-current
assets) should be added back to profit.

29
(ii) Non-cash income
 One example of non-cash income is a decrease in
the allowance for doubtful trade receivables
 Gain on sale of PPE is also considered as non-cash
income as it increases profit as other income
-full proceeds from disposal of PPE should be
included in the Investing activities sect.
-subtract from profit as non-cash item in the operating
section (e.g. gain on disposal)

30
(ii) Working capital adjustments
 Increase in Inventories, Trade Receivables and
Prepayments means less cash flows
 Similarly, decrease in Trade Payables or Accrued
expenses means less cash flows
-all of these reduce cash flows, so deduct the changes
from profit before tax
 Decrease in Inventories, Trade Receivables and
Prepayment means more cash flows
 Similarly, increase in Trade Payables or Accrued
expenses means more cash flows
-all of these increase cash flows, so add the changes to
profit before tax

31
Summary of Working capital adjustments
Summary of the adjustments for the working capital – current assets
and liabilities:

Increases Decreases
Inventories Subtract Add
Trade receivables & prepaid expenses Subtract Add
Trade payables & accrued expenses Add Subtract

32
 SUMMARY OF THE SCF STRUCTURE (INDIRECT METHOD)
Cash flows from operating activities
Profit before taxation
Adjustments for:
+ Depreciation
-/+ Gain or loss on sale of non-current assets
+ Interest expense
Adjustments for changes in working capital:
-/+ Increase/decrease in trade and other
receivables
-/+ Increase/decrease in inventories
+/- Increase/decrease in trade payable
Cash generated from operations
- Interest paid
- Income taxes paid
Net cash inflows /(outflows) from operating
activities (A)
Cash flows from investing activities
- Purchase of property, plant and equipment
+ Proceeds from sale of equipment
+ Interest received
+ Dividends received
Net cash inflows /(outflows) from investing activities
(B)
Cash flows from financing activities
+ Proceeds from issue of share capital
+ Proceeds from long-term borrowings
- Dividends paid
Net cash inflows /(outflows) from financing activities
(C)
Net increase/decrease in cash and cash equivalents
(A+B+C)
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
33
Illustrations—Tax Consultant Inc
Tax Consultant Inc started its operation on 1 January 2019. The statement of comprehensive
income and comparative statements of financial position at the beginning and end of the year 2020
are as follow:
Tax Consultant Inc
Statement of Comprehensive Income
For the year ended 31 December 2020
$
Revenues 492,000
Operating expenses (excluding
depreciation) (269,000)
Depreciation expenses (21,000)
Profit before tax 202,000
Tax expenses (68,000)
Profit after tax/ Net Income 134,000

Additional Information:

(a) The company declared and paid an RM18,000 cash dividend.

(b) The company obtained RM150,000 cash through the issuance

of long-term bonds.

(c) Land, building, and equipment were acquired for cash.

34
 Illustrations—Tax Consultant Inc
Tax Consultant Inc
Comparative Statements of Financial Position
as at 31 December
2020 2019
$ $
ASSETS
Land 70,000 0
Buildings 200,000 0
Accumulated depreciation-buildings (11,000) 0
Equipment 68,000 0
Accumulated depreciation-equipment (10,000) 0
Accounts receivable 26,000 36,000
Prepaid expenses 6,000 0
Cash 37,000 49,000
386,000 85,000

EQUITY AND LIABILITIES

Share capital-Ordinary (RM1 par) 60,000 60,000
Retained earnings 136,000 20,000
Bond payable 150,000 0
Accounts payable 40,000 5,000
386,000 85,000
REQUIRED:
Prepare the Statement of Cash Flows (SOCF) for the year ended 31 December 2020 using the
indirect method. 35
Step 1: Classification of the SFP Items

a)Calculate the differences between the opening

and the closing balances of the items reported
in the SFP
b) Decide which items are to be reported under:
-operating activities?
-investing activities?
-financing activities? or
-cash and cash equivalents?

LO 2
Step 1: Cont’d

LO 2
Step 1: Cont’d

Accounts receivable decreased during the period because cash receipts

(cash-basis revenues) are higher than revenues reported on an accrual
basis.
LO 2
Step 1: Cont’d
To convert profit before tax to net cash flow from operating
activities, the decrease of $10,000 in accounts receivable must
be added to profit before tax.

Cash flows from operating activities $ $

Profit before taxation 202,000
Adjustments:

Adjustment for changes in working capital:

Decrease in accounts receivable 10,000

LO 2
Step 1: Cont’d

When prepaid expenses (assets) increase during a period, expenses

on an accrual-basis income statement are lower than they are on a
cash-basis income statement. LO 2
Step 1: Cont’d

To convert PBT to net cash flow from operating activities, the

increase of $6,000 must be deduct from net income.

Cash flows from operating activities $ $

Profit before taxation 202,000
Adjustments:

Adjustment for changes in working capital:

Decrease in accounts receivable 10,000
Increase in prepaid expenses (6,000)

LO 2
Step 1: Cont’d

When accounts payable increase, the company incurred a greater

amount of expense than the amount of cash it disbursed.

LO 2
Step 1: Cont’d

Tax Consultants must add the 2020 increase of $35,000 in

accounts payable to PBT, to convert to net cash flow from
operating activities.

Cash flows from operating activities $ $

Profit before taxation 202,000
Adjustments:

Adjustment for changes in working capital:

Decrease in accounts receivable 10,000
Increase in prepaid expenses (6,000)
Increase in accounts payable 35,000

LO 2
Step 1: Cont’d

Depreciation expense of $21,000 (also represented by the increase

in accumulated depreciation) is a non-cash charge.

LO 2
Step 1: Cont’d
Tax Consultants adds depreciation expense back to PBT

Cash flows from operating activities $ $

Profit before taxation 202,000
Adjustments:
Depreciation 21,000
Adjustment for changes in working capital:
Decrease in accounts receivable 10,000
Increase in prepaid expenses (6,000)
Increase in accounts payable 35,000 60,000
Cash generated from operations 262,000

LO 2
Step 2: Identification of the SCI Items

This step is about the SCI items after PBIT:

Interest expenses
Profit before tax
Income tax expense
Dividends paid, which needs the following clarification:
• dividends paid could be classified under operating
activities,
• alternatively, dividends paid could be classified under
financing activities.

LO 2
Step 2: Cont’d

Payment of tax expense of $68,000 to be deducted.

LO 2
Step 2: Cont’d
Tax Consultants minuses $68,000 tax expenses to PBT, to arrive
at net cash flow from operating activities.
Cash flows from operating activities $ $
Profit before taxation 202,000
Adjustments:
Depreciation 21,000

Decrease in accounts receivable 10,000

Increase in prepaid expenses (6,000)
Increase in accounts payable 35,000 60,000
Cash generated from operations 262,000
Income taxes paid (68,000)
Net cash generated from operating activities 194,000LO 2
Step 3: Determine Net Cash Flow from
Investing and Financing Activities
ILLUSTRATION 23.9

The company purchased land, building and equipment of $70,000,

$200,000 and $68,000 respectively.
LO 2
Step 3: Cash Flows from Investing Activities

Cash flows from investing activities $ $

Purchase of land (70,000)
Purchase of building (200,000)
Purchase of equipment (68,000)
Net cash outflow from investing activities (338,000)

LO 2
Step 3: Cash Flows from Financing Activities

Tax Consultants acquired received $150,000 from the issuance of

bonds.

LO 2
Step 3: Cash Flows from Financing Activities

Cash Flow from financing activities

Issuance of bonds 150,000

LO 2
Step 3: Cash Flows from Financing Activities

Two factors explain the increase in retained earnings: (1) net income
of $134,000 increased retained earnings, and (2) dividends of
$18,000 decreased retained earnings.

LO 2
Step 3: Cash Flows from Financing Activities

Cash Flow from financing activities

Issuance of bonds 150,000

Payment of cash dividends (18,000)
Net cash inflow from financing activities 132,000

LO 2
LO 2
RECONCILIATION OF CASH AND CASH EQUIVALENTS

 The amounts of cash and cash equivalents

reported in the SCF should be reconciled to the
equivalent items reported in the SFP.
 As shown in the above example, the following
lines make this reconciliation:
Net increase/decrease in cash and cash
equivalents
Cash and cash equivalents at beginning of
period
Cash and cash equivalents at end of period
56
Special Problems in Statement Preparation
Accounts Receivable (Net)

Indirect Method
Because an increase in Allowance for Doubtful Accounts results from
a charge to bad debt expense, a company should add back an
increase in Allowance for Doubtful Accounts to net income to arrive at
net cash flow from operating activities.

ILLUSTRATION 23.28
Accounts Receivable Balances, Redmark AG LO 4
Accounts Receivable (Net)

Indirect Method
One method of presenting this information ILLUSTRATION 23.29
Presentation of Allowance
in the statement of cash flows: for Doubtful Accounts—
Indirect Method

REDMARK CO.
Statement of Cash Flows (Partial)
For The Year 2014

LO 4
Accounts Receivable (Net)

Indirect Method
ILLUSTRATION 23.30
Alternate method (net approach) of presenting Net Approach to
Allowance for Doubtful
this information in the statement of cash flows: Accounts—Indirect
Method

REDMARK CO.
Statement of Cash Flows (Partial)
For The Year 2014

LO 4
Accounts Receivable (Net)

Direct Method
Company should not net Allowance for Doubtful
ILLUSTRATION 23.31
Accounts against Accounts Receivable. Income Statement,
Redmark AG

LO 4
Accounts Receivable (Net)
ILLUSTRATION 23.31 REDMARK CO.
Direct Method Income Statement
For The Year 2014

Company should not net Allowance

for Doubtful Accounts against
Accounts Receivable.
ILLUSTRATION 23.32
Bad Debts—Direct
Method

Cash sales should be reported at €85,000 (€100,000 - 9,000 - 6,000).

Increase in Accounts Receivable LO 4
Net
Net Cash
Cash Flow
Flow from
from Operating
OperatingActivities—
Activities—
Indirect
Indirect Versus
Versus Direct
Direct Method
Method
Direct Versus Indirect Controversy
In Favor of the Direct Method
 Shows all operating cash receipts and payments.
Investors, creditors, and management can actually see
where the company is collecting funds from and whom it
is paying funds to. The indirect method doesn’t list these
types of details.

LO 7 Identify sources of information for a statement of cash flows.

Net
Net Cash
Cash Flow
Flow from
from Operating
OperatingActivities—
Activities—
Indirect
Indirect Versus
Versus Direct
Direct Method
Method
Direct Versus Indirect Controversy
In Favor of the Indirect Method
 Focuses on the differences between profit before tax and
net cash flow from operating activities.
 Provides link between the statement of cash flows and the
income statement and statement of financial position.

LO 7 Identify sources of information for a statement of cash flows.

Disclosures
Disclosures

Significant Non-Cash Transactions

Common non-cash transactions that a company should
disclose in its notes:
1. Acquisition of assets by assuming liabilities (including finance
lease obligations) or by issuing equity securities.

2. Exchanges of non-monetary assets.

3. Refinancing of long-term debt.

4. Conversion of debt or preference shares to ordinary shares.

5. Issuance of equity securities to retire debt.

LO 8 Discuss special problems in preparing a statement of cash flows.

REFERENCES
Keiso, D.E., Weygandt, J. J., and Warfield, T. D. (2017), Intermediate Accounting, IFRS
edition, 3rd ed., John Wiley & Sons Inc., USA.
 
Malaysian Accounting Standards Board. (2018), MASB, accessed 15 August 2018,
www.masb.org.my

Melville, A. (2017), International Financial Reporting: A Practical Guide. 6thed, Harlow,

England: Pearson.

65