Q.Describe the procedure to prepare Cash Flow Statement.

The procedure to prepare a Cash Flow Statement involves classifying cash inflows and outflows into three distinct activities: Operating, Investing, and Financing, and then reconciling the net cash flow with the opening and closing balances of cash and cash equivalents.

1. Determine Cash Flow from Operating Activities:

   • Begin with Net Profit before Tax and Extraordinary Items.
   • Adjust this profit for non-cash items (like depreciation, amortization) and non-operating items (such as interest paid, dividend income, profit or loss on sale of assets) to arrive at Operating Profit before Working Capital Changes.
   • Further adjust for changes in current assets and current liabilities (excluding cash and cash equivalents, and bank overdraft) to calculate Cash Generated from Operations.
   • Finally, deduct income tax paid and extraordinary items (if any) to determine the Net Cash Flow from Operating Activities.

2. Determine Cash Flow from Investing Activities:

   • Identify cash inflows from the sale of fixed assets (tangible and intangible) and non-current investments.
   • Identify cash outflows for the purchase of fixed assets and non-current investments.
   • Include interest and dividends received on investments. The net sum represents the Net Cash Flow from Investing Activities.

3. Determine Cash Flow from Financing Activities:

   • Identify cash inflows from the issue of shares and debentures, and proceeds from long-term borrowings.
   • Identify cash outflows for the redemption of preference shares and debentures, repayment of long-term loans, payment of dividends, and interest paid on debentures/loans. The net sum represents the Net Cash Flow from Financing Activities.

4. Reconcile Cash and Cash Equivalents:

   • Aggregate the net cash flows from operating, investing, and financing activities to find the Net Increase or Decrease in Cash and Cash Equivalents.
   • Add the opening balance of cash and cash equivalents to this net change to arrive at the closing balance of cash and cash equivalents.

The Cash Flow Statement (CFS) is a crucial financial statement that provides information about the cash inflows and outflows of an enterprise during a specific accounting period. Unlike the Income Statement (which uses accrual accounting) or the Balance Sheet (a snapshot at a point in time), the CFS focuses purely on cash movements, offering insights into a company's liquidity and solvency. It helps users understand how cash is generated and used, and whether the company can meet its short-term obligations.

In India, the preparation of Cash Flow Statements is governed by Accounting Standard 3 (AS-3 Revised) issued by the Institute of Chartered Accountants of India (ICAI), which is largely converged with International Accounting Standard 7 (IAS 7). For companies following Indian Accounting Standards (Ind AS), Ind AS 7 applies.

The core concept behind the Cash Flow Statement is to classify all cash transactions into three main categories:

1. Operating Activities: These are the principal revenue-generating activities of the enterprise and other activities that are not investing or financing activities. Essentially, they represent the cash generated from the day-to-day operations of the business.
   • Why: This section shows the cash-generating ability of the core business, independent of its investment or financing decisions.
2. Investing Activities: These are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
   • Why: This section reflects how the company is investing its cash to grow or maintain its operations, or how it's liquidating assets.
3. Financing Activities: These are activities that result in changes in the size and composition of the owner's capital (including preference share capital in the case of a company) and borrowings of the enterprise.
   • Why: This section shows how the company is raising capital (e.g., issuing shares, taking loans) and repaying it, and how it's distributing returns to its owners (e.g., dividends).

Procedure to Prepare a Cash Flow Statement (Indirect Method)

The indirect method is commonly used in examinations and by many companies because it starts with net profit and adjusts it for non-cash items and changes in working capital to arrive at cash flow from operations.

Here is the step-by-step procedure:

Step 1: Ascertain Net Profit Before Tax and Extraordinary Items

The starting point for the indirect method is the Net Profit (or Loss) as per the Statement of Profit and Loss. However, this profit needs to be adjusted to arrive at a figure that represents the profit before considering tax and any extraordinary items, and before appropriations like proposed dividends or transfers to reserves.

To calculate this:

• Start with Net Profit as per Statement of Profit and Loss (Closing Balance - Opening Balance of Surplus, i.e., Balance in Statement of Profit and Loss).
• Add back:
  • Interim Dividend Paid (during the year)
  • Proposed Dividend (for the current year, if treated as an appropriation)
  • Provision for Tax (for the current year)
  • Transfer to Reserves
  • Extraordinary Items (if debited to Statement of Profit and Loss)
• Deduct:
  • Refund of Tax (if credited to Statement of Profit and Loss)
  • Extraordinary Items (if credited to Statement of Profit and Loss)

Step 2: Calculate Cash Flow from Operating Activities

This is the most complex part and involves several adjustments to the Net Profit Before Tax and Extraordinary Items.

1. Adjustments for Non-Cash and Non-Operating Items:

   • The Net Profit Before Tax and Extraordinary Items includes items that do not involve cash (non-cash items) and items that relate to investing or financing activities (non-operating items). These need to be adjusted to convert accrual profit into cash profit.
   • Add back (if debited to P&L):
     • Depreciation (a non-cash expense)
     • Amortisation of Intangible Assets (e.g., Goodwill, Patents, Trademarks written off)
     • Loss on Sale of Fixed Assets/Investments (an investing activity loss, not operating cash outflow)
     • Interest Expense (a financing activity expense)
     • Premium on Redemption of Debentures/Preference Shares (a financing activity expense)
   • Deduct (if credited to P&L):
     • Gain/Profit on Sale of Fixed Assets/Investments (an investing activity gain, not operating cash inflow)
     • Interest Income (an investing activity income)
     • Dividend Income (an investing activity income)
     • Rental Income (an investing activity income)

   The result after these adjustments is "Operating Profit Before Working Capital Changes."

2. Adjustments for Working Capital Changes:

   • Changes in current assets and current liabilities (excluding cash and cash equivalents, bank overdraft, and provision for tax) affect cash flow from operations.
   • Add:
     • Decrease in Current Assets (e.g., decrease in Debtors, Stock, Prepaid Expenses). A decrease in current assets means cash has been collected or less cash is tied up.
     • Increase in Current Liabilities (e.g., increase in Creditors, Bills Payable, Outstanding Expenses). An increase in current liabilities means more credit has been taken, saving cash.
   • Deduct:
     • Increase in Current Assets (e.g., increase in Debtors, Stock, Prepaid Expenses). An increase means more cash is tied up.
     • Decrease in Current Liabilities (e.g., decrease in Creditors, Bills Payable, Outstanding Expenses). A decrease means cash has been used to pay off liabilities.

   The result after these adjustments is "Cash Generated from Operations."

   Tip

   Remember the simple rule for working capital adjustments:

   • Current Assets: Opposite relationship with cash flow. If current asset increases, cash flow decreases. If current asset decreases, cash flow increases.
   • Current Liabilities: Same relationship with cash flow. If current liability increases, cash flow increases. If current liability decreases, cash flow decreases.

3. Less: Income Tax Paid:

   • Deduct the actual income tax paid during the year. This is usually different from the provision for tax made for the current year. If no separate information is given, the provision for tax for the current year is assumed to be the tax paid.

   The result is "Cash Flow Before Extraordinary Items."

4. Adjust for Extraordinary Items:

   • Add or deduct cash flows related to extraordinary items (e.g., insurance claim received for loss of assets, settlement of litigation). These are rare and unusual events.

   The final result is Net Cash Flow from Operating Activities.

Step 3: Calculate Cash Flow from Investing Activities

This section includes cash movements related to the acquisition and disposal of long-term assets and investments.

• Cash Inflows:

  • Sale of Fixed Assets (Tangible and Intangible)
  • Sale of Investments (other than cash equivalents)
  • Interest Received (on investments)
  • Dividends Received (on investments)
  • Rental Income Received (from investment properties)

• Cash Outflows:

  • Purchase of Fixed Assets (Tangible and Intangible)
  • Purchase of Investments (other than cash equivalents)

  Calculate the net of these inflows and outflows to arrive at Net Cash Flow from Investing Activities.

Step 4: Calculate Cash Flow from Financing Activities

This section deals with cash movements related to changes in the capital structure and borrowings of the company.

• Cash Inflows:

  • Issue of Shares (Equity and Preference)
  • Issue of Debentures/Bonds
  • Raising of Long-term Loans

• Cash Outflows:

  • Redemption of Preference Shares
  • Redemption of Debentures/Bonds
  • Repayment of Long-term Loans
  • Buyback of Equity Shares
  • Payment of Dividends (Interim and Final/Proposed of previous year)
  • Payment of Interest (on debentures, loans)

  Calculate the net of these inflows and outflows to arrive at Net Cash Flow from Financing Activities.

Step 5: Calculate Net Increase or Decrease in Cash and Cash Equivalents

Sum up the net cash flows from the three activities:

Net Cash Flow from Operating Activities

(+) Net Cash Flow from Investing Activities

(+) Net Cash Flow from Financing Activities

= Net Increase / (Decrease) in Cash and Cash Equivalents

Step 6: Add Opening Cash and Cash Equivalents

Add the balance of cash and cash equivalents at the beginning of the accounting period to the net increase/decrease calculated in Step 5.

• Cash and Cash Equivalents typically include:
  • Cash in Hand
  • Cash at Bank (Current Accounts, Demand Deposits)
  • Marketable Securities / Short-term Investments (highly liquid investments with original maturity of three months or less)

Step 7: Verify with Closing Cash and Cash Equivalents

The sum from Step 6 should exactly match the balance of cash and cash equivalents at the end of the accounting period as shown in the Balance Sheet. This acts as a crucial check for the accuracy of the statement.