Financial Statements (Copy)
Chapter 24: Statement of Cash Flows
Introduction to Statement of Cash Flows
- A Statement of Cash Flows reports a company’s cash inflows and outflows over a specific period.
- It highlights how a company generates cash and how it spends it, distinguishing cash movements from profitability.
- Importance:
- Ensures businesses maintain liquidity.
- Helps identify cash shortages even in profitable firms.
- Assists investors and creditors in evaluating a company’s financial health.
- Required under IAS 7 for financial reporting.
24.1 IAS 7: Statement of Cash Flows
- IAS 7 (International Accounting Standard) mandates how companies should present cash flow statements.
- Main provisions:
- Cash flows must be categorized into operating, investing, and financing activities.
- Transactions must be reported using either direct or indirect method.
- The statement should reconcile the profit from operations with net cash from operating activities.
24.2 Components of a Cash Flow Statement
- Divided into three main sections:
- Operating Activities – Day-to-day business cash flows.
- Investing Activities – Cash used for buying/selling assets.
- Financing Activities – Cash from loans, shares, and dividends.
1. Operating Activities
- Definition: Cash generated from a company’s core operations.
- Key items include:
- Revenue collected from customers.
- Payments to suppliers and employees.
- Tax payments and interest paid.
- Formula (Indirect Method):
Net Cash from Operating Activities = Profit from Operations + Non-Cash Expenses (Depreciation) + Decrease in Working Capital - Increase in Working Capital - Example Calculation:
- Profit from Operations: $50,000
- Depreciation: $5,000
- Increase in Inventory: $2,000
- Decrease in Receivables: $3,000
Net Cash = 50,000 + 5,000 - 2,000 + 3,000 = $56,000
2. Investing Activities
- Definition: Cash spent or received from investment transactions.
- Examples:
- Purchase of non-current assets (machinery, buildings).
- Sale of assets.
- Cash inflows from interest and dividends received.
- Formula:
Net Cash from Investing Activities = Sales of Assets - Purchase of Assets - Example Calculation:
- Sale of Equipment: $20,000
- Purchase of New Equipment: $30,000
Net Cash = 20,000 - 30,000 = -$10,000 (cash outflow)
3. Financing Activities
- Definition: Cash transactions involving external financing.
- Examples:
- Loans borrowed and repaid.
- Issuance of shares.
- Dividend payments.
- Formula:
Net Cash from Financing Activities = Share Issue + Borrowings - Loan Repayments - Dividend Payments - Example Calculation:
- Shares Issued: $15,000
- Loan Taken: $10,000
- Loan Repayment: $5,000
- Dividend Paid: $2,000
Net Cash = 15,000 + 10,000 - 5,000 - 2,000 = $18,000
24.3 Preparing a Cash Flow Statement
- The statement summarizes cash movement during the year.
- Format:
Cash Flows from Operating Activities: - Profit before Tax - Adjustments for: - Depreciation - Gain/Loss on Asset Disposal - Changes in Working Capital ---------------------- Net Cash from Operating Activities Cash Flows from Investing Activities: - Purchase of Property, Plant & Equipment - Sale of Assets - Interest/Dividend Received ---------------------- Net Cash from Investing Activities Cash Flows from Financing Activities: - Proceeds from Share Issue - Loans Borrowed/ Repaid - Dividends Paid ---------------------- Net Cash from Financing Activities Net Change in Cash and Cash Equivalents
24.4 Worked Example
- Given:
- Operating Profit: $70,000
- Depreciation: $10,000
- Increase in Inventory: $3,000
- Decrease in Receivables: $2,000
- Asset Purchased: $40,000
- Asset Sold: $15,000
- Shares Issued: $20,000
- Loan Taken: $10,000
- Loan Repayment: $5,000
- Dividend Paid: $3,000
Step 1: Operating Cash Flow Calculation
Net Cash from Operations = 70,000 + 10,000 - 3,000 + 2,000 = $79,000
Step 2: Investing Cash Flow Calculation
Net Cash from Investing = 15,000 - 40,000 = -$25,000
Step 3: Financing Cash Flow Calculation
Net Cash from Financing = 20,000 + 10,000 - 5,000 - 3,000 = $22,000
Final Cash Flow Summary:
Net Cash Flow = 79,000 - 25,000 + 22,000 = $76,000
24.5 Common Adjustments in Cash Flow Statements
- Depreciation: Added back as it’s a non-cash expense.
- Gains/Losses on Asset Disposal: Deduct gains and add losses.
- Changes in Working Capital:
- Increase in Inventory = Cash Outflow
- Decrease in Payables = Cash Outflow
- Increase in Receivables = Cash Outflow
24.6 Importance of the Cash Flow Statement
- Liquidity Analysis: Helps businesses maintain cash reserves.
- Investor Confidence: Shareholders assess company sustainability.
- Creditworthiness: Banks and lenders evaluate a firm’s ability to repay loans.
- Fraud Detection: Unexplained discrepancies in profit and cash flow indicate financial mismanagement.
Conclusion
- The cash flow statement is essential for financial health analysis.
- IAS 7 mandates structured reporting of operating, investing, and financing activities.
- Accurate cash flow management prevents liquidity crises, even in profitable businesses.
Introduction to Incomplete Records
- Many small business owners and self-employed individuals do not maintain a complete set of accounting records due to a lack of accounting knowledge or time constraints.
- Instead of following the double-entry bookkeeping system, they often use a single-entry system or maintain partial records, leading to gaps in financial data.
- Accountants must use various techniques to reconstruct financial statements accurately from these incomplete records.
- The key objectives include:
- Determining profit or loss.
- Reconstructing missing financial data.
- Preparing financial statements.
16.1 Understanding Incomplete Records
- Definition: Incomplete records refer to accounting situations where a business does not maintain a full double-entry system.
- Common reasons for incomplete records:
- Lack of accounting expertise.
- Small businesses relying on cash transactions.
- Loss of records due to theft, damage, or negligence.
- Accountants use forensic methods to reconstruct missing financial details.
- Common challenges:
- Missing sales and purchase figures.
- Unrecorded assets and liabilities.
- No clear capital or profit computation.
16.2 Using the Statement of Affairs to Determine Capital
- When financial records are incomplete, the Statement of Affairs method helps estimate business capital by listing known assets and liabilities.
- Formula:
Opening Capital = Assets - Liabilities - Example:
- Assets: Bank balance $5,000, Equipment $20,000, Receivables $3,000.
- Liabilities: Payables $2,000, Loan $8,000.
- Opening Capital:
5,000 + 20,000 + 3,000 - (2,000 + 8,000) = $18,000
- Steps to determine profit or loss:
- Calculate Opening Capital.
- Identify any capital introduced during the year.
- Consider drawings taken by the owner.
- Compare Closing Capital with the adjusted opening capital.
- Formula for profit:
Profit = Closing Capital - (Opening Capital + Additional Capital - Drawings)
16.3 Control Accounts to Find Missing Figures
- Control accounts help determine missing figures for sales and purchases.
- Two key control accounts:
- Sales Ledger Control Account (to determine total credit sales).
- Purchases Ledger Control Account (to determine total credit purchases).
- Sales Ledger Control Account Formula:
Opening Debtors + Credit Sales - Cash Received - Discounts Allowed - Irrecoverable Debts = Closing Debtors - Purchases Ledger Control Account Formula:
Opening Creditors + Credit Purchases - Cash Paid - Discounts Received = Closing Creditors - By reconstructing these accounts, accountants can identify the missing sales or purchases figures.
16.4 Non-Current Assets and Depreciation
- Identifying missing asset values:
- If incomplete records do not provide asset values, businesses use previous financial statements or insurance records.
- If records of asset purchases exist, accountants calculate depreciation.
- Depreciation Methods:
- Straight-line method:
Annual Depreciation = (Cost - Residual Value) / Useful Life - Reducing balance method:
Depreciation = Net Book Value × Depreciation Rate
- Straight-line method:
- Example Calculation:
- Equipment bought for $10,000, expected to last 5 years, no residual value.
- Straight-line depreciation:
(10,000 - 0) / 5 = $2,000 per year
16.5 Preparing the Statement of Profit or Loss and Statement of Financial Position
- After determining missing values, accountants prepare financial statements:
- Statement of Profit or Loss Format:
Revenue - Cost of Sales -------------------- Gross Profit - Expenses (Wages, Rent, Depreciation, etc.) -------------------- Net Profit - Statement of Financial Position Format:
Assets: Non-current assets (after depreciation) Current assets (cash, inventory, receivables) Liabilities: Current liabilities (payables, bank overdraft) Non-current liabilities (loans, mortgages) Capital: Opening capital + Net profit - Drawings - Worked Example:
- Revenue = $80,000
- Cost of Sales = $45,000
- Expenses = $20,000
- Net Profit:
80,000 - 45,000 - 20,000 = $15,000
- Financial Position:
- Assets: $50,000 (Non-current) + $20,000 (Current)
- Liabilities: $15,000
- Capital Calculation:
55,000 (Assets - Liabilities)
16.6 Worked Questions and Practical Application
- Question 1: Calculate capital at the beginning and end of the year using:
Capital = Assets - Liabilities - Question 2: Construct control accounts to determine missing values.
- Question 3: Determine depreciation for missing non-current assets.
- Question 4: Prepare final financial statements from incomplete data.
Conclusion
- Even when records are incomplete, accountants can reconstruct financial information using logical techniques.
- The Statement of Affairs, Control Accounts, and Profit Calculation Formulas allow estimation of financial position and performance.
- Understanding depreciation ensures accurate asset valuation.
- These methods help businesses comply with accounting standards and make informed financial decisions.
Chapter 17: Incomplete Records – Further Considerations
Introduction to Further Considerations in Incomplete Records
- Incomplete records can present challenges when trying to reconstruct a business’s financial position.
- This chapter focuses on advanced techniques for determining missing figures in financial statements.
- Key areas covered:
- Using the trading account structure.
- Applying mark-up and margin to determine missing purchases and sales figures.
- Dealing with inventory calculations and valuation methods.
- Calculating the impact of lost or stolen inventory.
- Evaluating the benefits of a complete double-entry system.
17.1 Using Trading Account Structures
- The trading section of the Statement of Profit or Loss helps estimate missing financial figures.
- Formula for Cost of Sales:
Cost of Sales = Opening Inventory + Purchases - Closing Inventory - Example:
- Given: Revenue = $120,000, Opening Inventory = $17,800, Closing Inventory = $19,100, Gross Profit = $41,400.
- Find missing purchases:
Purchases = Cost of Sales + Closing Inventory - Opening InventoryPurchases = (Revenue - Gross Profit) + 19,100 - 17,800Purchases = (120,000 - 41,400) + 19,100 - 17,800 = 79,900
17.2 Mark-up and Margin for Finding Missing Figures
- Mark-up: The percentage increase added to the cost price to determine the selling price.
Mark-up = (Gross Profit / Cost of Sales) × 100 - Margin: The percentage of revenue that is gross profit.
Margin = (Gross Profit / Revenue) × 100 - Example Calculation:
- If a business has revenue of $80,000 and uses a mark-up of 25%, find cost of sales:
Cost of Sales = Revenue / (1 + Mark-up %)Cost of Sales = 80,000 / (1 + 0.25) = 64,000
- If a business has revenue of $80,000 and uses a mark-up of 25%, find cost of sales:
17.3 Inventory Calculation Using Dummy Figures
- Sometimes, businesses do not provide opening or closing inventory figures.
- A temporary dummy figure can be used, ensuring that the closing inventory is adjusted accordingly.
- Example:
- Revenue: $171,300, Mark-up: 50%
- Inventory increased by $5,280 during the year.
- Assume Opening Inventory as $10,000, Closing Inventory will be $15,280.
- Compute Cost of Sales:
Cost of Sales = Opening Inventory + Purchases - Closing InventoryCost of Sales = 10,000 + Purchases - 15,280Purchases = Cost of Sales + 15,280 - 10,000
17.4 Inventory Lost in Fire, Theft, or Accidents
- Step 1: Determine expected inventory using the trading account structure.
- Step 2: Subtract the remaining inventory from the expected closing inventory.
- Example:
- Revenue: $137,940, Opening Inventory: $25,870, Purchases: $76,900, Mark-up: 90%
- Determine Closing Inventory Before Fire:
Cost of Sales = Revenue / (1 + Mark-up %)Cost of Sales = 137,940 / (1 + 0.90) = 72,600Expected Closing Inventory = Opening Inventory + Purchases - Cost of SalesExpected Closing Inventory = 25,870 + 76,900 - 72,600 = 30,170 - If only $4,600 of inventory remains, Inventory Lost:
Inventory Lost = 30,170 - 4,600 = 25,570
17.5 Valuing Inventory Under Accounting Standards
- IAS 2 states inventory should be valued at the lower of cost or net realizable value (NRV).
- Example:
- A suit cost $200 but requires $30 worth of repairs before selling at $250.
- Net Realizable Value (NRV):
NRV = Selling Price - Further CostsNRV = 250 - 30 = 220 - Inventory should be valued at $200 since cost < NRV.
17.6 The Benefits of Keeping Complete Records
Advantages:
- Accurate Financial Reporting: Ensures correct profit/loss figures.
- Error and Fraud Prevention: Easier to detect mistakes.
- Legal Compliance: Required for tax and regulatory filings.
- Better Decision-Making: Managers can analyze business performance.
- Improved Cash Flow Management: Enables tracking of receivables and payables.
Disadvantages:
- Time-Consuming: Maintaining records requires effort.
- Costly: Hiring accountants or purchasing software increases expenses.
- Requires Accounting Knowledge: Business owners may lack expertise.
17.7 Worked Questions and Exam Preparation
- Question 1: Calculate missing purchases using the trading account.
- Question 2: Determine cost of inventory lost due to theft.
- Question 3: Apply the lower of cost or NRV rule for inventory valuation.
- Question 4: Justify the benefits of a double-entry system.
Conclusion
- Using trading accounts, mark-up, and margin can help reconstruct missing financial information.
- Inventory valuation follows IAS 2, ensuring proper financial reporting.
- Keeping full accounting records improves accuracy, compliance, and decision-making.
- Even when records are incomplete, logical techniques can help accountants produce reliable financial statements.