Thursday 6 February 2014

Accounting Standard 3-- Cash Flows



INTRODUCTION:


Earlier the enterprises were used to prepare the statements of profit and loss account and balance sheet; the profit and loss account is prepared on accrual basis and the users of financial statements were getting the problem regarding “why the enterprise has not got any money to pay for dividends while the net profit of that company is good enough?” apart from this the users wanted to know from where the company was generating cash? and how the company was using that cash?  Thus, this create the need of preparing the statement which shows the inflows and the out flows of the cash during an accounting year. In June 1981 first time the AS introduced in the name “change in the financial position” later in 1997 the revised AS 3 INTRODUCED BY ICAI named “cash flow statements”and this AS is mandatory for the level 1 enterprises on or after 1 april 2001.

 

Definitions:


Cash flows: cash flows mean the inflows and the outflows of cash and cash equivalents.

Cash: cash means cash on hand and demand deposits with bank.

Cash equivalents: these are the short term investments that are readily converted into cash and which has no risk of change in value.

 

Now this cash flow statement is divided into 3 parts cash flow from 1)operating activities2)investing activities and 3)financing activities. The division was necessary to facilitate the users of financial statements so that they come to know from which category the cash is being generated and used.

              CASH FLOWS FROM OPERATING ACTIVITIES:


               First we need to understand what are the operating activities?

                All those activities that need to operate/run the principal (main) business of an enterprise are the operating activities. Now take a garment company, the principal business of that company is to manufacture and sale the garments, so all those activities which that company does like purchasing the raw-material, converting it into the finished products and selling them in to the markets are the operating activities. Similarly for a finance company giving loan and earning interests are the operating activities. So it depends upon the nature of the company. Apart from these, operating activities also include all those activities that are not investing and financing activities. For example purchase and sales of shares for trading purpose is not a principal revenue generating activities but because it’s not to be included in investing and financing activities it will be regarded as operating activity.

Now cash flows from operating activities mean the incoming (cash inflows) and outgoing (cash outflow) of cash from the operating activities during an accounting year. Thus cash purchase, cash sales, payment to supplier, receipts from debtor during the year, are some of the cash flows from operating activities of Non-Finance Company.

Some students misunderstand this concept and write the full amount of item written in p/l account. Let me give you an example suppose a company sold its garments at RS 5000 and customer paid 3000 during the year in this case we will take 3000 as cash inflow from operating activity but record full 5000 as revenue in profit and loss account, so both are completely different concepts.

Now once you understood this concept the rest of the work is pretty easy.

Methods:

There are two methods by which we can determine cash flows from operating activities, 1) direct and 2) indirect method.

In the direct method, we add all the cash inflows in the operating activities like cash sales, cash received from customer etc and deduct all those cash outflows in that process, for example- salaries of employees, administrative expenses, selling expenses, payment to supplier etc.

 

In the Indirect method, we write as a first step “Net profit before tax” amount taken directly from the profit and loss Account. (Now NPBT include both non operating and non cash items its definite, that’s why we need to refine that too, so)

As a second step we need to ADD BACK all the non cash expenses like depreciation, provisions etc and non operating expenses like loss on sale of fixed assets, interests paid on loan, etc and deduct all the non operating incomes like profit on sale of assets, interest received etc etc.

 In the third step, we will adjust the effect of change in working capital by keeping in mind that whenever there is an increase in current assets in comparison to the opening balance it always means that the cash is blocked in the business (like expenditure) so we have to deduct that much amount (from the balance remained in the second step) and if the C/A decrease in comparison to last balance it means that cash has come in the business so we have to add that much amount. Similarly if C/L decreases we will have to deduct that much amount because cash has been gone from the business (as we paid to the creditors) and if C/L increase vice versa.

Then at last, Tax paid during the year will be deducted from the balance amount left after following above three steps.

After that, the balance amount we got is cash from operating activities.  

So this was how you have to determine cash flows from operating activities.

             

              CASH FLOWS FROM INVESTING ACTIVITIES:


Apart from their operating activities enterprises are engaging in investing activities as other sources of income. Investing activities means purchasing and selling long term assets and investments. So in this head all the cash inflows will be added and outflows will be deducted and the resultant amount will be cash flows from investing activities.

             

CASH FLOWS FROM FINANCE ACTIVITIES:


Financing activities: these are the activities that change the size and the compositions of owner’s capital and the borrowings of an enterprise. It include issue of shares, debentures, loan taken from bank, etc etc

Some Important points relating to cash flows:


 

ASSETS:


Purchase and the sales of long term assets (including intangibles like patent, trademark etc) are the investing activities for all the enterprises as well as research and developments costs that are capitalized is also an investing activity that are not capitalized is an operating activity.

SHARES:


Purchase and sales of the shares of other enterprises for long term basis and dividend earned on them is an investing activity for non finance enterprise and operating activity for finance enterprise. For short term when taken for trading purpose, is an operating activity for all the enterprise.

Purchase and sales of the shares of subsidiary company is an investing activity for all enterprise.

 But when the company issues its own shares or debentures it will be financing activities.

LOANS AND ADVANCES:


Loans and advances given or taken and interests earned or paid on them are an operating activities for finance companies, and  Loans and advances given to the other enterprise and interests earned on them is an investing activity for non finance company. Loans and advances taken from other enterprise and interest paid on them is a financing activities.

  Loans and advances given to employees and interests earned on them are an operating activity for all enterprises. Interests earned from customer for late payment and vice versa are operating activities. Loans and advances given or taken to the subsidiary company and interests earned or paid on them is an investing activity for both finance and non-finance company.

TAX DEDUCTED FROM SOURCE:


TDS against the income is an operating activity if the concerned income is operating income or whereas it will be investing activity if related with investing incomes. TDS against expenses is an operating activity if related with operating expenses and financing activity if related with financing activity.

BUSINESS PURCHASE:


Cash flows from the business purchase should be regarded as investing activities.

RECORDING NET BASIS:


This AS tells that we can’t net of the items relating to investing and financing activities. Example cash received from the issue of debentures is 500000 and cash paid as repayment of borrowed money is 200000 should not be net off and written as 300000 (net)..

But for operating activities we can net of that, such as cash received from customer is 50000 and paid to customer 10000 can be written as 40000.

This AS allows to netting of the purchase and sales of investment.

Effect of foreign currency transaction:


The effect of foreign currency transaction should be written as separately in the reconciliation of change in the cash and cash equivalent during the year.

DISCLOSURE:


According to this AS we should disclose the amount of cash and cash equivalents held by an enterprise that are not available for use.

Amount of undrawn borrowing facilities that may be available for future operating activities should be disclosed.

This AS says cash flow arises on the extra ordinary items should be disclose separately in the respective head. For example:

The insurance claim received from the loss of stock or loss of fixed assets should be disclosed separately in cash from operating head and cash from investing head respectively, in such a way that the users can identify the effect of that transaction.

THIS WAS ALL ABOUT THE THEORETICAL CONCEPT OF AS 3 CASH FLOWS.

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