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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