Preparation and interpretation of statements of cash flows
What the exam tests
This domain tests preparation of a statement of cash flows under IAS 7 using the indirect method, and interpretation of cash generation. You must classify operating, investing and financing activities and adjust profit for non-cash and working-capital movements.
Core rules
- Cash and cash equivalents include cash and short-term, highly liquid investments repayable within three months; bank overdrafts are included where repayable on demand.
- Operating activities under the indirect method start with profit before tax and adjust for depreciation, amortisation, impairment, profit or loss on disposal, interest and tax, then for movements in inventory, receivables and payables.
- Investing activities include purchases and sales of non-current assets and investments.
- Financing activities include share issues, loans, loan repayments and dividends paid.
- Interest paid and dividends paid may be classified as operating or financing under IAS 7, but must be applied consistently.
Worked example
Profit before tax is £100,000. Depreciation is £20,000. Receivables increased by £10,000 and payables decreased by £5,000.
Operating cash before tax = £100,000 + £20,000 − £10,000 − £5,000 = £105,000.
Reasoning: depreciation is added back because it is non-cash. An increase in receivables means sales exceeded cash received, so deduct it. A decrease in payables means more cash was paid to suppliers, so deduct it. In the direct method, the same economics appear as cash received from customers and cash paid to suppliers.
Traps
Reversing the signs on working-capital movements costs marks. Do not include depreciation in investing activities. Do not treat a revaluation as a cash flow. Watch the tax paid figure, which may differ from the SPL tax charge because of opening and closing tax liabilities. Check that cash and cash equivalents reconcile to the SFP.
Key points
- Start the indirect method with profit before tax.
- Add back depreciation and other non-cash items.
- Deduct increases in receivables and inventory; add decreases.
- Add increases in payables; deduct decreases.
- Reconcile the closing cash and cash equivalents to the SFP.