Get to grips with the statement of cash flows

May 01, 2018
Students all too often lose marks on a very predictable aspect of the CAP 1 and CAP 2 syllabi – the statement of cash flows. Here’s what you need to know.

The statement of cash flows is an integral part of an entity’s primary financial statements. It’s just as important as the profit or loss account or the entity’s statement of financial position. In fact, some would argue that it’s even more important! It’s surprising that students don’t appear to attach the same importance to it when studying for their CAP 1 Financial Accounting and CAP 2 Financial Reporting exams, especially as the statement of cash flows features regularly as a compulsory question on these papers.

The usual suspect

The statement of cash flows comfortably remains the worst-answered compulsory question on the CAP 1 Financial Accounting and CAP 2 Financial Reporting exam paper. Unfortunately, during the examination marking process, it no longer comes as a surprise to see a student’s exam performance significantly drop once their statement of cash flows question has been marked. In the Exams Department, experience tells us that in a paper where a candidate needs to achieve a passing score of 50 marks, improved performance in the statement of cash flows question can significantly improve your chances of exam success. This is absolutely achievable for students.

Variety is not the spice of life

The preparation of the statement of cash flows is arguably more formulaic than either the profit or loss account or the statement of financial position. By their very nature, statement of cash flows questions are very repetitive – many items are common to all statement of cash flows. Adequate preparation for these recurring items will mean that a comfortable pass is within the student’s control. The statement of cash flows requires cash flows to be classified under three headings – operating activities, investing activities and financing activities. The recurring items that fall under these headings are referred to below.


Operating activities

There are two different methods of preparing the statement of cash flows – the direct method and the indirect method. The candidate’s choice of method determines the type of adjustments required under operating activities. The vast majority of candidates prepare the statement of cash flows using the indirect method and this is the focus of the adjustments below. The indirect method starts with a profit figure, which candidates are required to reconcile to cash. Typical adjustments include:
  • Depreciation/amortisation: added to profit;
  • Profit/loss on disposal of a non-current asset: deducted from/added to profit;
  • Finance cost: added to profit;
  • Increase/decrease in inventory: deducted from/added to profit;
  • Increase/decrease in trade receivables: deducted from/added to profit; and
  • Increase/decrease in trade payables: added to/deducted from profit.

Additionally, under operating activities, the following cash flows are common:

  • Tax paid; and
  • Finance cost paid.

Investing activities
Cash flows included here relate to non-current assets. Common examples of cash flows include:

  • Cash paid to purchase property, plant and equipment (PPE);
  • Cash received from the disposal of PPE; and
  • Investment income received.

Financing activities
Entities are typically financed by a mixture of debt and equity. Financing activities include cash flows in respect of this finance. These include:

  • Cash received from the issue of shares;
  • Cash received from new loan borrowings;
  • Cash outflow to repay loans; and
  • Dividends paid to ordinary shareholders.

The items above are common to almost every company statement of cash flows. Calculations are necessary to arrive at some of these cash flows – these too are repetitive in nature. By practising these adjustments in past exam questions, students can very quickly become proficient in preparing (and comfortably passing) a statement of cash flows question.

Of course, in any exam question there will always be more challenging components. Good exam technique dictates that students should manage their time, focus first on the parts they recognise and score the marks available. Time permitting, other ‘non-recurring’ adjustments can then be attempted.

Consolidated statement of cash flows

A consolidated statement of cash flows is examinable at CAP 2 Financial Reporting. Additional adjustments need to be considered when preparing a group statement of cash flows. Cash flows specific to a subsidiary include:

  • Cash inflow/outflow from acquisition/disposal of a subsidiary; and
  • Dividends paid to the non-controlling interest.

Adjustments specific to an associate company include:

  • Dividends received from associate; and
  • Share of profit/loss of associate: deducted from/added to profit under operating activities.

Conclusion

The statement of cash flows is a primary financial statement. It forms a significant component of the CAP 1 Financial Accounting and CAP 2 Financial Reporting syllabi and, thus, can account for a significant number of marks in these exam papers. By its nature, the statement of cash flows is repetitive and formulaic. The majority of adjustments that will arise in a statement of cash flows question are not a secret – in fact, they are quite predictable. Students who choose to invest time in practising these adjustments significantly enhance their chances of success in their CAP 1 Financial Accounting and CAP 2 Financial Reporting examinations.

Garret Mulvin is a Paper Development Executive at Chartered Accountants Ireland.