Edexcel A-Level Accounting: Statement of cash flows (YAC11) – Revision Notes

For full explanations and a complete worked statement, read the study guide first.

These notes cover topic 2.3, Statement of cash flows (outcomes 2.3.1 and 2.3.2), in Unit 2 of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018. This is Unit 2 (A2) only content, assessed for the full International A Level. All figures are invented and in dollars.

Course links: Edexcel A-Level Accounting hub, printable checklist, practice questions and the free 10-minute diagnostics. Liquidity ratios are revised in analysis of accounting statements.

The two outcomes

Outcome	In one line
2.3.1	Prepare a statement of cash flows for a limited company under IAS 7
2.3.2	Explain the importance of liquidity to a company

Definitions to learn word for word

• Statement of cash flows: the IAS name (Appendix 6 of the specification) for what UK GAAP called the cash flow statement. It explains the change in cash and cash equivalents over a period.
• Cash: cash on hand and demand deposits.
• Cash equivalents: short-term, highly liquid investments, readily convertible to known amounts of cash, with an insignificant risk of changes in value.
• Bank overdraft: IAS 7 allows it to be included in cash and cash equivalents; it is a negative balance.
• Liquidity: the ability to meet debts as they fall due.
• Operating activities: the main revenue-producing activities of the company.
• Investing activities: acquiring and disposing of long-term assets and investments.
• Financing activities: changes in equity and borrowings.

Where each item goes

Item	Heading	Sign
Tax paid	Operating	Outflow
Interest paid	Operating or financing (IAS 7 allows either)	Outflow
Interest or dividends received	Operating or investing	Inflow
Purchase of property, plant and equipment	Investing	Outflow
Proceeds from sale of non-current assets	Investing	Inflow
Issue of shares (nominal value plus premium)	Financing	Inflow
Issue of debentures or new long-term loan	Financing	Inflow
Repayment of debentures or loans	Financing	Outflow
Dividends paid	Financing or operating (IAS 7 allows either)	Outflow
Bonus issue, revaluation, transfer to general reserve	Not shown	No cash

Indirect method: adjustments to profit from operations

Item	Adjustment	Reason
Depreciation	Add	Expense with no cash outflow
Loss on disposal	Add	Non-cash; proceeds go under investing
Profit on disposal	Deduct	Non-cash; proceeds go under investing
Increase in inventory	Deduct	Cash tied up in goods
Decrease in inventory	Add	Cash released
Increase in trade receivables	Deduct	Customers owe more, so less cash in
Decrease in trade receivables	Add	More cash collected
Increase in trade payables	Add	Company has kept cash it owes
Decrease in trade payables	Deduct	More cash paid out

If the start point is profit before tax, add back finance costs first.

The standard layout

Cash flows from operating activities
  Profit from operations
  Adjustments (depreciation, disposals, working capital)
  = Cash generated from operations
  Interest paid, tax paid
  = Net cash from operating activities
Cash flows from investing activities
  = Net cash used in investing activities
Cash flows from financing activities
  = Net cash from (used in) financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at start of year
Cash and cash equivalents at end of year

Method in steps

1. Read both statements of financial position and list every change.
2. Do the workings: disposal, purchases of non-current assets, tax paid, interest paid, share issue, dividends.
3. Write the operating section: profit, add-backs, working capital, then interest and tax paid.
4. Write investing and financing.
5. Total the net change, add opening cash and cash equivalents (an overdraft is negative).
6. Check the closing figure against the statement of financial position.

Key workings as formulas

Working	Formula
Tax paid	Opening tax payable + tax charge − closing tax payable
Interest paid	Opening interest accrued + finance costs − closing interest accrued
Dividends paid	Opening retained earnings + profit for the year − closing retained earnings (adjust for any transfers or bonus issue)
Purchases of non-current assets	Closing cost − (opening cost − cost of disposals)
Disposal proceeds	Carrying value − loss, or carrying value + profit
Share issue proceeds	Increase in share capital + increase in share premium (excluding any bonus issue)

Small worked reminders

Lusterby Lamps Ltd. Profit from operations 46,300; depreciation 12,800; profit on disposal 1,900; inventory up 2,400; trade receivables down 3,100; trade payables up 1,700.

46,300 + 12,800 - 1,900 - 2,400 + 3,100 + 1,700 = 59,600

Cash generated from operations is 59,600.

Brellow Freight Ltd. Debenture interest for the year 7,200; interest accrued at the start 600 and at the end 1,800.

Interest paid = 600 + 7,200 - 1,800 = 6,000

Direct method in one box

IAS 7 encourages it. Cash generated from operations is the same under both methods.

Receipts from customers = opening receivables + credit sales - closing receivables
Purchases              = cost of sales + closing inventory - opening inventory
Payments to suppliers  = opening payables + purchases - closing payables
Expenses paid          = expenses (excluding depreciation) adjusted for accruals and prepayments

Liquidity (2.3.2)

Why it matters:

• Suppliers, employees, lenders and the tax authority must be paid on time.
• Running out of cash can end a profitable company: creditors can seek liquidation.
• Lenders and suppliers judge credit risk on liquidity.
• Dividends need cash, not just reserves.
• Cash lets the company take opportunities, such as discounts for prompt payment.

What the statement of cash flows shows:

• Whether trading itself generates cash (net cash from operating activities compared with profit for the year).
• Whether investment was paid for from operating cash or from new finance.
• Whether dividends and loan repayments are affordable.
• Why the cash balance or overdraft moved.

Warning signs: negative operating cash flow while profit is positive; a growing overdraft; inventory and receivables rising faster than revenue (overtrading); long-term assets bought with short-term borrowing.

Ways to improve liquidity: tighter credit control, lower inventory, longer supplier credit, new share or debenture issue, sale and leaseback or sale of surplus assets, lower dividends, delayed capital spending. Each has a cost; say what it is.

Must-know distinctions

• Profit vs cash: profit is measured on the accruals basis; cash is what actually moved.
• Liquidity vs profitability: a profitable company can be short of cash, while a company making losses may still hold a large cash balance for a while.
• Charge vs paid: the statement of profit or loss shows the tax and interest charge; the statement of cash flows shows what was paid.
• Carrying value vs proceeds: only proceeds are cash.
• Cash generated from operations vs net cash from operating activities: the second is after interest and tax paid.
• Rights issue vs bonus issue: a rights issue raises cash; a bonus issue raises none.

Quick self-test

1. Name the three headings in an IAS 7 statement of cash flows.
2. Depreciation of 18,000 was charged. What adjustment is made in the indirect method?
3. Trade receivables rose by 4,000. What is the adjustment?
4. Tax payable was 9,500 at the start and 11,000 at the end; the tax charge was 12,300. Calculate tax paid.
5. Retained earnings rose from 64,000 to 81,500. Profit for the year was 39,500 and there were no transfers. Calculate dividends paid.
6. A machine with a carrying value of 14,000 was sold for 10,500. Give both entries in the statement.
7. Where does a bonus issue appear?
8. Opening cash and cash equivalents were an overdraft of 7,200 and the net increase was 15,900. Find the closing figure.
9. Which method of presenting operating cash flows does IAS 7 encourage?
10. Opening receivables 23,000, credit sales 310,000, closing receivables 27,500. Calculate receipts from customers.
11. Share capital (shares of 1 each) rose from 150,000 to 180,000 and share premium from 20,000 to 41,000, with no bonus issue. Calculate the cash raised.
12. A company’s current ratio is healthy but its overdraft has grown for two years. Give one possible reason.

Answers

1. Operating activities, investing activities, financing activities.
2. Add 18,000 to profit.
3. Deduct 4,000.
4. 9,500 + 12,300 − 11,000 = 10,800.
5. 64,000 + 39,500 − 81,500 = 22,000.
6. Add back the loss of 3,500 in operating activities; show proceeds of 10,500 as an inflow under investing activities.
7. Nowhere: it involves no cash.
8. −7,200 + 15,900 = 8,700.
9. The direct method.
10. 23,000 + 310,000 − 27,500 = 305,500.
11. 30,000 + 21,000 = 51,000 (30,000 shares at 1.70).
12. Current assets may be made up mostly of slow-moving inventory or receivables, so cash is tied up even though the ratio looks high.

Where marks are usually lost

• Using the tax or interest charge in place of the amount paid.
• Showing a profit on disposal as an add-back, or showing the carrying value as proceeds.
• Reversing a working capital sign, especially for trade payables.
• Leaving out share premium when calculating cash from a share issue, or including a bonus issue.
• Forgetting that an overdraft at the start is a negative opening balance.
• No headings or subtotals, so the three sections cannot be followed.
• Omitting the reconciliation of the net change to opening and closing cash and cash equivalents.
• Answering a liquidity question with ratios alone and no reference to the cash flows.
• Recommending ways to improve liquidity without stating any drawback.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018, first teaching September 2015, published by Pearson Education Limited. Unit 2, topic 2.3 Statement of cash flows (outcomes 2.3.1 and 2.3.2).