Class 12 Accountancy Notes Chapter 6 (Cash Flow Statement) – Accountancy-II Book
Alright students, let's focus on a crucial chapter for your government exam preparation: Chapter 6 - Cash Flow Statement from your NCERT Class 12 Accountancy-II book. This statement provides vital information about the cash movements within a company, which is often tested in competitive exams.
Cash Flow Statement (As per Accounting Standard - 3 Revised)
1. Objective & Meaning:
- Objective: To provide information about the historical changes in cash and cash equivalents of an enterprise by classifying cash flows into operating, investing, and financing activities.
- Meaning: A statement showing inflows (receipts) and outflows (payments) of cash and cash equivalents during a specific period. It reconciles the opening and closing balances of cash and cash equivalents.
2. Cash and Cash Equivalents:
- Cash: Comprises cash on hand and demand deposits with banks.
- Cash Equivalents: Short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.
- Key characteristics: Short maturity (typically 3 months or less from the date of acquisition), readily convertible, insignificant risk of value change.
- Examples: Treasury bills, commercial papers, money market funds, short-term deposits.
- Important Note: Bank overdrafts and cash credit are usually considered financing activities (short-term borrowings), not part of cash and cash equivalents unless they are repayable on demand and form an integral part of the entity's cash management.
3. Classification of Cash Flow Activities:
This is the core of the statement and where most questions arise.
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(A) Operating Activities:
- Definition: These are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. They generally result from transactions and events that enter into the determination of net profit or loss.
- Key Indicator: Shows the extent to which operations have generated sufficient cash to maintain operating capability, pay dividends, repay loans, and make new investments without recourse to external financing.
- Examples of Inflows:
- Cash receipts from sale of goods and rendering services.
- Cash receipts from royalties, fees, commissions, and other revenue.
- Cash receipts from trade receivables (Debtors and Bills Receivable).
- Examples of Outflows:
- Cash payments to suppliers for goods and services.
- Cash payments to and on behalf of employees (salaries, wages).
- Cash payments to trade payables (Creditors and Bills Payable).
- Cash payments for operating expenses (rent, insurance).
- Payment of Income Tax (unless specifically identified with financing/investing).
- For Financial Enterprises (like banks): Interest paid, interest received, dividends received are usually classified as operating activities.
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(B) Investing Activities:
- Definition: Include the acquisition and disposal of long-term assets and other investments not included in cash equivalents. These activities represent expenditures made for resources intended to generate future income and cash flows.
- Examples of Inflows:
- Cash receipts from the sale of fixed assets (tangible and intangible).
- Cash receipts from the sale of investments (non-current).
- Interest received (for non-financial enterprises).
- Dividends received (for non-financial enterprises).
- Cash receipts from repayment of loans and advances made to third parties.
- Examples of Outflows:
- Cash payments to acquire fixed assets (tangible and intangible).
- Cash payments to acquire investments (non-current).
- Cash advances and loans made to third parties.
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(C) Financing Activities:
- Definition: Activities that result in changes in the size and composition of the owner's capital (including preference share capital) and borrowings of the enterprise.
- Examples of Inflows:
- Cash proceeds from issuing shares (equity or preference).
- Cash proceeds from issuing debentures, loans, bonds, and other short-term/long-term borrowings.
- Examples of Outflows:
- Cash payments for buy-back of equity shares.
- Redemption of preference shares.
- Redemption of debentures.
- Repayment of loans.
- Interest paid (for non-financial enterprises).
- Dividends paid (on equity and preference shares).
4. Methods of Reporting Cash Flow from Operating Activities:
- Direct Method: Major classes of gross cash receipts and gross cash payments are disclosed. (e.g., Cash received from customers, Cash paid to suppliers). Not commonly used or tested as extensively as the Indirect method in exams based on NCERT syllabus.
- Indirect Method: Net profit or loss is adjusted for the effects of:
- Transactions of a non-cash nature (e.g., Depreciation, Amortization, Goodwill written off, Provisions).
- Items of income or expense associated with investing or financing cash flows (e.g., Profit/Loss on sale of fixed assets/investments, Interest paid/received, Dividend received).
- Changes during the period in inventories and operating receivables and payables (Working Capital Changes).
Steps for Indirect Method (Crucial for Exams):
- Start with Net Profit Before Tax and Extraordinary Items:
- Calculate this from the P&L balance by adding back Provision for Tax (made during the year), Proposed Dividend (for the current year), Interim Dividend (paid during the year), Transfer to Reserves, and deducting any refund of tax credited to P&L. Add back Extraordinary loss / Deduct Extraordinary gain if already adjusted in P&L.
- Adjust for Non-Cash & Non-Operating Items:
- Add: Depreciation, Amortization (Goodwill, Patents, etc. written off), Interest on Borrowings/Debentures, Loss on Sale of Fixed Assets/Investments, Increase in Provision for Doubtful Debts.
- Subtract: Interest Income, Dividend Income, Rent Income (if investing), Profit on Sale of Fixed Assets/Investments, Decrease in Provision for Doubtful Debts.
- Result = Operating Profit Before Working Capital Changes.
- Adjust for Working Capital Changes:
- Add: Decrease in Current Assets (e.g., Debtors, Stock, Prepaid Exp), Increase in Current Liabilities (e.g., Creditors, Outstanding Exp).
- Subtract: Increase in Current Assets, Decrease in Current Liabilities.
- (Remember: Exclude Cash & Cash Equivalents and items related to financing like Bank Overdraft/Cash Credit unless part of cash management).
- Result = Cash Generated from Operations.
- Subtract: Income Tax Paid (Net of refunds received). Calculate tax paid using Provision for Tax A/c if needed.
- Adjust for Extraordinary Items (Add inflow / Subtract outflow, if any, related to operations).
- Result = Net Cash Flow from (or used in) Operating Activities.
5. Treatment of Specific Items (Common Exam Questions):
- Interest & Dividend:
- Non-Financial Company: Interest Paid & Dividend Paid -> Financing Outflow; Interest Received & Dividend Received -> Investing Inflow.
- Financial Company: Interest Paid, Interest Received, Dividend Received -> Operating Activity. Dividend Paid -> Financing Outflow.
- Income Tax: Generally treated as Operating Outflow unless it can be specifically identified with Investing or Financing activities. Tax paid should be disclosed separately.
- Extraordinary Items: Cash flows associated should be classified under Operating, Investing, or Financing as appropriate and disclosed separately. (e.g., Insurance claim received for loss of stock by fire - Operating; Insurance claim for machinery destroyed by earthquake - Investing).
- Purchase/Sale of Marketable Securities: Usually part of Cash Equivalents, so their purchase/sale doesn't result in cash flow between activities but is part of cash management. However, if held as investments, classify under Investing.
- Dividend Proposed: Not a cash flow until paid. Dividend paid (including interim dividend) is a Financing Outflow.
6. Importance of Cash Flow Statement:
- Assesses liquidity and solvency.
- Helps in evaluating the ability to generate future cash flows.
- Useful for short-term planning and cash management.
- Facilitates comparison of operating performance (removes effects of different accounting policies).
- Provides information for decision-making by users (investors, creditors).
7. Limitations of Cash Flow Statement:
- Does not show the non-cash transactions (e.g., issue of shares for assets, conversion of debentures into shares). These are disclosed separately in notes.
- Based on historical data.
- Not a substitute for an Income Statement; doesn't show profitability based on accrual basis.
- Window dressing is possible.
Remember to practice preparing the statement, especially calculating Cash Flow from Operating Activities using the Indirect Method and correctly classifying various transactions. Pay close attention to the adjustments required.
Multiple Choice Questions (MCQs):
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Which of the following is considered a 'Cash Equivalent' as per AS-3 (Revised)?
a) Investment in Equity Shares
b) 5-year Bank Fixed Deposit
c) Treasury Bill with 2 months maturity from date of acquisition
d) Debentures held as investment -
Cash received from the sale of machinery by a manufacturing company is classified under which activity?
a) Operating Activity
b) Investing Activity
c) Financing Activity
d) Cash Equivalents -
Payment of Income Tax should generally be classified under:
a) Operating Activity
b) Investing Activity
c) Financing Activity
d) Separately disclosed item not part of activities -
When preparing Cash Flow from Operating Activities using the Indirect Method, Depreciation is:
a) Added back to Net Profit
b) Subtracted from Net Profit
c) Ignored
d) Treated as an outflow -
An increase in Trade Receivables (Debtors) during the year will result in (using Indirect Method):
a) Increase in cash flow from operating activities
b) Decrease in cash flow from operating activities
c) No effect on cash flow from operating activities
d) Increase in cash flow from investing activities -
Which of the following is a Financing Activity for a non-financial company?
a) Sale of old furniture
b) Receiving interest on investments
c) Payment of dividends
d) Cash received from customers -
Cash Flow Statement is prepared based on:
a) Accrual basis of accounting
b) Cash basis of accounting
c) Going concern concept
d) Matching concept -
Interest received by a bank is classified as:
a) Operating Activity
b) Investing Activity
c) Financing Activity
d) Extraordinary Item -
While calculating Cash Flow from Operating Activities (Indirect Method), which item is subtracted from Net Profit Before Tax?
a) Loss on Sale of Fixed Asset
b) Increase in Creditors
c) Profit on Sale of Investment
d) Amortization of Goodwill -
Which Accounting Standard governs the preparation of Cash Flow Statement in India?
a) AS-1
b) AS-2
c) AS-3 (Revised)
d) AS-9
Answer Key:
- c) Treasury Bill with 2 months maturity from date of acquisition
- b) Investing Activity
- a) Operating Activity
- a) Added back to Net Profit
- b) Decrease in cash flow from operating activities
- c) Payment of dividends
- b) Cash basis of accounting
- a) Operating Activity
- c) Profit on Sale of Investment
- c) AS-3 (Revised)
Study these notes carefully, focusing on the classifications and adjustments. Practice problems from your textbook to solidify your understanding. Good luck with your preparation!