Prepare a statement of cash flows for a single entity

Introduction: Why Cash is King!

Welcome to one of the most practical chapters in your Financial Accounting studies! So far, you have learned how to prepare a Statement of Profit or Loss and a Statement of Financial Position. But have you ever wondered: "How can a company show a huge profit but still have no money in the bank?"

That is exactly why we need the Statement of Cash Flows. While profit is based on "accounting rules" (accruals), cash is real. In this chapter, we will learn how to track every dollar entering and leaving a single entity. Don't worry if this seems tricky at first; we will break it down into three simple "buckets" of activity!

1. What Exactly is "Cash"?

Before we build the statement, we need to know what counts as "Cash and Cash Equivalents" under HKAS 7 Statement of Cash Flows.

Cash vs. Cash Equivalents

• Cash: This is the easy part! It includes cash on hand (physical notes) and demand deposits (your bank account).
• Cash Equivalents: These are short-term, highly liquid investments that are "as good as cash." To qualify, they must be easily convertible to known amounts of cash and have a very low risk of changes in value. Usually, an investment with a maturity of three months or less from the date of acquisition counts.

Quick Review: If a company buys a 10-year government bond, it is not a cash equivalent. If they buy a 2-month Treasury Bill, it is!

2. The Three "Buckets" of Cash Flow

To make the statement organized, HKAS 7 requires us to group every cash movement into one of three categories. Think of these as the three main stories a business tells about its money:

A. Operating Activities (The "Heartbeat")

These are the day-to-day activities that produce revenue. If you run a bakery, selling bread and paying for flour are operating activities. This is the most important section because it shows if the business can generate enough cash to stay alive without borrowing money.

B. Investing Activities (The "Future")

These relate to the acquisition and disposal of long-term assets (like machinery, buildings, or vehicles) and other investments not included in cash equivalents. When you buy a new oven for your bakery, cash goes out. When you sell an old delivery van, cash comes in.

C. Financing Activities (The "Funding")

These are activities that change the size and composition of the contributed equity and borrowings. This is where the company gets its capital. Examples include issuing shares, taking out a bank loan, or paying back a loan principal.

Key Takeaway: Every single cash transaction must fit into one of these three buckets. If you aren't sure where it goes, ask yourself: Is this day-to-day (Operating), for the long-term (Investing), or about funding the business (Financing)?

3. Preparing Operating Cash Flows: The Indirect Method

In the HKICPA QP Associate Level, you will most commonly use the Indirect Method. Instead of listing every single cash sale, we start with the Profit Before Tax and "clean it up" to find the cash.

Think of it like this: Profit is "dirty" because it contains non-cash items (like depreciation). We need to filter those out to find the "pure" cash.

Step 1: Adjust for Non-Cash Items

We add back expenses that didn't actually involve cash leaving the bank, and subtract income that didn't involve cash coming in.

• Depreciation: Add this back! It’s an expense in the profit or loss, but no one wrote a check for "depreciation."
• Loss on sale of assets: Add back. (The actual cash from the sale goes in the Investing section).
• Gain on sale of assets: Deduct this.

Step 2: Adjust for Working Capital Changes

This is where students often get confused. Use this simple "Toy Store" analogy:

• Inventory: If your inventory increases, it means you spent cash to buy more toys. So, an increase in assets = cash outflow (subtract).
• Receivables: If your customers owe you more money than last year, you haven't collected that cash yet. So, an increase in assets = cash outflow (subtract).
• Payables: If you owe your suppliers more money, you are "holding onto" your cash longer. So, an increase in liabilities = cash inflow (add).

Memory Aid:
Asset UP \(\uparrow\) = Cash DOWN \(\downarrow\)
Liability UP \(\uparrow\) = Cash UP \(\uparrow\)

Step 3: Interest and Taxes

Finally, we subtract the actual Interest Paid and Tax Paid in cash during the year. Note: The "Tax Expense" in the profit or loss is usually different from the "Tax Paid" in the cash flow statement!

4. Investing and Financing: The Straightforward Parts

These sections are generally simpler because we only look at the actual cash movements.

Investing Activities Checklist:

• (Minus) Cash paid to buy Property, Plant, and Equipment (PPE).
• (Plus) Cash received from selling PPE.
• (Plus) Interest or Dividends received from investments.

Financing Activities Checklist:

• (Plus) Cash received from issuing new shares.
• (Plus) Cash received from taking a new bank loan.
• (Minus) Repayment of loan principal.
• (Minus) Dividends paid to shareholders.

Common Mistake to Avoid: Do not include the depreciation of a machine in the Investing section. Only include the purchase price or sale proceeds of the machine!

5. Bringing it All Together: The Final Reconciliation

Once you have the totals for the three sections, you sum them up to get the Net Increase or Decrease in Cash.

The Golden Rule:
\( \text{Net Increase/Decrease} + \text{Cash at Beginning of Year} = \text{Cash at End of Year} \)

The "Cash at End of Year" figure must match exactly with the Cash and Cash Equivalents shown on your Statement of Financial Position. If it matches, you’ve likely done it correctly! 🎉

Summary: Quick Review Box

1. Operating: Start with Profit Before Tax \(\rightarrow\) Add back Depreciation \(\rightarrow\) Adjust for Working Capital \(\rightarrow\) Deduct Tax Paid.
2. Investing: Focus on Non-Current Assets (Buying/Selling).
3. Financing: Focus on Equity and Loans (Raising money/Paying it back).
4. Interest/Dividends: Interest Paid is usually Financing; Interest Received is usually Investing. (HKAS 7 allows some flexibility, but stick to the entity's policy consistently).

Don't worry if your first few attempts don't balance. Cash flow statements take practice! Focus on categorizing the items correctly first, and the math will follow.