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Statement of Cash Flows Chapter 12 p.1

CHAPTER 12

STATEMENT OF CASH FLOWS

QUESTIONS

1. Though the profit and loss statement provides information about an enterprise's

financial performance during a period, it does not show the cash generated through an

enterprise's operations because earnings are measured by accrual accounting. The

balance sheet provides information about an enterprise's asset and how these assets

have been financed by owned and borrowed funds at a point of time, but it does not

explain the changes during a period in assets, obligations, and owner's equity resulting

from an enterprise's activities. Therefore, a statement providing information on the

major sources of cash receipts and cash outlays is needed.

2. Cash equivalents are short-term, highly liquid investments, including Treasury bills,

certificates of deposit, commercial paper, and money market deposits.

3. The primary purpose of the statement of cash flows is to provide relevant information

about the cash receipts and cash payments of an enterprise during a period.

4. The information in the statement of cash flows will help financial statement users to

assess the amounts, timing, and uncertainty of prospective cash flows to the enterprise.

The statement of cash flows is useful to investors, lenders, analysts, and others in

assessing an enterprise's liquidity, financial flexibility, profitability, and risk. It also

provides a feedback about previous assessments of these factors.

5. Cash flows are classified into three categories: Operating, Investing, Financing

activities. Examples for each category are as follows:

Operating activities : Cash receipts from customers for sale of goods and services and

cash payments to suppliers for purchase of materials.

Investing activities: Cash receipts from collections of loans and cash payments for

disbursements of loans.

Financing activities: Proceeds from issuing equity instruments and payment of

dividends.

6. Although non cash transactions do not result in cash inflows or outflows in the period

in which they occur, they generally have a significant effect on the prospective cash

flows of a company. For example, conversion of debt to equity will eliminate payments

of interest on the debt and a finance lease obligation requires future lease payments in

cash. Therefore, information about major non cash investing and financing activities is

usually provided in a note or schedule to the statement of cash flows.

7. The direct method shows major classes of operating cash receipts and payments, such

as cash received from customers, cash paid to suppliers and employees, and income tax

p.2 Instructor's Manual to Accompany Financial Accounting: A Managerial Perspective 2/e

paid, the sum of which is net cash flow from operating activities. The indirect method

starts with net profit and adjusts it for revenue and expense items that did not involve

operating cash receipts or cash payments in the current period to arrive at net cash flow

from operating activities. Both methods result in the same figure of net cash flow from

operating activities.

8. Possible sources of the difference include: increase in debtors, increase in inventory,

gain on sale of fixed assets or investments, decrease in creditors, and decrease in bills

payable.

9. Classification of items:

a. A cash outflow from financing activities.

b. A cash inflow from investing activities.

c. A cash outflow from financing activities.

d. A cash inflow from investing activities.

e. A part of the sale price of related investments, hence a cash inflow from investing

activities, Under the indirect method, the gain is deducted from net profit.

f. Does not involve any cash flow.

g. A part of the cash outflow for redemption of debentures, hence a cash outflow

from financing activities. Under the indirect method, the gain is deducted from

net profit.

10. Adjustment of items:

a. Add to net profit.

b. Deduct from net profit.

c. Deduct from net profit.

d. Add to net profit.

e. Add to net profit.

f. Add to net profit.

11. The sale price of Rs 29,000 will appear as a cash inflow in the investing activities

section of the statement of cash flows.

12. None of a, b, and c involves any cash inflow or outflow. All of them will be shown in

the supplemental schedule of non-cash transactions.

13. Possible reasons include: increase in debtors , increase in inventory, decrease in

creditors, decrease in bills payable, net purchase of plant and machinery, net of

purchase of investments, payment of dividends, and redemption of debentures.

14. If the sum of net cash flows from investing and financing activities is negative and it

exceeds net cash flow from operating activities, it can be generally inferred that short-

term, operating cash flows have been used for long-term purposes.


EXERCISES

Exercise 12.1: Classification of Activities

a. None of the above. e. Non cash activity. i. Investing activity. m. Financing activity.

b. Financing activity. f. Financing activity. j. Operating activity,

extraordinary item.

c. Investing activity. g. Investing activity. k. Operating activity.

d. Investing activity. h. Financing activity. l. Non cash activity.

Exercise 12.2: Classification of Activities

a. None of the above. e. Operating activity. i. Non cash activity. m. Operating

activity.

b. Operating activity. f. Operating activity. j. Financing activity.

c. Non cash activity. g. None of the

above.

k. None of the

above.

d. Operating activity. h. Non cash activity. l. Non cash activity.

Exercise 12.3: Determining Net Cash Flow from Operating ActivitiesDirect Method

Praveen Company

Cash Flow from Operating Activities

For the Year Ended December 31, 20X5 Cash Flow from Operating Activities

Cash Received from Customers (1) Rs 4,74,000

Cash Paid to Suppliers and Employees (2) (2,71,000)

Income Tax Paid (3) (56,000)

Net Cash Provided by Operating Activities Rs 1,47,000

(1) (25,000 + 4,36,000 + 78,000 − 49,000 − 16,000).

(2) (2,69,000 + 61,000 − 43,000 − 7,000 + 62,000 + 51,000 + 3,000 − 67,000 − 39,000 −

19,000).

(3) (53,000 + 14,000 − 11,000).

Exercise 12.4: Determining Net Cash Flow from Operating ActivitiesIndirect Method

Ajay Company



Net Profit Rs 3,40,000

Adjustments to Reconcile Net profit to Cash Flow from

Operating Activities

Depreciation Expense 49,000

Gain on Sale of Investments (8,000)

Decrease in Inventory 13,000

Increase in Debtors (33,000)


Increase in Prepaid Expenses (11,000)

Increase in Creditors 4,000

Decrease in Income Tax Payable (6,000)

Total Adjustments 8,000

Net Cash Provided by Operating Activities 3,48,000

Exercise 12.5: Determining Net Cash Flow from operating ActivitiesDirect Method

Abhijit Company






Net Cash Provided by Operating Activities Rs 70,000

(1) (7,29,000 + 92,000 − 97,000 − 4,000).

(2) (4,85,000 + 56,000 − 45,000 − 29,000 + 68,000 + 81,000 + 74,000 + 21,000 − 57,000 −

41,000 − 15,000).

(3) (67,000 + 33,000 − 48,000).

Exercise 12.6: Determining Net Cash Flow from Operating ActivitiesIndirect Method

Dutt Company



Net Profit Rs 89,000

Adjustments to Reconcile Net Profit to Cash Flow from


Depreciation Expense Rs 67,000

Provision for Doubtful Debts 15,000


Dividend from Subsidiaries (3,000)

Loss on Sale of Plant & Machinery 8,000

Increase in Inventory (14,000)




Interest Income (9,000)

Interest Expense 11,000

Decrease in Bills Payable (44,000)



Net Cash Provided by Operating Activities 91,000


Exercise 12.7: Determining Net Cash Flow from Investing Activities

Haveli Company


For the Year Ended March 31, 20X7 Cash Flow from Investing Activities

a. Purchase of Investments Rs (65,000)

b. Proceeds from Sale of Investments 34,000

c. Purchase of Plant & Machinery (1,58,000)

d. Construction of Building (78,000)

e. Proceeds from Sale of Plant and Machinery 52,000

Net Cash Used in Investing Activities Rs (2,15,000)

Exercise 12.8: Determining Net Cash Flow from Financing Activities

Supra Corporation


For the Year Ended November 30, 20X9 Cash Flow from Financing Activities

a. Dividend Paid Rs (12,000)

b. Redemption of Secured Debentures (47,000)

c. Payment of Unsecured Loans (21,000)

d. Proceeds from Issuance of Secured Convertible

Debentures

1,70,000

Net Cash Provided by Financing Activities Rs 90,000

Item e is a non cash transaction to be shown in a supplement schedule.

Exercise 12.9: Preparing the Statement of Cash Flows

Sikandar Company

Statement of Cash Flows

For the Year Ended March 31, 20X4 Cash Flow from Operating Activities





Cash Flow from Investing Activities

Purchase of Investments Rs (1,87,000)

Proceeds from Sale of Plant and Machinery 41,000

Proceeds from Sale of Patents 4,000

Purchase of Investments (23,000)

Proceeds from Sale of Investments 42,000

Interest Received 8,000

Net Cash Used in Investing Activities (1,15,000)

Cash Flow from Financing Activities

Proceeds from Issuance of Share Capital Rs 75,000


Dividend Paid (45,000)

Interest Paid (18,000)

Net Cash Provided by Financing Activities 12,000

Net Decrease in Cash and Cash Equivalents (26,000)

Cash and Cash Equivalent at Beginning of Period 70,000

Cash and Cash Equivalents at End of Period 44,000

(1) 9,73,000 + 1,56,000 − 2,09,000 = 9,20,000

(2) 6,85,000 + 53,000 − 49,000 − 14,000 + 194,000 + 15,000 + 1,06,000 + 12,000 − 1,98,000

− 29,000 = 7,75,000

(3) 67,000 + 7,000 − 6,000 = 68,000

PROBLEM SET A

Problem A-1: Classification of Activities

a. Operating activity. g. Non cash activity. m. Investing activity. s. Operating activity.

b. Investing activity. h. Operating activity. n. Operating activity. t. Operating activity.

c. Investing activity. i. Investing activity. o. Investing activity. u. Operating activity.

d. Investing activity. j. None of the

above.

p. Non cash activity.

e. Non cash activity. k. Investing activity. q. Investing activity.

f. Financing activity. l. None of the

above.

r. Financing activity.

Problem A-2: Cash Flow from Operating Activities

1. Cash Flow from Operating Activities-Direct Method

Gopal Dairy Company


For the Year Ended September 30, 20X7 Cash Flow from Operating Activities





(1) (2,71,000 − 12,000 − 2,000).

(2) (1,86,000 + 19,000 − 9,000 + 7,000 − 4,000).

(3) (8,000 − 3,000).


2. Cash Flow from Operating Activities-Indirect Method

Gopal Dairy Company


For the Year Ended September 30, 20X7 Cash Flow from Operating Activities

Net Profit Rs 7,000

Adjustments to Reconcile Net profit to Cash Flow from





Loss on Sale of Plant and Equipment 2,000



Decrease in Creditors (7,000)



Increase in Income Tax Payable 3,000



Problem A-3: Cash Flow from Operating Activities


Vijaya Company


For the Year Ended August 31, 20X3 Cash Flow from operating Activities



Income Tax Paid (3 (53,000)

Net Cash Provided by Operating Activities Rs

1,50,000

(1) (9,28,000 + 46,000 − 7,000).

(2) (8,12,000 + 43,000 + 73,000 − 59,000 − 87,000 − 18,000).

(3) (39,000 + 14,000).



Vijaya Company


For the Year Ended August 31, 20X3 Cash Flow from Operating Activities






Gain on Sale of Plant (11,000)

Loss on Sale of Investments 8,000


Decrease in Debtors 39,000


Interest Received (32,000)

Interest Paid 10,000




Problem A-4: Preparing and Interpreting the Statement of Cash Flows

1. Statement Cash Flows-Direct Method

Pioma Plastics Company


For the Year Ended April 30, 20X3 Cash Flow from Operating Activities

Cash Received from Customers (a) Rs 6,46,000

Cash Paid to Suppliers and Employees (b) (8,51,000)

Income Tax Paid (c) (1,16,000)

Insurance Proceeds Received 76,000

Net Cash Used in Operating Activities Rs (2,45,000)


Purchase of Plant and Machinery Rs (53,000)


Proceeds from Sale of Land 1,33,000


Dividend Received 20,000

Net Cash Provided by Investing Activities 1,73,000





Proceeds from Issuance of Secured Debentures 6,000

Proceeds from Issuance of Unsecured Loans 48,000




Cash and Cash equivalent at Beginning of Period 1,33,000


Supplemental Schedule of Non-cash Investing and Financing Activities: During the year, the

company purchased machinery for Rs 78,000 in exchange for secured debentures.

(a) (7,58,000 + 1,18,000 − 2,16,000 − 14,000)

(b) 5,37,000 + 1,23,000 − 93,000 − 11,000 + 63,000 + 1,47,000 + 1,65,000 + 8,000 − 19,000

− 11,000 − 38,000 − 20,000

(c) (98,000 + 41,000 − 23,000)

2. Statement of Cash FlowsIndirect Method

Pioma Plastics Company


For the Year Ended April 30, 20X3 Cash Flow from Operating Activities

Net Profit Rs 1,18,000





Gain on Sale of Land (63,000)

Loss on Sale of Plant 38,000


Increase in Debtors (1,12,000)

Decrease in Creditors (1,36,000)


Dividend Income (20,000)


Decrease in Prepaid Expenses 3,000

Decrease in Bills Payable (44,000)


Total Adjustments 3,63,000

Net Cash Used in Operating Activities (2,45,000)

Cash flows from Investing Activities



Proceeds from Sale of Land 1,33,000



Net Cash Provided by Investing Activities 1,73,000










Cash and Cash Equivalent at Beginning of Period 1,33,000



company purchased machinery for Rs 78,000 in exchange for secured debentures.

3. The statement of cash flows reveals a net cash outflow from operations of Rs 2,45,000,

where as the profit and loss account shows a net profit of Rs 1,18,000. Sharp increases in

debtors and inventory, coupled with sharp decreases in creditors and bills payable,

contributed to the cash deficit from operations. Further, a net gain of Rs 25,000 from

disposal of assets appears in the profit and loss account, but is excluded from cash flows

from operating activities in the statement of cash flows. There is a net inflow of Rs

1,95,000 from investing and financing operating activities. In sum, Pioma Plastics

Company used more cash in operations than all of the cash it received from its investing

and financing activities, resulting in a net decrease in cash.

Problem A-5: Preparing and Interpreting the Statement of Cash Flows

1. Statement Cash FlowsDirect Method

Arun Music Company


For the Year Ended October 31, 20X5 Cash Flow from Operating Activities



Income Tax Paid (c) (29,000)

Net Cash Used in Operating Activities Rs 5,000


Purchase of Plant and Machinery Rs (1,99,000)






Net Cash Used in Investing Activities (42,000)



Redemption of Secured Debentures (6,000)

Repayment of Unsecured Loans (41,000)








company purchased machinery for Rs 55,000 on long-term, unsecured credit.

(a) (9,27,000 + 61,000 − 1,27,000 − 21,000)

(b) (7,51,000 + 1,45,000 − 1,64,000 − 15,000 + 27,000 + 21,000 + 2,13,000 + 24,000 −

39,000 − 64,000 − 61,000 − 32,000

(c) (19,000 + 19,000 − 9,000)


Arun Music Company


For the Year Ended October 31, 20X5 Cash Flow from Operating Activities






Gain on Sale of Plant (23,000)








Increase in Bills Payable 12,000



Total Adjustments (24,000)

Net Cash Used in Operating Activities 5,000





















3. The statement of cash flows reveals a net cash inflow from operations of Rs 5,000,

whereas the profit and loss account shows a net profit of Rs 29,000. There were sizeable

additions to debtors and inventory, but creditors and bills payable decreased. Further, a

gain of Rs 9,000 (net) from disposal of assets appears in the profit and loss account, but is

excluded from cash flows. The outflow of Rs 42,000 from investing and financing

activities exceeded the net inflow from operating activities. In sum, Arun Music Company

used more cash in its investing activities than all of the cash it received from its operating

and financing activities, resulting in a decrease in cash.

PROBLEM SET B

Problem B-1: Classification of Activities

a. Operating activity. g. None of the

above.

m. None of the

above.

s. Financing activity.

b. Operating activity. h. Investing activity. n. Investing activity. t. Investing activity.

c. Non-cash activity. i. Non-cash activity. o. Non-cash activity. u. Investing activity.

d. Operating activity. j. Investing activity. p. Financing activity.

e. Financing activity. k. Financing activity. q. None of the

above.

f. Financing activity. l. Non-cash activity. r. Operating activity.

Problem B-2: Cash Flows from Operating Activities

1. Cash Flows from Operating ActivitiesDirect Method

Shamsher Leather Company


For the Year Ended July 31, 20X8 Cash Flow from Operating Activities




Net Cash Provided by Operating Activities Rs 1,22,000

(1) (7,69,000 + 23,000 − 3,000).

(2) (5,83,000 + 27,000 + 15,000 + 16,000 − 7,000).

(3) (28,000 + 5,000).


2. Cash Flow from Operating ActivitiesIndirect Method

Shamsher Leather Company








Gain on Sale of Plant and Equipment (8,000)



Decrease in Debtors 20,000





Decrease in Income Tax Payable (5000)



Problem B-3: Cash Flow from Operating Activities


Saleem Steel Company


For the Year Ended November 30, 20X9 Cash Flow from Operating Activities





(1) (9,69,000 − 1,41,000 − 11,000)

(2) (7,69,000 + 55,000 − 1,18,000 + 49,000 + 1,53,000 − 1,34,000 − 13,000)

(3) (76,000 − 29,000)



Saleem Steel Company


For the Year Ended November 30, 20X9 Net Profit Rs 1,61,000



Depreciation Expense Rs 1,34,000


Loss of Sale of Trademarks 72,000


Decrease in Inventory 1,18,000

Increase in Debtors (1,52,000)


Decrease in Creditors (1,53,000)


Interest Expense (23,000)

Increase in Income Tax Payable 29,000

Total Adjustments (1,52,000)


Problem B-4: Preparing and Interpreting the Statement of Cash Flows


Vinay Electronics Company






Insurance Proceeds Received 17,000



Purchase of Plant and Machinery (1,39,000)








Proceeds from Issuance of Share Capital 20,000


Proceeds from Issuance of Secured Debentures 1,50,000

Proceeds from Issuance of Unsecured Loans 1,10,000




Net Cash Provided by Financing Activities 1,78,000

Net Increase in Cash and Cash Equivalents 1,28,000

Cash and Cash equivalent at Beginning of Period 33,000

Cash and Cash Equivalents at End of Period 1,61,000



(a) (4,39,000 + 1,04,000 − 1,54,000 − 16,000)

(b) (3,84,000 + 75,000 − 1,37,000 − 16,000 + 15,000 + 1,12,000 + 79,000 + 19,000 − 47,000

− 71,000 − 21,000 − 22,000).

(c) ( 20,000 − 5,000).


Vinay Electronics Company



Net Profit Rs (48,000)






Loss on Sale of Patent 26,000




Increase in Bills Payable 32,000







Net Cash Used in Operating Activities 5,000














Proceeds from Issuance of Unsecured Loans 1,10,000




Net Increase in Cash and Cash Equivalents 1,28,000





3. The statement of cash flows reveals a net cash inflow from operations of Rs 5,000, though

the profit and loss account shows a net loss of Rs 48,000. It is strange for the company to

experience an increase in cash. But a careful analysis of the statement of cash flows shows

that cash increased as a result of the issuance of share capital, secured debentures and

unsecured loans, which together resulted in an inflow of Rs 2,42,000, net of loan payments.

When the net outflow of Rs 55,000 from investing activities is deducted, there is still a net

inflow of Rs 1,23,000. After considering the net inflow from operating activities of Rs

5,000, there is a net increase in cash of Rs 1,28,000. Thus, it is clear that the increase in

cash is due to issuance of equity and debt during the period.

Problem B-5: Preparing and Interpreting the Statement of Cash Flows


Cochin Marine Foods Company


For the Year Ended November 30, 20X7 Cash Flow from Operating Activities




Net Cash Used in Operating Activities Rs (71,000)


Purchase of Plant and Machinery (33,000)





Net Cash Provided by Investing Activities 34,000









Net Increase in Cash and Cash Equivalents 78,000



(a) (8,58,000 + 65,000 − 93,000).

(b) (8,61,000 + 1,12,000 − 71,000 − 12,000 + 86,000 + 76,000 + 5,000 − 1,18,000 − 45,000).

(c) (8,000 − 1,000).


Cochin Marine Foods Company


For the Year Ended November 30, 20X7 Net Profit Rs (1,56,000)





Loss on Sale of Plant and Machinery 11,000



Decrease in Prepaid Expenses 7,000







Net Cash Used in Operating Activities (71,000)







Net Cash Used in Investing Activities 34,000












3. The statement of cash flows reveals a net cash outflow from operations of Rs 71,000 and

the profit and loss account shows a net loss of Rs 1,56,000. It is strange for the company to

experience an increase in cash. But a careful analysis of the statement of cash flows shows

that cash increased as a result of the issuance of share capital, secured debentures and

unsecured loans, which together resulted in an inflow of Rs 1,62,000. The net outflow from

operating activities totalled Rs 71,000. After considering the net inflow from investing

activities of Rs 34,000, there is a net increase in cash of Rs 78,000. It is clear that the

increase in cash is due to the issuance of equity and debt during the period.

Business Decision Cases

I. RELIANCE STATIONERY COMPANY

Teaching Notes

Case Setting and Objectives

This case involves preparation of a statement of cash flows in a standard format and

interpreting the statement. The focus of the case is that an increase in cash at the year-end

does not imply that the operations are profitable.

Suggested Solution

1.

Reliance Stationery Company


For the year Ended March 31, 20X4 Cash Flow from Operating Activities

Cash Received from Customers Rs 2,89,600

Cash Paid to Suppliers and Employees (a) (2,74,400)



Purchase of Fixtures and Office Equipment (2,72,000)




Net Cash Used in Investing Activities (2,69,600)


Proceeds from Issuance of Share Capital 3,52,000


Repayment of Loans (8,000)



Supplemental Schedule of Non-cash Investing and Financing Activities: The company

purchased a delivery van for Rs 24,000 on long-term credit.


(a) (2,02,400 + 1,28,000 − 56,000)

2. The statement of cash flows shows that there is a net cash inflow of Rs 15,200 from

operations. The net cash outflow from investing activities of Rs 2,69,600 resulted mainly

from the purchase of fixtures and office equipment. The purchase was paid for from the

proceeds from issuance of share capital. The net increase in cash of Rs 87,200 comes

mainly from two sources: from operations and from issuance of share capital. The

operations of Reliance Stationery Company in the first year are profitable and the earnings

are represented in cash. But this does not mean that the increase in cash of Rs 87,200 came

entirely by way of cash flow from operating activities.

Therefore, Uday's assessment that the Reliance Stationery Company had a successful first

year is probably correct, although his assumption that all of the increase in cash came from

the company's operations is not correct.

II. ANTARIKSH MATERIALS COMPANY

Teaching Notes


This case illustrates the interpretation and use of the statement of cash flows in a lending

context.

1.

Antariksh Materials Company


For the year Ended June 30, 20X8 (in thousands) Cash Flow from Operating Activities



Income Tax Paid (c) (4,30,00)

Net Cash Used in Operating Activities Rs (4,08,25)



Net Cash Provided by Investing Activities 21,00



Dividend Paid (3,12,75)





Net Decrease in Cash and Cash Equivalents 2,20,00

Cash and Cash Equivalents at the Beginning of the Period 2,90,00

Cash and Cash Equivalents at the End of the Period 70,00


(1) (29,00,00 + 5,40,00 − 9,54,25)

(2) (16,78,00 + 2,05,00 − 8,50,00 − 80,00 + 1,80,00 + 15,30,00 + 11,00 − 1,20,00 − 90,00)

(3) (4,20,00 + 50,00 − 40,00)

Supplemental Schedule of Non-cash Investing and Financing Activities: The company

purchased a plant costing Rs 1,90,00,000 in exchange for equity shares.

2. From the statement of cash flows, Antariksh Materials Company had a net outflow of Rs

4,08,25,000 from operating activities. In other words, the company did not generate any

cash from operations. Even then the company paid dividends of Rs 3,12,75,000 during the

period.

3. Though the Antariksh Materials Company earned a net profit of Rs 5,75,00,000 during the

year ended June 30, 20X8, it lost cash of Rs 4,08,25,000 in its operations during the period.

A study of the statement of cash flows shows that this resulted mainly from the large

additions to inventory (Rs 6,80,00,000) and debtors (Rs 4,14,25,000). In spite of losing

cash in operations, the company went ahead with paying a dividend of Rs 3,12,75,000,

adding to its cash flow problems. It is clear from the statement of cash flows that the

dividend could not have been disbursed had the company not borrowed cash to pay

dividends. This is imprudent because dividends are supposed to be paid from profits

represented by cash. What the company has done can be labelled as bad financial

management.

Coming to the company's investment plans, it needs about Rs 10 crore. If its performance

during the year ended June 30, 20X8 is any indication, the company is unlikely to generate

significant positive cash flow from operations in 20X9. Therefore, the entire finance will

have to come from borrowings (at this time, the prospects for an equity issue do not seem

to be too bright). Even though its current level of borrowings is not unreasonable, the

company may not be much successful in raising additional loans if it continues to lose cash

in its operations. Also, the planned expansion in operations will require additional working

capital.

In these circumstances, the company's investments plans appear to be over ambitious, What

the company needs to do first is to manage its inventory and debtors more efficiently by

reviewing its policies and practices in these areas. A bank lending officer will not be

justified in recommending the loan at this stage.

Interpreting Financial Reports

I. NATIONAL THERMAL POWER CORPORATION

Teaching Notes


This case looks at a certain action taken by a power generation company to collect the

amounts receivable from its customer, a state electricity board (SEB) that has had difficulty

in paying its dues on time. The case examines whether the action would have the expected


results for NTPC. The case is significant in the context of the current debate on reforming the

energy industry in India.

The case illustrates accounting practices purely for the purpose of classroom discussions and

should not be taken as a judgement on the practices followed by the organisations that are

featured in the case.

Suggested Solution

1. The swap of the power plant for unpaid bills reduces the total dues of NTPC, as the

following entry shows:

Plant and Machinery (Power plant) 546,00,00,000

Debtors 546,00,00,000

2. The swap will not be reflected in NTPC's statement of cash flows because it does not

involve cash receipt. However, NTPC might like to mention the deal in the supplemental

schedule.

One effect of the plant-for-dues swap is the loss of cash inflow from UPSEB that might

have paid at least a part of the dues in the near future. Of course, NTPC could be assumed

to have considered the probability of that happening before agreeing to the deal. Also,

NTPC will end up paying the fuel, salaries and other expenses of the plant after it has been

taken over. But the electricity generated by the plant will have to be sold to the UPSEB for

logistical as well as political reasons. It is not clear how the UPSEB plans to pay for the

additional electricity purchased from NTPC, particularly when it has not been able to pay

for its existing purchases. It is likely that the deal will not improve NTPC's cash flow and

will end up further straining its cash flow. Furthermore, other SEBs may come up with

offers of plant-for-dues swap and NTPC would be stuck with uneconomical and inefficient

power plants and a workforce that does not meet NTPC's expectations, while being unable

to recover current and incremental dues for a long time to come. Eventually, NTPC could

very well end up in the unenviable position of having to face the problems that affect the

functioning of SEBs. In other words, the deal will spread to NTPC the malaise that affects

SEBs rather than solve it.

3. NTPC's main problem was that it was not able to collect its receivables from SEBs. Much

of the billings ended up increasing the year-end balance of debtors rather than getting

converted into cash. As a result, there was a wide gap between its accrual-based profit and

cash flow from operating activities.

NTPC has the following options:

i. Stop sale of power to defaulting SEBs and redirect the power to the SEBs that pay on

time. This may not be feasible for logistical as well as political reasons.

ii. Insist on advance payments or a revolving letter of credit from defaulting SEBs.

iii. Sell or securitise its receivables at a discount, likely to be considerable.

iv. Employ collection agents. This may not help much because the problem of non-payment

has to do with the SEBs' inability, not reluctance, to pay.


v. Ask the Central Government to divert its Plan allocations to the States concerned to

NTPC in settlement of the dues of the SEBs of the respective States.

The ICAI's AS 9 Revenue Recognition states that it may be more appropriate to recognise

revenue only when it is reasonably certain that the ultimate collection will be made. In the

case of SEBs' dues while there is no uncertainty about the ultimate collection of the amounts

because the SEBs are government organisations and will eventually pay, considerable delay

is likely given the financial position of these organisations. So the question whether NTPC

was proper in recognising the dues as revenues cannot be answered categorically.

II. STEEL AUTHORITY OF INDIA LIMITED

Teaching Notes


This case examines the reconciliation of net profit and cash flow from operating activities.

Many users of financial statements are puzzled when a company reports a loss, yet has a

positive cash flow from operating activities. By reviewing on the fundamentals of accrual

accounting and the cash flow statement, this case can help in understanding how such a

situation is not impossible. The items that explain the difference between the two can tell us a

lot about a company’s earnings quality. Also, the cash flow statement can provide insights

into how a company manages its finances.

The case illustrates accounting practices purely for the purpose of classroom discussions and

should not be taken as a judgement on the practices followed by the organisations that are

featured in the case.

Suggested Solution

1. It is possible for an enterprise to have a positive cash flow from operating activities despite

a net loss. The difference can be due to one or more of the following reasons (amounts are in

crores of rupees):

�� Net profit or net loss is calculated using accrual accounting, whereas cash flow from

operating activities is determined on the cash receipts and cash payments. Some

accrual items, such as depreciation expense, do not involve cash flow. SAIL has the

following non-cash items:

o depreciation, Rs 1164.12;

o provision for diminution in value of assets, Rs 0.02;

o bad debt expenses written off, Rs 7.08;

o deferred revenue expenditure, Rs 232.54.

�� Items of gains and losses that do not pertain to operating activities are excluded from

net profit or net loss to determine cash flow from operating activities. An example is

profit on sale of assets. SAIL has the following items of this kind:


o profit on sale of fixed assets, Rs 662.47;

o interest expenses, Rs 1562.03;

o interest income, Rs 105.30;

o dividend income, Rs 5.74.

�� Cash flow from operating activities is determined after adjusting net profit or net loss

for changes in current assets and current liabilities. For example, increase in

inventories does not affect the profit and loss account in accordance but it is treated as

a cash flow. In the case of SAIL, we find the following items:

o decrease in inventories, Rs 477.16;

o decrease in debtors, Rs 291.10;

o decrease in loans and advances, Rs 138.53;

o increase in current liabilities and provisions, Rs 132.96;

o deferred charges incurred during the year but not expensed, Rs 438.20;

2. The company's cash came from operating activities and, to a lesser extent, reduction of

cash and cash equivalents. The major uses of cash were payment of interest and finance

charges and repayment of borrowings. There was net inflow from investing activities which

suggests that the company sold more assets than it acquired. While the company incurred a

net loss in 2001-2002, it managed pay its obligations. The high level of borrowings was

responsible for the huge interest payment which hurt the company in a bad year. This raises

the question whether the company had excessive debt. Also, we should remember that the

steel industry is cyclical and this year might have been the bottom of the cycle. To confirm

this we should look at the performance of other steel companies in the year. In part, the

company managed its problem by selling of (conceivably excess or spare) assets.

3. From the profit and loss account and the cash flow statement, it appears that there were

many one-time or non operating items that raise questions about the company's quality of

earnings. These include the following:

o profit on sale of fixed assets, Rs 662.47 that is much higher than in the previous

year (this item is probably included in other revenues in the profit and loss

account);

o provision no longer required written back that is higher than in the previous year;

o a large addition to deferred revenue expenditure that is carried on the balance

sheet.

Download - Solman 12 Second Ed

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