Unit III

Financial Accounting Policies and Statements - II

Meaning and Concept of ‘Flow of Funds’:
The term ‘flow’ means movement and includes both ‘inflow’ and ‘outflow’. The term ‘flow of
funds’ means transfer of economic values from one asset of equity to another. Flow of funds is
said to have taken place when any transaction makes changes in the amount of funds available
before happening of the transaction.
If the effect of transaction results in the increase of funds, it is called a source of funds and if it
results in the decrease of funds, it is known as an application of funds. Further, in case the
transaction does not change funds, it is said to have not resulted in the flow of funds.
According to the working capital concept of funds, the term ‘flow of funds’ refers to the
movement of funds in the working capital. If any transaction results in the increase in working
capital, it is said to be a source or inflow of funds and if it results in the decrease of working
capital, it is said to be an application or out-flow of funds.
The flow of funds occurs when a transaction changes on the one hand a non-current account and
on the other a current account and vice-versa. When a change in a non-current account e.g., fixed
assets, long-term liabilities, reserves and surplus, fictitious assets, etc., is followed by a change in
another non-current account, it does not amount to flow of funds. This is because of the fact that
in such cases neither the working capital increases nor decreases. Similarly, when a change in
one current account results in a change in another current account, it does not affect funds. Funds
move from non-current to current transactions or vice-versa only.
In simple language funds move when a transaction affects:
(i) A current asset and a fixed asset, or
(ii) A fixed and a current liability, or
(iii) A current asset and a fixed liability, or
(iv) A fixed liability and current liability;
And funds do not move when the transaction affects fixed assets and fixed liability or
current assets and current liabilities.
General Rules for Preparing Funds Flow Statement:
The following general rules should be observed while preparing funds flow statement:
1. Increase in a current asset means increase (plus) in working capital.
2. Decrease in a current asset means decrease (minus) in working capital.
3. Increase in a current liability means decrease (minus) in working capital.
4. Decrease in a current liability means increase (plus) in working capital.
5. Increase in current asset and increase in current liability does not affect working capital.
6. Decrease in current asset and decrease in current liability does not affect working capital.
7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working
capital.
Current and non-current account
● Current assets are short-term assets that a company expects to liquidate and spend in one
year or less, while non-current assets are long-term investments that aren’t easy to
liquidate and have an expected life of more than a year.
● Examples of current assets include cash, cash equivalents and accounts receivable, and
examples of non-current assets include long-term investments, intangible assets and fixed
assets.
● Current and non-current assets differ in their lifespans, function, liquidity, depreciation
and their location on the balance sheet.
Examples of non-current assets?
Non-current assets can be both “tangible” and “intangible.” Tangible non-current assets are the
physical property, plant, and equipment that the business owns. They are the main form of assets
in most industries and include:
● Buildings
● Land
● Machinery
● Vehicles (company cars, trucks, forklifts)
● Tools
● Computer equipment
Intangible non-current assets are things that your business holds that do not have a physical form.
They provide value to your business but it can be difficult to convert them into cash. For
example:
● Trademarks
● Patents
● Long-term investments
● Goodwill
● Brand recognition
 ● Customer lists
Even licenses and permits fall into the category of intangible non-current assets. 
Examples of current assets?
You can also split current assets into two subgroups: “liquid” and “more liquid.”Your business
can convert liquid current assets into cash within a period of 90 days to one year. Examples
include:
● Inventory
● Prepaid expenses
● Accounts receivable (more than 90 days)
● Short-term investments
Assets that you can convert into cash in less than 90 days are known as more liquid current
assets. Examples are:
● Cash and cash balances
● Bank deposits
● Accounts receivable (within 90 days) 
The most liquid asset in your business is cash in hand. That’s followed closely by money that
you can withdraw from your business’s bank account.   
Key Differences
● Current assets are equivalent to cash or will get converted into cash within a time frame
of one year. Non-current assets or long-term assets are those assets that will not get
converted into cash within one year and are non-current.
● The list of current assets includes cash and cash equivalents, short-term investments,
accounts receivables, inventories, and prepaid revenue. The list of non-current assets
includes long-term investments, plant property and equipment, goodwill, accumulated
depreciation and amortization, and long term deferred taxes.
● Current assets, when sold, are considered as trading profits and are subject to corporate
tax. On the other hand, whenever long term assets are sold, that is regarded as capital
gain, and capital gain tax is applicable in that case.
● Current assets are not subject to revaluation in general. Only in some cases may
inventories be subject to revaluation. Long-term assets, like PP&E, need to be revalued
by the company. Whenever the market value of a tangible asset decreases compared to
the book value of that asset. The company needs to revalue that assets book value and the
difference is reported as a loss in the income statement for that period.
 Comparative Table

Basis Current assets Non-current assets

Current assets are equivalent to cash or will Noncurrent assets are those assets that will not get
Definition get converted into cash within a time frame converted into cash within one year and are
of one year. noncurrent.

Currents assets include line items like cash Noncurrent assets include long term investments,
and cash equivalents, short term plant property and equipment, goodwill,
Items
investments, accounts receivables, accumulated depreciation and amortization, and
inventories, and prepaid revenue. long term deferred taxes assets.

Current assets are the short term resources of These assets are the long term resources to run the
Nature
a company. business.

Long term assets are valued in the balance at

Generally, current assets are valued in the acquisition cost less accumulated depreciation. For
Valuation
balance sheet at market prices. intangible assets, they are valued at cost less
depreciation.

Noncurrent assets can be further subdivided into

tangible assets and intangible assets. A
Goodwill Not part of current assets
most popular intangible asset is goodwill, which
is created through acquisition.

Tax The selling of the current assets results in a Selling the long-term assets results in capital gains,
implications profit from trading activities and capital gain tax is applicable in such a case.

Revaluation of PP&E is very common in the case

Current assets are not generally subject to of long-term assets. Whenever the market value of
Revaluation revaluation; only in some cases may a tangible asset decreases compared to the book
inventories be subject to revaluation. value of that asset. The company needs to revalue
that asset’s book value and the difference in
Basis Current assets Non-current assets

reported a loss in the income statement for that

period.

Conclusion
Assets are the resources required by a company to run and grow its business. Long-term assets
are required for long-term business purposes like land equipment and machinery, which are
needed for long-term business—current and noncurrent assets combined to form the total assets
required by a company.

Statement of Changes in Working Capital

A statement of changes in working capital is prepared by recording changes in current
assets and current liabilities during the accounting period.
Working capital during this period is bound to change due to an increase or decrease in the
current assets and current liabilities.
Purpose of Preparing the Statement
A statement of changes in working capital is prepared to measure the increase or decrease in the
individual items of current assets and current liabilities. It also shows the net increase or decrease
in the working capital during the accounting period.
A convenient format is used to depict the changes in working capital, as shown below.
Format of a Statement of Changes in Working Capital
Before preparing a statement of changes in working capital, the following important notes should
be borne in mind:
1. An increase in current assets and a decrease in current liabilities increases working
capital.
2. A decrease in current assets and an increase in current liabilities decreases working
capital.

Funds from Operations

Funds from operations is the cash flows generated by the operations of a business, usually a real
estate investment trust (REIT). This measure is commonly used to judge the operational
performance of REITs, especially in regard to investing in them.
While cash flow denotes the amount of cash that is coming in and out of business, FFO
represents a specific approach to determine the total monetary amount a business generates,
exclusive to Real Estate Investment Trusts (REITs).
What is FFO?
FFO is the cash flow generated by a company through its business operations. When you reduce
expenses from revenues, you get net profit. This profit is derived after considering non-operating
incomes and expenses (or incomes and expenses not related to a business’s core activities). For
example, for a company selling jewelry, income from investments or a one-time sale of a fixed
asset could be considered non-operating income.
How to Calculate Funds from Operations
Funds from operations does not include any financing-related cash flows, such as interest income
or interest expense. It also does not include any gains or losses from the disposition of assets, or
any depreciation or amortization of fixed assets.
Thus, the calculation of funds from operations is:
Funds from operations = Net income – (Interest income + Gains on sale of assets) + Interest
expense + losses from sale of assets + depreciation and amortization
How to Calculate Funds from Operations?
In order to calculate FFO, one needs to consider a few pointers –
● It does not include income or expense via financing activities.
● Funds from operations do not constitute gains or losses generated from non-recurring
business activities like sale of land.
● It includes depreciation and amortization.

✔ Therefore, to calculate funds from operations, one must deduct any interest income and
non-recurring gains from the net income. Then they must add back interest expense, losses
from the sale of assets, and depreciation & amortization to the net income.
✔ The funds from operations formula can, therefore, be written as –

✔ Funds from operations = Net income – (Interest income + Gains on sale of assets) + Interest
expense + losses from sale of assets + depreciation and amortization
✔ Once funds from operations are calculated individuals can also find the per-share value by
dividing the total amount by the number of outstanding shares.
✔ Funds from operations per share = Funds from operations / Total number of outstanding
shares
The Funds from Operations shall be prepared as follows:-

Particulars Amount

Net Income xxx

ADD
1. Depreciation on Fixed Assets xxx
2. Amortization of Intangible Assets xxx
3. Amortization of Loss on Sale of Investments xxx
4. Amortization of Loss on sale of Fixed Assets xxx
5. Losses from Other Non-Operating Incomes xxx
6. Tax Provision (Created out of Current Profits) xxx
7. Proposed Dividend xxx
8. Transfer to Reserve xxx
(LESS)
1. Deferred credit xxx
2. Profit on Sale of Investments xxx
3. Profit on Sale of Fixed Assets xxx
4. Any written back Reserve & Provision xxx

Funds Flow Statement

Funds Flow Statement is a statement prepared to analyze the reasons for changes in the Financial
Position of a Company between 2 Balance Sheets. It shows the inflow and outflow of funds i.e.
Sources and Applications of funds for a particular period. In other words, a Funds Flow
Statement is prepared to explain the changes in the Working Capital Position of a Company.
There are 2 types of Inflows of Funds:-
1. Long Term Funds raised by Issue of Shares, Debentures or Sale of Fixed Assets
2. Funds generated from Operations
If the Long Term Fund requirements of a company are met just out of the Long Term Sources of
Funds, then the whole fund generated from operations will be represented by increase in
Working Capital. However, if the Funds generated from Operations are not sufficient to bridge a
gap of Long Term Fund Requirements, then there will be a decline in Working Capital.
Benefits of Funds Flow Statement
Funds Flow Statement is useful for Long Term Analysis. It is a very useful tool in the hands of
the management for judging the financial and operating performance of the Company.
1. The Funds Flow Statement helps in answering the following questions:-
● Where have the profits gone?
● Why is there an imbalance existing between liquidity position and profitability position
of an enterprise?
● Why is the concern financially solid in spite of losses?
2. The Funds Flow Statement analysis helps the management to test whether the working capital
has been effectively used or not and the working capital level is adequate or inadequate for the
requirements of the business.
3. The Funds Flow Statement Analysis helps the investors to decide whether the company has
managed the funds properly. It also indicates the credit worthiness of a company which helps the
lenders to decide whether to lend money to the company or not.
4. It helps the management to take policy decisions and to decide about the financing policies
and Capital Expenditure for the future.
Preparation of Funds Flow Statement
Step I: Prepare Statement of Changes in Working Capital
For preparing the Funds Flow Statement, the first step is to prepare the Statement of Changes in
Working Capital. 
Step II: Prepare Funds from Operations
The next Step is to prepare the Funds generated only from the operating activities of the
business and not from the Investing/Financing Activities of the business.
Step III: Preparation of Funds Flow Statement
While preparing the Funds Flow Statement, the Sources and Uses of Funds are to be disclosed
clearly so as to highlight the Sources from where the Funds have been generated the Uses to
which these Funds have been applied. This Statement is also sometimes referred to as
the Sources and Applications of Funds Statement or Statement of Changes in Financial Position.
Sources of Funds
Items to be shown under the head Sources of Funds are as follows:-
1. Issue of Shares and Debentures for Cash: – The total amount received from the Issue of
Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or
Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be
shown here as there is no inflow of Cash
2. Long Term Loans: The Amount received on raising Long Term Loans is shown under
this head. Short Term Loans are not to be shown here as their treatment has already been
done while preparing the Statement of Changes in Working Capital.
3. Sale of Investments and other Fixed Assets: The Total Amount received on the sale of
Investments and other Fixed Assets is to be shown under this head.
4. Funds from Operations: The Funds generated from Operations as computed in Step II are
also required to be shown here.
5. Decrease in Working Capital: This would be the Balancing Figure of the Statement and
will come from change in Working Capital Statement
Application of Funds
Items to be shown under Application of Funds are as follows:-
 1. Purchase of Fixed Assets and Investments: The Cash Payment made for purchase of
Fixed Assets and Investments is an application of Funds. But if the purchase if made by
issue of shares or debentures, such a transaction will not constitute application of funds.
Similarly, if the purchases are on credit, these will not constitute fund applications.
2. Redemption of Debentures, Preference Shares and Repayment of Loan:-  Payment made
including Premium (less: Discount) is to be taken as fund application
3. Payment of Dividend & Tax: Payment of Dividend and tax are to be taken as applications
of fund if the provisions are excluded from current liabilities and Current Provisions are
added back to profit to determine the “Funds from Operations”
4. Increase in Working Capital: This would be the Balancing Figure of the Statement and
will come from change in Working Capital Statement

Cash Flow Statement

A cash flow statement provides information about the changes in cash and cash equivalents of a
business by classifying cash flows into operating, investing and financing activities. It is a key
report to be prepared for each accounting period for which financial statements are presented by
an enterprise.
Objectives of preparing Cash Flow Statement
 ● Cash flow statement shows inflow and outflow of cash and cash equivalents from various
activities of a company during a specific period under the main heads i.e., operating
activities, investing activities and financing activities.
● Information through the Cash Flow statement is useful in assessing the ability of any
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize
those cash flows.
● Taking economic decisions  requires an evaluation of the ability of an enterprise to
generate cash and cash equivalents, which is provided by the cash flow statement
Table of Difference between Funds Flow Statement and Cash Flow Statement
Basis of
Funds Flow Statement Cash Flow Statement
Difference
1. Basis of Funds flow statement is based on Cash flow statement is based on narrow
Analysis broader concept i.e. working concept i.e. cash, which is only one of
capital. the elements of working capital.
2. Source Funds flow statement tells about the Cash flow statement stars with the
various sources from where the opening balance of cash and reaches to
funds generated with various uses to the closing balance of cash by
which they are put. proceeding through sources and uses.
3. Usage Funds flow statement is more useful Cash flow statement is useful in
in assessing the long-range financial understanding the short-term phenomena
strategy. affecting the liquidity of the business.
4. Schedule of In funds flow statement changes in In cash flow statement changes in current
Changes in current assets and current liabilities assets and current liabilities are shown in
Working are shown through the schedule of the cash flow statement itself.
Capital changes in working capital.
5. End Result Funds flow statement shows the Cash flow statement shows the causes
causes of changes in net working the changes in cash.
capital.
6. Principal of Funds flow statement is in In cash flow statement data obtained on
Accounting alignment with the accrual basis of accrual basis are converted into cash
accounting. basis.

Classification of Activities for Cash Flow Statement

Cash flow activities majorly classified into three categories they are:
● Operating activities
 ● Investment activities
● Financing activities
These three activities help us to assess the financial position of a firm and also helps to know
various cash and cash equivalent transactions incurred.
Operating Activities
These are the main or primary activities of a business. Operating activities mainly deals with
major activities of buying and selling of goods and services of a business firm. These activities
include manufacturing, distributing, selling, marketing etc. Even though these activities does not
include investing and financing activities but provides a major cash flow in the organization and
also helps in better assessing the profitability of the firm.
Cash Flow from Operating Activities = Earnings before interest and Tax + depreciation – Taxes
+/- Change in working capital
Cash Inflows from Operating Activities
● Receipts from the sale of goods and services.
● Cash receipts from the sale of patents.
Cash Outflows from Operating Activities
● Payments made on salaries to the employees.
● Cash payments made to suppliers.
Investment Activities
Investment activities are the other type of cash flow statement activities in which cash
transactions made on purchasing or sale of investments. These activities include money spent on
long-term assets, shares, debentures etc.
Cash Inflow from Investment Activities
● Investment activities cash inflow include the sale of assets.
● Cash received on interest on loans and advances given to the third parties.
● Cash receipts received on the investment made in the other companies or firms.
● Receipts received on trading of shares, debentures, bonds etc.
Cash Outflow from Investment Activities
● Cash payments on purchasing long-term assets and other intangible goods like patents.
● Payments made on acquiring of other company shares, debentures and other debt issues.
● Advances and loans given to third parties.
Financing Activities
Financing activities can be defined activities involving in the rise of the company’s capital. Even
though these lie at the bottom of the statement but had its own importance. These activities are
confined mainly financial activities of the firm like trading of company’s shares, repaying
investors, adding or changing loans, or issuing more stock whenever required. Most importantly
these activities change the capital and borrowings of the firm.
Cash Flow from Financing activity = Cash Received from Issuing shares or debts – Cash Paid
as Dividends and Reacquiring of shares or debts
Cash Inflow from Financing Activities
● Receipts on the issuing of shares and other debt instruments.
● Cash received from issuing of debentures, loans and other borrowings.
Cash Outflow from Financing Activities
● Interest paid on long-term borrowings and debentures.
● Dividends paid to the shareholders of the company.
● Repaid borrowings made by the firm.
Advantages of Cash Flow Statement:
The advantages of Cash Flow Statement are:
(a) Ascertaining Liquidity and Profitability Positions:
Cash Flow Statement helps the management to ascertain the liquidity and profitability position of
a firm.
Liquidity means one’s ability to pay the obligation as soon as it becomes due.
(b) Ascertaining Optimum Cash Balance:
Cash Flow Statement helps also to ascertain the optimum cash balance of a firm. If optimum
cash balance can be determined, it is possible for a firm to ascertain the idle and/or excess and/or
shortage of cash position. After ascertaining the cash position, the management can invest the
surplus cash, if any, or borrow funds from outside sources accordingly to meet the cash deficit.
(c) Cash Management:
Proper management of cash is possible if cash flow statement is properly prepared. The
management can prepare an estimate about the various inflows of cash and outflows of cash so
that it becomes very helpful for them to make plans for the future.
(d) Capital Budgeting Decisions:
Since capital budgeting relates to the decision of capital expenditure in various forms on a
long-term basis cash flow timing is very important for this purpose.
(e) Superiority over Accrual Basis of Accounting:
No doubt, Cash Flow Statement or cash basis of accounting is more reliable or dependable than
accrual basis of accounting as a number of technical adjustments are made in the latter case.
Cash flow accounting is free from such snags.
(f) Planning and Co-ordination:
Cash Flow Statement is prepared on an estimated basis meant for the succession/next year which
helps the management to know how much funds are required for what purposes, how much cash
is generated from internal sources, how much cash can be procured from outside the business.
(g) Movement of Cash:
A Cash Flow Statement presents the management the flows in and flows out of cash for various
purposes on the basis of which future estimates can be prepared.
(h) Performance appraisal:
By comparing the actual Cash Flow Statement with the projected Cash Flow Statements, the
management can evaluate or appraise the performances regarding cash. If any unfavourable
variance is found, the reason for such variation is located and rectified accordingly.
Limitations of Cash Flow Statement
Even though a cash flow statement is a useful tool for financial analysis, it has its own
limitations. Some of these are discussed below:
1. Does not show a complete picture:
A cash flow statement, on its own, cannot give an exhaustive analysis of the financial position of
a business.
2. Needs other tools for analysis: For better interpretation, a cash flow statement would need to
be seen in confirmation with other financial statements (like balance sheet & income statement)
and analytical tools like ratio analysis. In isolation, its usage is limited.
3. Shows cash position only:
Since it depicts only the cash position, one cannot arrive at the actual profit and loss of the
business by just looking at this statement alone. Moreover, as working capital is a wider concept
of funds, a funds fund statement might give a clearer picture than a cash flow statement.
4. Difficult to define the term “cash”:
It becomes quite difficult to precisely define the term “cash”.
5. Cannot be equated with income statement:
You cannot equate the cash flow statement with the income statement of a business entity. Since
an income statement takes into consideration both cash as well as non-cash transactions, the net
cash flow arising from the cash flow statement need not necessarily depict the net income of the
business.
6. May not represent the real liquid position:
You cannot assess the real liquid position of a business by looking at the net cash balance as
disclosed by the cash flow statement. This is so because many times, this balance may be easily
influenced by postponing purchases and other payments.
7. Future estimates not possible:
A cash flow statement is prepared on the basis of historical information. It shows the current
inflows and outflows of cash but not the projected ones.
8. Inter-industry comparison may be difficult:
Cash flow statements do not compare the economic efficiency of one company to another. A
company with a large capital investment will often have a larger cash inflow. As a result,
comparing cash flow numbers across industries may be misleading.
Preparation of Cash Flow statement

1. Determine the Starting Balance

The first step in preparing a cash flow statement is determining the starting balance of cash and
cash equivalents at the beginning of the reporting period. This value can be found on the income
statement of the same accounting period.
The starting cash balance is necessary when leveraging the indirect method of calculating cash
flow from operating activities. However, the direct method doesn’t require this information.
2. Calculate Cash Flow from Operating Activities
One you have your starting balance, you need to calculate cash flow from operating activities.
This step is crucial because it reveals how much cash a company generated from its operations.
Cash flow from operations are calculated using either the direct or indirect method.
 Direct Method
The direct method of calculating cash flow from operating activities is a straightforward process
that involves taking all the cash collections from operations and subtracting all the cash
disbursements from operations. This approach lists all the transactions that resulted in cash paid
or received during the reporting period.
Indirect Method
The indirect method of calculating cash flow from operating activities requires you to start with
net income from the income statement (see step one above) and make adjustments to “undo” the
impact of the accruals made during the reporting period. Some of the most common and
consistent adjustments include depreciation and amortization.
Both the direct and indirect methods will result in the same number, but the process of
calculating cash flow from operations differs.
While the direct method is easier to understand, it’s more time-consuming because it requires
accounting for every transaction that took place during the reporting period. Most companies
prefer the indirect method because it's faster and closely linked to the balance sheet. However,
both methods are accepted by Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS).
3. Calculate Cash Flow from Investing Activities
After calculating cash flows from operating activities, you need to calculate cash flows from
investing activities. This section of the cash flow statement details cash flows related to the
buying and selling of long-term assets like property, facilities, and equipment. Keep in mind that
this section only includes investing activities involving free cash, not debt.
4. Calculate Cash Flow from Financing Activity
The third section of the cash flow statement examines cash inflows and outflows related to
financing activities. This includes cash flows from both debt and equity financing—cash flows
associated with raising cash and paying back debts to investors and creditors.
When using GAAP, this section also includes dividends paid, which may be included in the
operating section when using IFRS standards. Interest paid is included in the operating section
under GAAP, but sometimes in the financing section under IFRS as well.
5. Determine the Ending Balance
Once cash flows generated from the three main types of business activities are accounted for,
you can determine the ending balance of cash and cash equivalents at the close of the reporting
period.
The change in net cash for the period is equal to the sum of cash flows from operating, investing,
and financing activities. This value shows the total amount of cash a company gained or lost
during the reporting period. A positive net cash flow indicates a company had more cash flowing
into it than out of it, while a negative net cash flow indicates it spent more than it earned.