Statement of Cash Flows or Cash Flow Statement can be prepared using two methods; direct method or indirect method.
As under indirect method, income statement or statement of comprehensive income is used to determine cash flows from operating activities therefore, profit or loss figure requires some adjustments.
These adjustments are made because entity is required to determine profit or loss on accrual basis and not on cash basis. Whereas statement of cash flows involves only actual amounts received and paid during the period.
In addition to that, determination of entity’s financial performance also involves such transactions or items which are not backed by real cash flows. For example, depreciation is considered in calculation of profit (loss) for the year but depreciation expense does not involve cash outflow or in simple words, for this expense we do not pay in cash to anybody rather it is just an estimated amount of devaluation of asset for which company has already paid in full at the time such non-current asset was acquired.
The items which are of the following nature are adjusted or reversed in the profit or loss figure if entity is preparing statement of cash flows using indirect method:
- All such transactions i.e. incomes or expenses which are non-cash in nature i.e. incomes or expenses are recognized but no inflow or outflow occurred.
For example, depreciation or amortization or impairment expense and all kinds of provisions; provision for doubtful debts, provision for contingent liabilities etc.
- All such transactions i.e. incomes or expenses which are recognized on accrual basis shall be reversed. And only that amount of income or expense should be considered which was actually received or paid respectively.
- Any deferrals such as deferred tax, unearned incomes, unrealised gains and losses would be reversed and only those items shall be disclosed on the face of statement of cash flows that are actually paid or received during the period.
- Any changes that occurred in the inventory, operating receivables and operating payables, prepayments, accrued liabilities etc would be adjusted.
This is done by comparing the opening and closing balances of such items.
- All such items that are required to be disclosed under the headings of investing or financing activities of cash flow statements shall be reversed so that such cash flows do not affect the calculation of cash flows from operating activities. For example disposal of non-current asset, dividends received etc.