Accounting Business Reporting for Decision Making

270 Accounting: Business Reporting for Decision Making

Relationship of the statement of cash flows to other

financial statements

Illustrative example 7.1 emphasised the importance of the statement of cash flows by highlighting the

additional information it contains. The financial statements comprise:

1. the statement of profit or loss and statement of comprehensive income — which show the results of an

entity’s performance for the reporting period

2. the balance sheet — which shows the entity’s financial position at a particular point in time


3. the statement of changes in equity — which shows the change in an entity’s equity between two

reporting periods

4. the statement of cash flows — which shows the entity’s cash inflows, outflows and net cash flow for

the reporting period.

The statement of cash flows was introduced because the statement of profit or loss and balance sheet

did not provide a complete picture of an entity’s economic activities. That is, a statement of profit or

loss summarised the entity’s income and expense transactions but did not identify the flow of funds

relating to those transactions; and a comparison of successive balance sheets would show the change

in cash position from one point in time to another, but would not expose the cash flows associated with

that change. Cash flows refer to the movement of cash resulting from transactions with external parties.

As discussed in chapter 5, the balance sheet lists the assets (investing decisions) and the liabilities and

equity (financing decisions) of the entity. The statement of cash flows also helps to identify changes in

balance sheet items. For example, the sale or purchase of an asset for cash would have an effect on both

the balance sheet and the statement of cash flows. Similarly, borrowing money and paying a dividend to

the owners of the entity are examples of transactions that affect both statements.

So, the purpose of a statement of cash flows is to give information additional to that provided by

the other statements. Generally, the information provided should assist decision makers in assessing an

entity’s ability to:

1. generate cash flows


2. meet its financial commitments as they fall due, including the servicing of borrowings and the pay-

ment of dividends

3. fund changes in the scope and/or nature of its activities


4. obtain external finance.

Together, the statement of profit or loss and the balance sheet (based on accrual accounting) and the

statement of cash flows provide a rich source of information regarding the profitability, liquidity and sta-

bility of an entity.

Let’s look at a simple case study to:

• understand more clearly the relationship of the statement of cash flows to the statement of profit or

loss and balance sheet

• gain an appreciation of the types of information the statement of cash flows contains and therefore the

format of the statement of cash flows.

The simple case study is that of a sole trader, Teresa Tang, starting a business, Teresa’s Carpets and

Rugs. Teresa is unhappy in her present job as an office administrator for an import and export company.

She wants to do something more fulfilling and challenging. Teresa loves textiles and feels that there is a

business opportunity in selling imported rugs and carpets. She knows that you have completed studies in

accounting and asks for your help.

Teresa is willing to invest her savings of $20 000 into the business known as Teresa’s Carpets and

Rugs but she also knows that she will need to borrow money to get the business started. Her aunt is

willing to lend her $50 000 at commercial rates. According to the terms of the loan, the interest is based

on a 6 per cent variable rate tied to commercial bank rates. The loan is to be paid back by 2026. So, on

1 April 2016, Teresa creates a business account with her bank, transfers her $20 000 and banks her aunt’s

cheque for $50 000.