Expert Advisory Committee
ICAI-Expert Advisory Committee
Options:

Query No. 31

Subject:

Disclosure in the cash flow statement of borrowings and loan disbursements and

related repayments in case of a financial institution.1

 

 

A. Facts of the Case

1. A Government of India undertaking, incorporated under the Companies Act, 1956 in the year 1987, is a dedicated financial institution engaged in the financing of power sector in India. The company is also notified as a public financial institution under section 4A of the Companies Act, 1956. The company is mainly engaged in providing loans and other non-fund based products to various power utilities.

2. The company prepares its cash flow statement using the indirect method as per Accounting Standard (AS) 3, ‘Cash Flow Statements’. While preparing the draft financial statements for the financial year 2008-09, according to the querist, the company being a financial institution, disclosed the net cash outflows/inflows from loan disbursements made to/principal repayments received from the borrowers under the head ‘cash flows from financing activities’ in the cash flow statement prepared in accordance with the indirect method as per AS 3. The company also disclosed the net cash inflows/outflows from loans borrowed from/principal repayments made to lenders under the head ‘cash flows from financing activities’.

3. The government auditors during the audit of the draft financial statements observed that the “amount of Rs. XXXX crore on account of loans disbursed (net) shown under ‘cash flow from financing activities’ should be shown under ‘cash flow from operating activities’ in terms of paragraph 14 of AS 3”. Reference was also made to paragraph 14 of AS 3 which provides that “an enterprise may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made by financial enterprises are usually classified as operating activities since they relate to the main revenue-producing activity of that enterprise”.

4. The querist has stated that AS 3 defines operating activities as “the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities”. The querist has also stated that paragraph 12 of AS 3 further explains that cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. Therefore, they generally result from the transactions and other events that enter into the determination of net profit or loss. According to the querist, for a financial institution, main revenues are generated from interest on the loans advanced, unlike manufacturing companies, which generate revenues from sale of goods. Also, paragraph 20 of AS 3 provides as under:

        “20. Under the indirect method, the net cash flow from operating activities is determined by adjusting net profit or loss for the effects of:
                (a) changes during the period in inventories and operating receivables and payables;
                (b) non-cash items such as depreciation, provisions, deferred taxes, and unrealised foreign exchange gains and losses; and
                (c) all other items for which the cash effects are investing or financing cash flows.
…”

Therefore, according to the querist, for a financial institution, since the operating revenues (i.e., interest on loans, etc.) are generated from the loans disbursed, the loan disbursements made/repayments received from the borrowers should be classified as cash flows from the operating activities.

5. The querist has also mentioned that AS 3 defines financing activities as “activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise”, which generally arise from the issue of shares, bonds, debentures and such type of instruments. Since the borrowings of a company, i.e., bonds and loans raised are to be classified as financing activities as stated in AS 3, it is not prudent to classify the loan disbursements to / repayments received from borrowers under the operating activities since both are interdependent in nature for a financial company. Further, as per the querist, if loan disbursements to /repayments received from borrowers are classified under the cash flows from operating activities, and the borrowings of a company are classified as financing activities, the net operating cash flows will show huge negative cash flows which imply that the operational performance/capability of the company is very weak as is also described in paragraph 11 of AS 3, which, inter alia, states that “the amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external sources of financing” and similarly, net cash flows from the financing activities will show huge excessive cash inflows year on year. Therefore, in the view of the querist, loan disbursements to / repayments received from borrowers should ideally be shown under the financing activities along with the borrowings of a company, i.e., bonds and loans raised.

6. The querist has expressed his view that the classification of the loan disbursements to/repayments received from borrowers under the head ‘cash flows from operating activities’ resulting in huge negative net operating cash flows will

  • not present a true and fair view of the financial statements thereby contradicting the fundamental qualitative characteristics of financial statements, namely, understandability and relevance, and
  • indicate that a cash rich company having a net worth of around Rs. 10, 800 crore has not generated sufficient cash flows to maintain the operating capability, pay dividends, repay loans and make new investments without recourse to external sources of financing.

7. The querist has also stated that the industry practice is also such that even some of the leading financial institutions are classifying increase/decrease in both the loan assets (disbursed to borrowers) and loan liabilities (borrowings of a company) under the head ‘cash flows from financing activities’.

B. Query

8. The querist has sought the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India on the following issues:

    (i) Whether it is correct to classify the amounts of loans disbursed to and the repayments received from the borrowers under the head ‘cash flows from operating activities’, and the amounts of loans raised from and the repayments made to the lenders under the head ‘cash flows from financing activities’, as per the indirect method of preparation of cash flow statement as per AS 3.

    (ii) If not, what is the correct method of disclosure of the amounts of loans disbursed to and the repayments received from the borrowers, and the loans raised from and the repayments made to the lenders, as per the indirect method of preparation of cash flow statement as per AS 3.

C. Points considered by the Committee

9. The Committee notes that the basic issue raised in the query relates to the disclosure of loan disbursements to and repayments received from the borrowers and that of loans raised from and repayments made to the lenders by the company (a financial institution) in the cash flow statement. The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, classification and disclosure of interest paid on the loans raised by the company, etc.

10. As far as disclosure of cash flows arising from loan disbursements to and repayments from the borrowers is concerned, the Committee notes the definition of ‘operating activities’ (reproduced in paragraph 4 above) and paragraph 14 of AS 3 (reproduced in paragraph 3 above). The Committee notes that the Standard explicitly states that cash flows arising from loans advanced by a financial enterprise should be classified as operating activity as these relate to main revenue-producing activities of the enterprise. As far as classification of these activities under ‘financing activities’, as being argued by the querist, is concerned, the Committee notes the definition of ‘financing activities’ (reproduced in paragraph 5 above) and paragraph 17 of AS 3 which provides as follows:

        “17. The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise. Examples of cash flows arising from financing activities are:

                (a) cash proceeds from issuing shares or other similar instruments;

                (b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings; and

                (c) cash repayments of amounts borrowed.”

From the above, the Committee is of the view that the basic objective of the financing activities is to finance the business of the enterprise irrespective of its nature of operations. An activity could be classified as financing activity only if it meets this definition. Since the loans disbursed and the repayments received do not result in changes in the size and composition of the owners’ capital and borrowings of the company, these cannot, in any case, be classified as financing activities.

11. With respect to the disclosure of cash flows arising from loans raised and repayments made to the lenders by the company (a financial institution) in the cash flow statement, the Committee notes the definition of ‘financing activity’ and paragraph 17 of AS 3 (reproduced in paragraph 10 above). From the above, the Committee is of the view that the cash flows from loans raised and bonds issued and cash repayments of the amounts borrowed in case of all enterprises (financial or non-financial) have to be classified under ‘financing activities’ as the definition of ‘financing activities’ as per AS 3 does not make any distinction between financial and non-financial enterprises or between the funds raised for operating activities or investing activities. Accordingly, in case of a financial enterprise, even though the ‘loans raised and repayments made’ and ‘loan disbursements and repayments received’ are interdependent, the former cannot also be classified as ‘operating activity’ for the purposes of AS 3.

D. Opinion

12. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8 above:


     (i) Yes, it is correct to classify the amounts of loans raised from and the repayments made to the lenders under the head ‘cash flows from financing activities’ and the amounts of loans disbursed to and the repayments received from the borrowers under the head ‘cash flows from operating activities’, as per the indirect method of preparation of cash flow statement as per AS 3. For the purpose of the preparation of cash flow statement, the aforesaid amounts would be arrived as increase/decrease in the borrowings and loans & advances outstanding in the two balance sheets relevant for the Cash Flow Statement.


     (ii) Since the answer to (i) above is not in the negative, this question does not arise.

1Opinion finalised by the Committee on 15.12.2009