Unit V - Statement of Cash Flows

The basic financial statements we have presented so far provide only limited information about the company’s asset “Cash”. For example, balance sheet shows how much cash the business owns on the date the report was prepared but it does not indicate the amount of cash generated by operating activities, or financing activities. The income statement may show expenses and revenues that may have an effect to cash but will not provide reader of this report how these income and expenses affected “Cash” account. The capital statement shows what happened to the capital balance of the owner during the year. None of these statements presents a detailed summary of where cash came from and how it was used.

Statement of Cash Flows Defined The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period.

Usefulness of the Statement of Cash Flows The information in a statement of cash flows should help investors, creditors, and others assess: 1. The entity’s ability to generate future cash flows. By examining relations between items in the statement of cash flows, investors and others can make predictions of the amounts, timing, and uncertainty of future cash flows better than they can from accrual basis data.

2. The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders should be particularly interested in statement, because it alone shows the flows of cash in a business.

3. The reasons for the difference between net income and net cash provided (used) by operating activities. Net income provides information on the success or failure of a business enterprise. However, some are critical of accrual basis net income because it requires many estimates. As a result, the reliability of number is often challenged. Such is not the cash with cash. Many readers of statement of cash flows want to know the reasons for the difference between net income and net cash provided by operating Marivic Valenzuela-Manalo 1

Cash Receipts Cash Payments ------------------------------------------------------------------------------------------------------Collections from customers for sales of Payment to suppliers of merchandise goods and services and services, including payments to Interest and dividends received Then they can assess for of interest the reliability of the income number. Payments themselves activities. Other receipts from operations; for Payments of income taxes example, proceeds from settlement of Other expenditures relating to operations; litigation for example, payments in settlement of litigation 4. The cash investing and financing transactions during the period. By examining a

company’s investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period.

Classification of Cash Flows The cash flows shown in the statement are grouped into three major categories: (1) operating activities. (2) investing activities, and (3) financing activities. We will now look briefly at the way cash flows are classified among these three categories.

Operating Activities. The operating activities section shows the cash effects of revenue and expense transactions. Stated another way, the operating activities section of the statement of cash flows includes the cash effects of those transactions reported in the income statement. To illustrate this concept, consider the effects of credit sales. Credit sales are reported in the income statement in the period when the sales occur. But the cash effects occur later – when the receivables are collected in cash. If these events occur in different accounting periods, the income statement and the operating activities section of the statement of cash flows will differ. Similar differences may exist between the recognition of an expense and the related cash payment. Consider, for example, the expense of postretirement benefits earned by employees during the current period. If this expense is not funded with a trustee, the cash payments may not occur for many years – after today’s employees have retired.

Cash flows from operating activities include:

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Cash Receipts Cash Payments Cash Receipts Cash Payments ----------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------Cash proceeds from selling investments and Proceeds from both short-term and long-term Payments to acquire investments and plant Repayment of amounts borrowed (excluding plant assets assets borrowing interest payments) Cash proceeds from collecting(for example, Amounts advanced to borrowers Cash received from owners principal Payments to owners, such as cash withdrawals Amounts onNotice that receipts and payments of interest are classified as operating activities, not as loans From investment)

investing or financing activities because these are shown in the income statement.

Investing Activities. Cash flows relating to investing activities present the cash effects of transactions involving plant assets, intangible assets, and investments. They include:

Financing Activities. Cash flows classified as financing activities include the following items that result from debt and equity financing transactions:

Repayment of amounts borrowed refers to repayment of loans, not to payments made on accounts payable or accrued liabilities. Payments of accounts payable and of accrued liabilities are considered payments to suppliers of merchandise and services and are classified as cash outflows from operating activities. Also, remember that all interest payments are classified as operating activities.

The following illustration lists typical cash receipts and cash payments within each of the three classifications. Study the list carefully. It will prove very useful in solving homework

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Note the following general guidelines: (1) Operating activities involve income statement items. (2) Investing activities involve cash flows resulting from changes in investment and longterm asset items. (3) Financing activities involve cash flows resulting from changes in long-term liability and owner’s equity items.

Some cash flows related to investing or financing activities are classified as operating activities. For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because these items are reported in the income statement, where results of operations are shown.

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