Purpose of the Statement of Cash Flows
Understanding the impact of a business activity on cash flow is essential for successful financial analysis. Helpful in assessing cash flows, the statement of cash flows includes operating, investing, and financing activities, as well as any significant noncash transactions. This statement is one of the four major financial statements, representing an organization's cash receipts and payments. The statement of cash flows may be prepared for a month, a quarter, or a year. The purpose of the statement of cash flows is to reconcile net income to the ending cash balance. In order to do this, the statement reflects the changes in three main areas: operating activities, investing activities, and financing activities.
Cash flows from operating activities include all transactions and events that are not investing and financing activities and represent items that impact net income. Examples of cash flows from operating activities include payments from customers, payment for labor, and payments for materials.
Cash flows from investing activities include all transactions and events that relate to acquiring and disposing of investments and productive long-lived assets. Examples of cash flows from investing activities include purchasing a building or equipment, purchasing a long-term investment such as a bond, or selling a long-term asset such as equipment or land.
Cash flows from financing activities include all liability and owners' equity items that relate to obtaining and repaying borrowed amounts from creditors and obtaining capital from shareholders. Examples of cash flows from financing activities include cash inflow from taking out a loan or cash outflow when paying interest on a loan. Noncash transactions are included as a footnote to the statement.
This information should help investors, creditors, and others assess the potential for a company to produce future cash flows, a company's capacity to pay dividends and meet obligations, the likely explanations for net income amount differences as compared to net cash flows from operating activities, and both cash and noncash activities related to investing and financing transactions during the period.
A common misconception is that the information needed to identify how much cash a company generates or spends is available on the income statement. However, under generally accepted accounting principles (GAAP), a combination of accounting principles, standards, and procedures that govern the preparation of financial statements, the income statement is prepared using accrual basis accounting (or accrual method), a method of accounting recognizing revenue when earned and recording expenses when incurred regardless of the cash received or paid. It is not prepared using cash basis accounting, a method of recognizing and recording revenue or expenses in the period when cash is received or paid, identifying cash inflows and outflows. For this reason, the statement of cash flows is an important and essential statement issued by all companies so that stakeholders can understand the cash position of the firm. Under the indirect method of preparation, the most commonly used method, an accrual net income calculation is translated into a cash basis net income calculation in order to display cash flow.
Cash in the statement of cash flows is comprised of both cash and cash equivalents. A cash equivalent is a highly liquid short-term investment having the ability to be readily converted into cash. For example, cash equivalents include money market funds and 90-day U.S. Treasury bills.
Regulation and Standards
Because of the high occurrence of cash flow statement errors, the Securities and Exchange Commission (SEC) has requested companies to thoroughly review their statements before submitting. The Securities and Exchange Commission (SEC) is an independent agency of the U.S. government that enforces federal securities laws, proposes securities rules, and regulates the securities industry. The Financial Accounting Standards Board (FASB) is an independent nonprofit standard-setting body responsible for establishing accounting standards for public companies in the United States.
FASB has supported the direct method for preparation of the statement as the most theoretically correct approach, since operating activities directly show the major classes of cash receipts and payments. The direct method is a basic accounting of cash receipts (or inflows) and cash disbursements (or outflows) from operating, investing, and financing activities. When the Financial Accounting Standards Board established the direct method standard for cash flow reporting in 1987, it faced significant scrutiny by most corporations. Unfortunately, most companies do not collect cash basis accounting information that allows them to determine amounts directly, such as cash received from customers or cash paid to suppliers. While additional cost was suggested as a drawback to the direct method, many supporters of the direct method assert that the incremental cost is not significant. In addition, academic researchers found that financial statement users preferred the direct method for obtaining more useful information for decision-making. Regardless of research and FASB preference, the most widely used method in industry is the indirect method of preparing the statement of cash flows. The key difference between the two methods is how the operating activities section is compiled. Both the investing activities and financing activities sections are prepared the same under the indirect and direct methods of presentation for the statement of cash flows.
Indirect Method Cash Flow Statement
When FASB offered the current standard for comment in 1987, most corporations lobbied against the direct method, in support of the indirect method, a method used in preparing the cash flow statement that reconstructs net cash flows from operating activities adjusting for noncash items in the income statement. They argued that utilization of the accrual method accounting information can be just as effective, more compatible with most accounting systems, and less costly.
Under this lobbying pressure, FASB acquiesced to allow both methods for GAAP presentation. However, in the joint presentation project of FASB and the International Accounting Standards Board, only the direct method of presentation was proposed. Again, significant pushback in favor of the indirect method suggested a similar scenario will play out. The International Accounting Standards Board (IASB) is an independent foundation that develops a single set of globally accepted accounting standards using due process. These standards are considered as International Financial Reporting Standards (IFRS), high-quality, understandable, enforceable, and globally accepted standards, based on clearly articulated principles.There is a basic format for the statement of cash flows, using the indirect method, as well as for the statement of cash flows using the direct method.