Cash Flows from Operating Activities
One of the most fascinating part of the business activities is the cash flows . I had a conversation the other day with a client; she was wondering how come she had a huge balance in her bank account one day but close to nothing the next day. That is the net impact of cash inflows and outflows. The timing for such activities is everything to manage a business in today’s global environment even when your business is local.
The statement of cash flows classifies cash flows into three major cash activity groups: operating, investing, and financing. Inflows and outflows affect each category. In this article we’ll focus on Cash flows from operating activities.
The operating section reports the cash effects of most recurring transactions and other events that enter into the determination of net income. It is the default classification under existing guidance. Operating inflows and operating outflows include those activities not defined as investing or financing activities.
Inflows: Cash receipts from the sale of goods or services; Cash receipts from the collection or sale of operating receivables. These receivables arise from the sales of goods or services; Cash interest received; Cash dividends received; Other cash receipts not directly identified with financing or investing activities (such as lawsuit settlements or normal insurance settlements);
Outflows: Cash payments for trade goods purchased for resale or for use in manufacturing; Cash payments for notes to suppliers of trade goods; Cash payments to other suppliers and to employees; Cash paid for taxes, fees, and fines; Interest paid to creditors; Other cash payments not directly identified with financing or investing activities (such as lawsuit settlements, contributions, or certain asset retirement obligations).
Existing cash flow reporting guidance permits organizations to use either of two methods of presenting the operating section of the statement of cash flows.
1. Direct method:
This method shows both cash receipts and cash disbursements as line items in the operating section. The direct method is the approach standard-setting bodies recommend that an entity use.
2. Indirect method:
This method starts the operating section with net income. Items that do not require cash are added and those requiring additional cash are subtracted from net income to determine cash provided by operations.
The total amount reported as cash flows from operating activities will be the same whether an organization uses the direct or uses the indirect method.
Identical investing and financing sections would follow the operating section,
the direct method focuses on gross cash inflow and outflow amounts, and the indirect method specifies which items included in income did not use cash and which required the use of more cash.
Here is a more detailed explanation of each method:
1. Direct method
The direct method of reporting cash inflows and cash outflows in the operating section of the statement of cash flows is the approach recommended by the standard-setting bodies. Its use is common in small firms and nonprofits. However, relatively few large public firms currently use the direct method in their statement of cash flows:
When an entity uses the direct method, it must also provide a reconciliation of net income to cash flows from operating activities. This indirect method presentation provides users with additional details about operating cash flows. This requirement has discouraged many firms from experimenting with direct method presentation.
Although the direct method is less familiar as a method of presentation, it may well become the required approach when the next major revision of cash flow reporting requirements is made.
Minimum requirements if direct method is used
Operating cash inflow disclosures
a) Cash collected from customers
b) Interest and dividends received in cash
c) Any other cash receipts related to operations
Operating cash outflow disclosures
a) Cash paid for normal operating expenses, such as payments to employees and suppliers
b) Interest paid in cash
c) Income taxes paid
d) Any other cash payments related to operations
These are minimum, but not maximum, cash inflow and outflow disclosure requirements. An entity may estimate the operating cash inflows and outflows if actual cash flow information is not available.
It is currently acceptable to lump most operating cash payments into a single outflow category. The existing guidance encourages entities to experiment with statements that provide additional disclosure details.
2. Indirect method
Entities may present cash flows from operating activities using the indirect method. When this method is used, you must remove from net income the effects of all deferrals of cash receipts and payments and all accruals of cash receipts and payments.
Required adjustments and disclosures if indirect method is used:
a) deferrals of operating cash receipts and payments, such as those for inventory and prepaid revenues.
b) accruals of operating cash receipts and payments, such as those for receivables and payables; and
c) adjustments for gains and losses where the cash flows are part of the investing or financing sections. Examples include depreciation, sale of capital assets, or debt extinguishment.
The cash provided by operating activities calculated by the indirect method will equal the amount an entity would report if it used the direct method:
Adjustments are made for period-to-period changes in such items as accounts receivable and accounts payable after eliminating any change amounts that represent investing and financing activities.
When using the indirect method, separate disclosure of the amount of interest and income taxes paid is required .
FASB has recommended that an entity use the direct method of presenting cash provided by operating activities in the statement of cash flows.
An entity should use actual cash inflow and outflow information if it is available.
Certain information is almost certain to be available, such as dividends paid or interest received.
Other operating information may require an analysis of transactions during the period. For example, accounts payable may need to be analyzed in conjunction with cost of goods sold to determine how much cash was paid to suppliers.
Some accounting systems do not collect actual cash inflows and outflows. To make the direct method easy to use, the existing reporting guidance specifically permits entities to estimate (determine indirectly) major operating cash inflows and outflows. This approach is sometimes called the indirect direct method.
To use this approach: Analyze the related income statement and balance sheet accounts to approximate cash inflows and outflows. Assume that sales were $100,000 during the period. The accounts receivable balance (all of which relate to operating activities) increased from $5,000 to $10,000. You would estimate that the cash collected from customers was $95,000. This is because the revenues include $5,000 of receivables that the entity has not yet collected. This analysis approach allows you to prepare an informative and cost effective statement of cash flows. Practically, the same type of analysis is completed for the indirect direct method as would be used for indirect method statement preparation. In the indirect method you would subtract the $5,000 increase in receivables from net income when computing the cash provided by operating activities total.
Summary
This article provides you with an overview of the current cash flow reporting requirements. We focused on developing your understanding of the two alternative operating section presentation options — indirect and direct methods. Developing this understanding is essential because the direct method may become a required part of cash flow reporting and is a particularly useful approach for internal use of cash flow information.
The article relies on the guidance in FASB Accounting Standards Codification (ASC) 230, Statement of Cash Flows.
Adapted from © 2021 Association of International Certified Professional Accountants.
