The conversations about Cash Flows. What is a Statement of Cash Flows?
Cash flows presentations are probably the most sensitive part of financial reporting. At the same time the most difficult and complex to present. Over the years of working with cash flows I find it easier to explain the Statement of Cash Flows first at high level and then diving into the detail of each section of the statement. I hope you like this (no one ever said they liked cash flows, but maybe that day will come in my life time) more articles on cash flows are on the horizon.
The statement of cash flows is a classified listing of the cash inflows and outflows of an organization during a set period.
The statement of cash flows is the bridge between accrual accounting and cash basis accounting. I don’t think I ever heard anyone defining cash flows statements like that (so I might start a heated debate on this topic), but once you look at what’s is going into each line in the cash flows statement you’ll probably agree with me. The statement of cash flows is:
provides information on cash inflows and outflows during a period.
provides users with a second flows statement, complementing the income statement;
does not replace and is not the same as the income statement;
provides information not available on other financial reports; and
indirectly provides information on an entity’s liquidity and financial flexibility.
The measurement of resource inflows and outflows is a critical part of the accounting process. There are two general flow statements prepared by accountants for external reporting purposes: the income statement and the statement of cash flows.
1. The statement of comprehensive income, or income statement, is the primary measure of the periodic performance of an organization. (most likely prepared accrual GAAP basis, otherwise there wouldn’t be a need for a statements for cash flows).
2. The statement of cash flows is a presentation of the inflows and outflows (during a period) of an individual asset or liability, a group of assets or liabilities, and cash, or cash and cash equivalents.
The focus of the statement is on cash inflows and outflows.
The reconciliation of the differences between these two flow statements (and also the statement of financial position) represents an issue of growing importance to standard-setting bodies( and this reconciliation is what suggest is the bridge between the GAAP and cash basis accounting).
Cash flow reporting guidance has been in place for more than 30 years, yet precisely what cash flow information entities should present and what level of detail should be provided remain arguable questions.
How individuals use the statement remains uncertain. This uncertainty leaves the purpose and function of the statement subject to dispute.
These and many other issues are addressed as you examine the preparation, presentation, and use of cash flow information.
The following are the major features of the statement of cash flows that reflect existing reporting requirements.
1. Cash flow information should be presented whenever a statement of financial position and an income statement are presented.
2. The presentation order in the statement is operating, investing, and financing.
3. Both the indirect method, or reconciliation technique, and the direct method are currently acceptable. The indirect approach does not have inflows and outflows in the operating section. ( a future article will discuss direct v indirect method approach).
4. The statement reconciles the change from beginning to ending cash and cash equivalents
Cash flow reporting guidance (the technical part from here to the end)
The statement of cash flows is an essential part of an entity’s financial report:
An organization should present a statement of cash flows whenever a set of financial reports, which also include a statement of comprehensive income and a statement of financial position (balance sheet), are prepared using accounting principles generally accepted in the United States of America (U.S. GAAP).
An entity should present comparative statements of cash flows.
The guidance in FASB ASC 230 specifies the general form and content of a statement of cash flows prepared under GAAP. The major statement requirements are summarized on the following pages.
The statement of cash flows is a valuable source of information, and we suggest it should be presented even if presentation is not required. Cash flow information can be particularly useful when statements are prepared primarily for internal use.
Cash and cash equivalents
The statement of cash flows uses cash, or cash and cash equivalents, as the definition of funds.
The statement should explain the change in cash and cash equivalents during the period.
The total ending cash (or cash and cash equivalents) amount should directly tie to a similar line item shown on the statement of financial position.
When an entity chooses a pure definition of cash for the statement of cash flows, cash consists of traditional cash items, such as cash on hand and cash in demand deposit accounts. There are, by definition, no cash equivalents when an entity uses the pure cash approach. The pure cash approach may become the required approach if there is a major revision of cash flow reporting guidance.
Many entities use a broader definition that includes cash equivalents for the statement of cash flows. In general terms:
Cash equivalents are short-term, highly liquid investments that are quickly convertible to known amounts of cash. There is essentially no credit risk.
Cash equivalents have original maturities to the entity of three months or less. There is essentially no market (or interest) rate risk.
Examples of cash equivalents include short-term Treasury bills, commercial paper, and money market funds. All highly liquid investments with maturities of three months or less at the date of purchase are considered cash equivalents.
Gross and net cash flows
Organizations should report the total (gross) amount of investing and financing cash inflow and cash outflow amounts on the statement of cash flows. For example, a firm would present the cash received (a) from the sale of investments separately from the cash paid for investments, and/or (b) from the issuance of long-term bonds separately from the cash paid to retire long-term bonds.
The guidance in FASB ASC 230 simply specifies that the original maturity of the asset or liability to the entity must be three months or less before the entity may net. For example, a bank may net demand deposit liabilities. An entity may choose to present total inflows and total outflows for any item that qualifies for netting. Net presentation is a choice, not a requirement.
Classification
The statement of cash flows classifies cash flows into three major cash activity groups: operating, investing, and financing. Inflows and outflows affect each category. Reporting guidance clearly identifies the basic classes of items that are part of the three sections of the statement of cash flows.
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).
Cash flows from investing activities
Activities classified as investing activities on the statement of cash flows are those activities associated with investments in productive assets and investments in the debt or equity securities of other entities. Interest and dividends received are classified as operating.
Inflows: Collections of principal amounts (such as the face value of a six-month note) on debt instruments issued by other entities; Cash proceeds from the sale of equity investments, such as common or preferred stock (the total proceeds from the sale, not the original investment); Cash received from the sale of productive assets
Outflows: Cash amounts paid out to acquire the debt instruments of other entities (such as loans to suppliers, and acquisitions of mortgage notes); Cash payments made to buy an equity interest (such as common or preferred shares) in other entities; Disbursements made to purchase productive assets (such as property, plant, and equipment).
Cash flows from financing activities
Most of the cash flows on the statement of cash flows that are classified as financing activities are between the entity and its providers of capital, both debt and equity.
Inflows: Cash proceeds from the sale of equity securities (such as common and preferred stock);Cash receipts from borrowing (such as bonds, mortgages, and notes); cash receipts from contributions and investment income donor restricted for endowments or buying, improving or constructing long-lived assets (also includes interest and dividends received on assets donor restricted for long-term purposes);
Outflows: Cash disbursed to repay principal on long and short-term debt, (such as bonds, mortgages, and notes); Cash paid to reacquire common and preferred equity instruments, whether retired or placed in the Treasury; Dividends paid to common and preferred shareholders; Debt issue costs, payments for prepayment or debt extinguishment, certain contingent liability payments made soon after an acquisition.
Reporting noncash transactions
Only cash inflows and outflows are reported on the statement of cash flows. Investing and financing activities not resulting in cash inflows or outflows are reported on a separate schedule or in a narrative presentation. This noncash information is not part of the statement of cash flows.
The following transactions are examples of events that would be included in a separate schedule of noncash investing and financing transactions:
Issuance of common stock in exchange for equipment
Capital lease transactions
Conversion of bonds to common stock
Technically, if there is a cash flow, the transaction belongs on the statement of cash flows. If there is not a cash flow, the transaction does not go on the statement of cash flows. Separate disclosure of major noncash transactions is necessary.
The presentation noncash information may take many forms. FASB ASC 230 permits the use of either a separate schedule or a narrative.
Preparing a statement of cash flows
The preparation of a statement of cash flows requires analysis of account changes and the reasons for these changes. Ideally, information on the actual cash inflows and outflows that affect an activity is available for transfer to the statement of cash flows.
An entity must present total inflow and outflow information for most financing and investing activities. The accounting system may provide these amounts directly or it may be necessary to analyze the accounts to get the necessary information. For example, it is relatively easy to determine the actual cash dividends paid during the year and the cash dividends received. The cash proceeds from the sale of investments are often readily available from external activity statements or transaction documents. It may be necessary to review the activities that affected a specific account or account group, such as long-term debt, to get cash flow information.
This article provides you with an overview of the current cash flow reporting requirements. It was written to help learn or recall the nature of cash flow reporting and the basic features of this financial statement. The article presents a quick look at existing reporting guidance including the following: cash and cash equivalents, gross versus net reporting, classification, and noncash transactions.
Do you want to know more about Cash flows from operating, investing and financing activities? Please check out future articles that will present each section in detail.
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.
