A cash flow statement is a financial report that describes the source of a company's cash and how it was spent over a specified time period. Because of the varied accrual accounting methods companies may employ, it is possible for a company to show profits while not having enough cash to sustain operations. A cash flow statement neutralizes the impact of the accrual entries on the other financial statements. It also categorizes the sources and uses of cash to provide the reader with an understanding of the amount of cash a company generates and uses in its operations, as opposed to the amount of cash provided by sources outside the company, such as borrowed funds or funds from stockholders. The cash flow statement also tells the reader how much money was spent for items that do not appear on the income statement, such as loan repayments, long-term asset purchases, and payment of cash dividends.
Cash flow statements classify cash receipts and payments according to whether they stem from operating, investing, or financing activities. It also provides that the statement of cash flows may be prepared under either the direct or indirect method, and provides illustrative examples for the preparation of statements of cash flows under both the direct and the indirect methods.
CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS At the beginning of a company's life cycle, a person or group of people come up with a idea for a new company. The initial money comes from the owners, or could be borrowed. This is how the new company is "financed." The money owners put into the company, or money the company borrows, is classified as a financing activity. Generally, any item that would be classified on the balance sheet as either a long-term liability or an equity would be a candidate for classification as a financing activity.
The owners or managers of the business use the initial funds to buy equipment or other assets they need to run the business. In other words, they invest it. The purchase of property, plant, equipment, and other productive assets is classified as an investing activity. Sometimes a company has enough cash of its own that it can lend money to another enterprise. This, too, would be classified as an investing activity. Generally, any item that would be classified on the balance sheet as a long-term asset would be a candidate for classification as an investing activity.
Now the company can start doing business. It has procured the funds and purchased the equipment and other assets it needs to operate. It starts to sell merchandise or services and make payments for rent, supplies, taxes, and all of the other costs of doing business. All of the cash inflows and outflows associated with doing the work for which the company was established would be classified as an operating activity. In general, if an activity appears on the company's income statement, it is a candidate for the operating section of the cash flow statement.
ACCRUAL AND ITS EFFECT ON FINANCIAL STATEMENTS Generally accepted accounting principles (GAAP) require that financial statements are prepared on the accrual basis. For example, revenues that were earned during an accounting period may not have been collected during that period, and appear on the balance sheet as accounts receivable. Similarly, some of the collections of that period may have been from sales made in prior periods. Cash may have been collected in a period prior to the services rendered or goods delivered, resulting in deferred recognition of the revenue. This would appear on the balance sheet as unearned revenue.
Sometimes goods or services are paid for prior to the period in which the benefit is matched to revenue (recognized). This results in a deferred expense, or a prepaid expense. Items such as insurance premiums that are paid in advance of the coverage period are classified as prepaid. Sometimes goods or services are received and used by the company before they are paid for, such as telephone service or merchandise inventory. These items are called accrued expenses, or payables, and are recognized on the income statement as an expense before the cash flow occurs. When buildings or equipment are purchased for cash, the cash flow precedes the recognition of the expense by many years. The expense is recognized over the life of the asset as depreciation. One of the main benefits of the cash flow statement is that it removes the effect of any such accruals or deferrals.
METHODS OF PREPARING THE CASH FLOW STATEMENT Small business owners preparing a cash flow statement chan choose either the direct or the indirect method of cash flow statement presentation. The operating section of a cash flow statement prepared using either method converts the income statement from the accrual to the cash basis, and reclassifies any activity not directly associated with the basic business activity of the firm. The difference lies in the presentation of the information.
Companies that use the direct method are required, at a minimum, to report separately the following classes of operating cash receipts and payments:
RECEIPTS Companies are encouraged to provide further breakdown of operating cash receipts and payments that they consider meaningful.
Companies using either method to prepare the cash flow statement are also required to separately disclose changes in inventory, receivables, and payables to reconcile net income (the result of the income statement) to net cash flow from operating activities. In addition, interest paid (net of amount capitalized) and income taxes paid must be disclosed elsewhere in the financial statements or accompanying notes. An acceptable alternative presentation of the indirect method is to report net cash flow from operating activities as a single line item in the statement of cash flows and to present the reconciliation details elsewhere in the financial statements.
The reconciliation of the operating section of a cash flow statement using the indirect method always begins with net income or loss, and is followed by an "adjustments" section to reconcile net income to net cash provided by operating activities.
Regardless of whether the direct or the indirect method is used, the operating section of the cash flow statement ends with net cash provided (used) by operating activities. This is the most important line item on the cash flow statement. A company has to generate enough cash from operations to sustain its business activity. If a company continually needs to borrow or obtain additional investor capitalization to survive, the company's long-term existence is in jeopardy.
The presentation of the investing and financing sections is the same regardless of whether the statement is prepared using the direct or indirect method. The final section of the cash flow statement is always a reconciliation of the net increase or decrease in cash for the period for which the statement is prepared, with the beginning and ending balances in cash for the period.
ANALYZING AND CLASSIFYING COMMON TRANSACTIONS
Transactions on the balance sheet also must be analyzed and converted from the accrual to the cash basis in preparation of the cash flow statement. Every balance sheet account reflects specific activity. There are only a few distinctive transactions that affect each account. Following are examples of some of the common transactions affecting balance sheet items:
Accounts receivable increases when the company sells merchandise or does a service on credit, and decreases when the customer pays its bill. Accounts receivable is associated with the income statement account Sales or Revenue. The change in accounts receivable or the cash collected from customers is classified as an operating activity.
Inventory increases when the company buys merchandise for resale or use in its manufacturing process, and decreases when the merchandise is sold. Inventory is associated with the income statement account Cost of Goods Sold. The change in inventory or the cash paid for inventory purchases is classified as an operating activity.
Prepaid insurance increases when the company pays insurance premiums covering future periods and decreases when the time period of coverage expires. Prepaid insurance is associated with the income statement account Insurance Expense. The change in prepaids or the amount paid for insurance is classified as an operating activity.
The Land, Building, and Equipment accounts increase when the company purchases additional assets. They also undergo a corresponding decrease when the assets are sold. The only time the income statement is affected is when the asset is sold at a price higher or lower than book value, at which time a gain or loss on sale of assets appears on the income statement. The amount of cash used or received from the purchase or sale of such assets is classified as an investing activity. The gain or loss is classified as an adjustment in the operating section on a cash flow statement prepared using the indirect method.
Accumulated depreciation increases as the building and equipment depreciates and decreases when building and equipment is sold. Accumulated depreciation is associated with depreciation expense on the income statement. Depreciation expense does not appear on a cash flow statement presented using the direct method. Depreciation expense is added back to net income on a cash flow statement presented using the indirect method, since the depreciation caused net income to decrease during the period but did not affect cash.
Goodwill increases when the parent company acquires a subsidiary for more than the fair market value of its net assets. Goodwill amortizes over a time period not to exceed 40 years. Goodwill is associated with amortization expense on the income statement. Amortization expense appears in the operating section of a cash flow statement prepared using the indirect method. Amortization expense does not appear on a cash flow statement prepared using the direct method.
Notes payable increases when the company borrows money, and decreases when the company repays the funds borrowed. Since only the principal appears on the balance sheet, there is no impact on the income statement for repaying the principal component of the note. Notes payable appear in the financing section of a cash flow section.
Premiums and discounts on bonds are amortized through bond interest expense. There is no cash flow associated with the amortization of bond discounts or premiums. Therefore, there will always be an adjustment in the operating section of the cash flow statement prepared using the indirect method for premium or discount amortization. Premium or discount amortization will not appear on a cash flow statement prepared using the direct method.
Common stock and preferred stock with their associated paid in capital accounts increase when additional stock is sold to investors, and decrease when stock is retired. There is no income statement impact for stock transactions. The cash flow associated with stock sales and repurchases appears in the financing section.
Retained earnings increases when the company earns profits and decreases when the company suffers a loss or declares dividends. The profit or loss appears as the first line of the operating section of the cash flow statement. The dividends appear in the financing section when they are paid.
CASH INFLOWS OR RECEIPTS When preparing the cash flow statement using the direct method, the cash collected from customers may be found by analyzing accounts receivable, as follows: Beginning balance of accounts receivable, plus sales for the period (from the income statement), less ending balance of accounts receivable, equals cash received from customers. This is an extremely simplified formula, and does not take into account written off receivables or other noncash adjustments to customer accounts. If there is no accounts receivable on the balance sheet, the company does a cash business and cash collected from customers will equal sales or revenue on the income statement.
If the cash flow statement is prepared using the indirect method, the adjustment to net income may be found in a similar manner. If the cash received from customers is more than the sales shown on the income statement, causing accounts receivable to decrease, the difference is added to net income. If cash received from customers is less than the sales shown on the income statement, causing accounts receivable to increase, the difference is subtracted from net income.
The amounts borrowed during the period may be found by analyzing the Liability Accounts. The amounts received from investors during the period may be found by doing a similar analysis on the Equity Accounts. Both of these types of transactions will be classified as financing activities.
If any land, buildings, or equipment were sold during the period, the information will be found in the Land, Building, and Equipment Accounts and their associated accumulated depreciation. One simple way to properly categorize the transaction is to reconstruct the journal entry. For example, assume that equipment that had cost $8,000 and had accumulated depreciation of $6,000 was sold during the period for $2,500. The journal entry for this transaction should indicate:
Accumulated depreciation $6,000
Gain on sale of equipment $500
The cash received from the sale of the equipment is classified as an investing activity. If the statement is prepared using the direct method, no other part of the journal entry is used. If the statement is prepared using the indirect method, the gain on sale of equipment is subtracted from net income. When the gain was recorded, net income increased. However, since the company is not in the business of buying and selling equipment, the gain needs to be subtracted from net income to arrive at the adjusted total related only to the proceeds from the company's direct business activities. If the sale had resulted in a loss, the loss is added back to net income.
CASH PAYMENTS Cash payments are found using similar methods to those used for determining cash received. Cash payments for the purchase of inventory are found by analyzing accounts payable. The following formula can be used to find the cash paid for inventory purchases: beginning balance of accounts payable, plus inventory purchases during the period, less ending balance of accounts payable, equals payments made for inventory during the period. This is a simplified formula and does not take into account any noncash adjustments.
If the cash paid for inventory is greater than the inventory purchased during the period, the difference between the amount purchased and the amount paid is deducted from net income if preparing the cash flow statement using the indirect method. If cash paid for inventory is less than the inventory purchased during the period, the difference between the amount purchased and the amount paid is added to net income if preparing the cash flow statement using the indirect method. Cash payments for land, building, and equipment purchases, repayments of loans, purchases of treasury stock, and payment of dividends may be found by performing similar analysis on the appropriate accounts.
SIGNIFICANT NONCASH TRANSACTIONS Noncash transactions are not to be incorporated in the statement of cash flows. Examples of these types of transactions include conversion of bonds to stock and the acquisition of assets by assuming liabilities. If there are only a few such transactions, it may be convenient to include them on the same page as the statement of cash flows, in a separate schedule at the bottom of the statement. Otherwise, the transactions may be reported elsewhere in the financial statements, clearly referenced to the statement of cash flows.
Other events that are generally not reported in conjunction with the statement of cash flows include stock dividends, stock splits, and appropriation of retained earnings. These items are generally reported in conjunction with the statement of retained earnings or schedules and notes pertaining to changes in capital accounts.