Chapter 23

Cash Flow: The cash flow statement explains the change in cash during the period.

Cash receipt= Source of fund

 Where the cash come from?

Cash payment= Use of fund

 Where it went?

Primary Purpose of Cash flow Statement

 Cash inflow

 Cash outflow

Secondary Purpose of Cash flow Statement

It summarize all the transaction that affect cash flow

1. Operating

2. Investing

3. Financing

Usefulness of the Statement of Cash Flows

1. The entity’s ability to generate future cash flows. A primary objective of financial reporting is to provide

information which helps to predict the amounts, timing, and uncertainty of future cash flows. By examining

relationships between items such as sales and net cash flow from operating activities, or net cash flow from

operating activities and increases or decreases in cash, it is possible to better predict the future cash flows

than is possible using accrual-basis data alone.

2. The entity’s ability to pay dividends and meet obligations. Simply put, cash is essential. Without adequate

cash, a company cannot pay employees, settle debts, pay out dividends, or acquire equipment. A statement

of cash flows indicates where the company’s cash comes from and how the company uses its cash.

Employees, creditors, shareholders, and customers should be particularly interested in this statement

because it alone shows the flows of cash in a business.

income number is important: It provides information on the performance of a company from one period to

another. But some people are critical of accrual-basis net income because companies must make estimates

to arrive at it. Such is not the case with cash. Thus, as the opening story showed, financial statement

readers can benefit from knowing why a company’s net income and net cash flow from operating activities

differ and can assess for themselves the reliability of the income number.

4. The cash and non-cash investing and financing transactions during the period. Besides operating activities,

companies undertake investing and financing transactions. Investing activities include the purchase and

sale of assets other than a company’s products or services. Financing activities include borrowings and

repayments of borrowings, investments by owners, and distributions to owners. By examining a company’s

investing and financing activities, a financial statement reader can better understand why assets and

liabilities increased or decreased during the period.

Classification of Cash Flows

1. Operating activities Provides information about the cash generated from a company’s daily operating

activities, such as cash receipts from sales of goods and services, and cash payments to suppliers and

employees for acquisitions of inventory and expenses. The amount of cash flows arising from operating

activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash

flows to repay loans, maintain the operating capability of the entity, pay dividends, and make new

investments without recourse to external sources of financing.

2. Investing activities Involve cash flows generally resulting from changes in long-term asset items

(a) Making and collecting loans

(b) Acquiring and disposing of investments and productive long-lived assets.

The separate disclosure of cash flows arising from investing activities is important because the cash flows

represent the extent to which expenditures have been made for resources intended to generate future income and

cash flows.

3. Financing activities involve liability and equity items and include

(a) Obtaining cash from creditors and repaying the amounts borrowed

(b) Obtaining capital from owners and providing them with a return on, and a return of, their investment.
The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting

claims on future cash flows by providers of capital to a company.

Preparing the statement of cash flows involves three major steps:

1. Determine the change in cash. The difference between the beginning and ending cash balance can be

easily computed from an examination of the comparative balance sheets.

2. Determine the net cash flow from operating activities. This procedure is complex; it involves analysing the

following:

 The current year’s income statement

 Comparative balance sheets

 Selected transaction data

3. Determine cash flows from investing and financing activities.

 All other changes in the balance sheet accounts must be analysed to determine their effect on cash.

Accrual Basis Income Statement Cash Basis Cash flow

 Revenues are recognized when earned.

 Expense are recognized when incurred.

The two ways of reporting cash flow:

1. The Direct method

2. The Indirect method (Reconciliation method)

 Under the accrual basis, net income is not the same as net cash flow from operation activities.

 To arrive at net cash flow from operating activities a company must determine (revenue and

expenses on Cash basis)

 Therefore in this method start with Net income by eliminating the effects of income statement

transactions that did not result in an increase or decrease in cash.

Disclosures Significant Non-Cash Transactions

Common noncash transactions that a company should report or disclose:

1. Acquisition of assets by assuming liabilities or by issuing shares.

2. Exchanges of non-monetary assets.

3. Conversion of debt or preference shares to ordinary shares.

4. Issuance of equity securities to retire debt.