14.1: Cash Flow Accounting

14.1.1: Importance of Cash Flow Accounting

The statement of cash flows provides insight that the balance sheet and income statement do not, particularly in regard to a company’s cash position.

Learning Objective

Summarize why cash flow accounting is important

Key Points

Without positive cash flow, a company will not be able to meet its financial obligations, thereby leading to a cash crunch or bankruptcy.
Cash flow is the movement of money into or out of a business, project, or financial product.
The statement of cash flows is a valuable reporting tool for managers, investors, and creditors.
Being profitable does not necessarily mean being liquid.

Key Terms

cash flow: The sum of cash revenues and expenditures over a period of time.
liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.
net income: Net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period.

Importance Of Cash Flow Accounting

Cash flow is the movement of money into or out of a business, project, or financial product from operating, investing, and financing activities. It is usually measured during a specified, finite period of time, or accounting period. The measurement of cash flow can be used for calculating other parameters that give information on a company’s value, liquidity or solvency, and situation. Without positive cash flow, a company cannot meet its financial obligations .

Cash Flow

Cash

Management is interested in the company’s cash inflows and cash outflows because these determine the availability of cash necessary to pay its financial obligations. In addition, management uses cash flow for the following:

To determine problems with a company’s liquidity
To determine a project’s rate of return or value
To determine the timeliness of cash flows into and out of projects, which are used as inputs in financial models such as internal rate of return and net present value

Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even when it is profitable. Cash flow is often used as an alternative measure of a company’s profitability when it is believed that accrual accounting concepts do not represent economic realities.

For example, a company may be profitable but generate little operational cash (as may be the case for a company that barters its products rather than selling for cash or when its accounts receivable turnover is long). In such cases if needed, the company may derive additional operating cash by issuing shares, raising additional debt finance, or selling its assets. In addition, cash flow can be used to evaluate the “quality” of income generated by accrual accounting. When net income is composed of large non-cash items, it is considered low quality.

14.1.2: Key Considerations for the Statement of Cash Flows

The statement of cash flows highlights the activities that directly and indirectly affect a company’s overall cash balance.

Learning Objective

Summarize what items are represented on the statement of cash flows

Key Points

The statement shows changes in cash and cash equivalents rather than working capital.
The statement of cash flows consists of three primary categories: operating activities, investing activities and financing activities.
The statement of cash flows lists all cash inflows and outflows during a reporting period.

Key Terms

liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.
equity: Ownership, especially in terms of net monetary value of some business.
working capital: A financial metric that is a measure of the current assets of a business that exceeds its liabilities and can be applied to its operation.

The Statement of Cash Flows

A cash flow statement provides information beyond that available from other financial statements, such as the Income Statement and the Balance Sheet, through providing a reconciliation between the beginning and ending balances of cash and cash equivalents of a firm over a fiscal or accounting period.The main purpose of the statement, according to the Financial Accounting Standard Board (FASB) is to provide information about the changes of an entity’s cash or cash equivalents in the accounting period .

Statement of Cash Flows

Balancing the Statement of Cash Flows by hand.

Structure of the Statement of Cash Flows

The statement shows historical changes in cash and cash equivalents rather than working capital. It provides information about a company’s borrowing and debt repayment activities, the company’s sale and repurchase of its ownership securities, and other factors affecting the company’s liquidity and solvency. It does not predict future cash flows.

In addition, the statement is used to assess the following: the company’s ability to meet its obligations to service loans, pay dividends, etc.; the reasons for differences between reported and related cash flows; and the effect on its finances of major transactions in the year. The statement of cash flows lists all cash inflows and outflows during a reporting period from operating, investing and financing activities.

It has three primary categories from which cash flows derive:

Operating activities – principal revenue-producing activities of the company and other activities that are not investing or financing activities. Cash inflows include cash receipts from sales of goods or services; interest received from making loans; dividends received from investments in equity securities; and cash received from the sale of securities that were held for trading purposes, issued by other businesses. Securities that are held for trade are generally investments that a business holds for a very short period of time with the intent to sell for a quick gain.
Investing activities – the acquisition and disposal of long term assets and other investments not included in cash equivalents. Transactions include the sale and acquisition of property, plant, and equipment; the collection and granting of long-term loans to others; and the trading of available-for-sale and held-to-maturity securities of other businesses. Securities that are held-to-maturity are those that a business plans to hold onto until the security’s term is up. An available-for-sale security is an investment that does not qualify as “held-to-maturity” or “trading”.
Financing activities – activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. Transactions include cash received by the company issuing its own capital stock and bonds, as well as any other short- or long-term borrowing it may do.

14.2: Calculating Cash Flows

14.2.1: Preparation of the Statement of Cash Flows: Direct Method

There is an indirect and a direct method for calculating cash flows from operating activities.

Learning Objective

Explain the direct method for preparing the statement of cash flows

Key Points

In order to identify the inflows and outflows for operating activities, you need to analyze the components of the income statement.
Under the direct method, adjustments are made to the “expense accounts” themselves.
The direct method of preparing a cash flow statement results in a more easily understood report, as compared with the indirect method.
The most common example of an operating expense that does not affect cash is a depreciation expense.

Key Term

asset: Something or someone of any value; any portion of one’s property or effects so considered

Example

The following is an example of using the direct method for calculating cash flows. For example, in order to find out the cash inflow from a customer we need to know the sales revenue, but the sales revenue is also affected by the accounts receivable account. So, if the sales revenue is 300, and the accounts receivable increases by 20, then the cash received from customers would be 280. In order to determine the cash paid to suppliers, you need to look at both the inventory and the accounts payable account, and then determine their effect on the cost of goods sold. For example, if the cost of goods sold was 220, and inventory increased by seven, and the accounts payable decreased by fifteen, the cash paid to suppliers would be 242. You add seven because the inventory increased, and you add fifteen because the accounts payable decreased, which means more money was paid.The cash paid for interest is determined by the bond interest expense and discount on the bonds payable. For example, if the interest expense is ten dollars, and the unamortized discount decreases by three dollars, then the cash paid for interest is seven dollars.

Calculating Cash Flows

Cash flows refer to inflows and outflows of cash from activities reported on an income statement. In short, they are elements of net income. Cash outflows occur when operational assets are acquired, and cash inflows occur when assets are sold. The resale of assets is normally reported as an investing activity unless it involves the purchase and sale of inventory, in which case it is reported as an operating activity. There are two different methods that can be used to report the cash flows of operating activities: the direct method and the indirect method .

Calculating Cash Flows

The two methods to calculate cash flows are the direct method and the indirect method

The Direct Method

For items that normally appear on the income statement, cash flows from operating activities display the net amount of cash that was received or disbursed during a given period of time. The direct method for calculating this flow involves deducting from cash sales only those operating expenses that consumed cash. In this method, each item on an income statement is converted directly to a cash basis, and each cash effect is directly reported. To employ this direct method, use the following equation:

add net sales
add ending accounts receivable
subtract beginning accounts receivable
add ending assets (prepaid rent, inventory, et al)
subtract beginning assets (prepaid rent, inventory, et al)
subtract ending payables (tax, interest, salaries, accounts payable, et al. )
add ending payables (tax, interest, salaries, accounts payable, et al. )

Once the cash inflows and outflows from operating activities are calculated, they are added together in the “Operating Activities” section of the cash flow statement to obtain the net cash flow for a company’s operating activities.

Indirect Method

In the indirect (addback) method for calculating cash flows, the accrual basis net income is established first. This net income is then indirectly adjusted for items that affected the reported net income but did not involve cash. The indirect method adjusts net income (rather than adjusting individual items in the income statement) for the following phenomena: changes in current assets (other than cash), changes in current liabilities, and items that were included in net income but did not affect cash.

14.2.2: Preparation of the Statement of Cash Flows: Indirect Method

The indirect method starts with net-income while adjusting for non-cash transactions and from all cash-based transactions.

Learning Objective

Explain how to use the indirect method to calculate cash flow

Key Points

The indirect method adjusts net income (rather than adjusting individual items in the income statement).
The most common example of an operating expense that does not affect cash is depreciation expense.
Depreciation expense must be added back to net income.

Key Terms

income statement: A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.
accrual: A charge incurred in one accounting period that has not been paid by the end of it.
indirect method: a way to construct the cash flow statement using net-income as a starting point, and makeing adjustments for all transactions for non-cash items, then adjusting from all cash-based transactions

Example

Consider a firm reporting revenues of $125,000.During the reporting period, the firm’s accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000.The net cash flow from operating activities, before taxes, would be:Cash flow from revenue: $89,000Cash flow from expenses: $(80,000)Net cash flow: $9,000The indirect method would find these cash flows as follows.Revenue: $125,000Expenses: $(85,000)Net Income: $40,000The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net cash flow.

Calculating Cash Flows

There are two different methods that can be used to report the cash flows of operating activities. There is the direct method and the indirect method.

Calculating cash flow

The indirect method adjusts net income (rather than adjusting individual items in the income statement).

Indirect Method

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for:

changes in current assets (other than cash) and current liabilities, and
items that were included in net income but did not affect cash.

The indirect method uses net income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:

Decrease in non-cash current assets are added to net income;
Increase in non-cash current asset are subtracted from net income;
Increase in current liabilities are added to net income;
Decrease in current liabilities are subtracted from net income;
Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period);
Revenues with no cash inflows are subtracted from net income;
Non operating losses are added back to net income;
Non operating gains are subtracted from net income.

Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expenses must be added back to net income. So, depreciation expense is shown (or captioned) on the statement of cash flows. Also, in the indirect method cash paid for taxes and cash paid for interest must be disclosed.

Direct Method Versus Indirect Method

Consider a firm reporting revenues of $125,000. During the reporting period, the firm’s accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000. The net cash flow from operating activities, before taxes, would be:

Cash flow from revenue: 89,000

Cash flow from expenses: (80,000)

Net cash flow: 9,000

The indirect method would find these cash flows as follows.

Revenue: 125,000

Expenses: (85,000)

Net Income: 40,000

The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net income.