Depreciation Information about cash flows can influence decision makers in many ways . For example , if a companys regular operations bring in more cash than it uses , investors will value the company higher than if property and equipment must be sold to finance operations . Information about cash flow can help creditors decide whether a company will have enough cash to pay its debts as they mature. Management and investors use cash flow information to evaluate a companys ability to meet unexpected obligations . Cash flow information is also used to evaluate companys ability to take advantage of new business opportunities that may arise.
In November 1987, the FASB issued Statement of Financial Accounting Standards “statement of cash flow ” This standard requires businesses to include a statement of cash flow in all financial reports that contain both a balance sheet and an income statement. The primary purpose of this statement is to present information about a companys cash receipts and disbursements during the reporting period. Direct Method of Presenting Cash Flow from Operating Activities When you prepare a statement of cash flow , the net cash provided by operating activities can be calculated two different ways . One is called Direct Method the other is Indirect Method .When the direct method is used , you separately list each major class of operating cash receipts and each major class of cash payments . Then the payments are subtracted from the receipts to determine the net cash provided by operating activities. The FASB encourage companies to use direct method. Indirect Method of Presenting Cash Flow from Operating Activities The indirect method is not as informative as direct method because it does not disclose the individual cash inflows and outflows from operating activities.
Instead the direct method discloses only the net cash provided by operating activities . When the indirect method is used , the net income is listed first . Then it is adjusted for items that are necessary to reconcile net income to the net cash provided by operating activities . For example , you know that depreciation expense is subtracted in the calculation of net income . But , depreciation expense does not involve a current cash payment. Therefore, depreciation expense is added back to net income in the process of reconciling net income to the net cash provided by operating activities.
Cash and Cash Equivalents In Statement of Financial Accounting Standards , the FASB concluded that a statement of cash flow should explain the difference between the beginning and the ending balances of cash and cash equivalents. Prior to this new standard ,cash equivalents were generally understood to be short term , temporary investments of cash . However , not all short-term investments meet the FASB definition of cash equivalents . To qualify as a cash equivalent , an investment must satisfy two criteria . These are: 1- The investments must be readily convertible to a known amount of cash. 2- The investments must be sufficiently close to its maturity date so that its market value is relatively insensitive to interest rate changes.
Classifying Cash Transactions A statement of cash flow describes the changes in cash plus cash equivalents. Therefore, cash payments to purchase cash equivalents and cash receipts from selling cash equivalents are not reported on the statement. All other cash receipts and payments are classified as operating , investing or financing activities. Within each category , individual cash receipts and payments are summarized and described in a manner that clearly presents the general nature of the companys cash transactions . Then , the summarized cash receipts and payments within each category are netted against each other . A category provides a net cash flow if the receipts in the category exceed the payments . And if the payments in a category exceed the receipts , the category is a net user of cash during the period. Operating Activities You should recognize the operating activities generally include only transactions that relate to the calculation of net income .
However, some income statement items are not related to the operating activities . As disclosed in a statement of cash flows , operating activities involve the production or purchase of merchandise and the sale of goods and services to customers . Operating activities also include the expenditures related to administering the business. In fact , cash flow from operating activities include all cash flows from transactions that are not defined as investing or financing activities . Cash Flows from Operating Activities Cash Inflows Cash Outflows -Cash sales to customers -Payments to employees for salaries and -Cash collections from credit customers wages -Receipts of cash dividends from stock -Payments to suppliers of goods and services investments in other entities -Payments to government agencies for taxes -Refunds from suppliers fines and penalties -Cash collected from a lawsuit -Interest payments, net of amounts capitalized -Receipts of interest payments -Cash refunds to customers Investing Activities Transactions that involve making and collecting loans or that involve purchasing and selling plant assets , other productive assets , and investments are called investing activities.
Usually , investing activities involve the purchase or sale of assets that are classified on the balance sheet as plant and equipment , intangible assets , or long term investments . However, the purchase and sale of short term investments other than cash equivalents are also investing activities. Cash Flows from Investing Activities Cash Inflows Cash Outflows -Proceeds from selling assets -Payments to purchase assets -Proceeds from collecting loans -Payments to acquire securities -Proceeds from selling securities -Payments to acquire dept securities -Proceeds from sale of loans made by -Payments in the form of loans made to other the enterprise parties Financing Activities A companies transactions with its owners and long term creditors are called financing activities. Also , financing activities include borrowing cash on a short term basis. However, cash payments to settle credit purchases of merchandise, whether on account or by note, are operating activities. Payments of interest expense are also operating activities. Cash Flows from Financing Activities Cash Inflows Cash Outflows -Proceeds from the issuance of -Payments of dividends and other distributions securities to owners -Proceeds from the issuance of -Payments to purchase treasury stock bonds and notes payable -Repayments of cash loans -Proceeds from other short or long -Payments of the principal amounts involved term borrowing transactions in long term credit arrangements Preparing a Statement of Cash Flows The information you need to prepare a statement of cash flow comes from a variety of sources .
These include comparative balance sheets at the beginning and the end of the accounting period , an income statement for the period and a careful analysis of each non cash balance sheet account . Grover Company (Example) Grover Companys December 31, 1989 and 1990 balance sheets and 1990 income statement are illustrated. The objective is to prepare a statement of cash flow that explains the $5000 increase in cash , based on these financial statements and the additional information about 1990 transactions that follows: 1- All accounts payable balances resulted from merchandise purchases . 2- Plant assets that cost $70,000 were purchased by paying $10,000 cash and issuing $60,000 of bonds payable to seller. 3- Plant assets with an original cost of $30,000 and accumulated depreciation of $12,000 were sold for $12,000 cash. The result was a $6,000 …