In context of Cash Flow Statement, what is cash and cash equivalent? In what categories cash flows are classified and explain how cash flow in each activity is calculated as per AS-3. Describe how cash flow statement is prepared under Direct Method.

 Q. In context of Cash Flow Statement, what is cash and cash equivalent? In what categories cash flows are classified and explain how cash flow in each activity is calculated as per AS-3. Describe how cash flow statement is prepared under Direct Method.

Cash and Cash Equivalents in the Context of a Cash Flow Statement

In accounting, particularly under Accounting Standard 3 (AS 3) – Cash Flow Statements, the term "cash and cash equivalents" refers to a company's most liquid assets, which can be quickly converted into cash or are already in cash form. The cash flow statement provides an overview of the inflows and outflows of cash within a company during a specific period, showing how a company manages its cash position and its ability to meet its financial obligations. Cash and cash equivalents typically include cash in hand, cash at bank, and short-term investments that are easily convertible into cash with a known amount of risk, usually within a 3-month period.

In more detail, cash and cash equivalents are assets that are either in hand or held in short-term deposits or other highly liquid investments that are subject to an insignificant risk of changes in value. These could include:

• Cash on hand: Physical currency, coins, and notes that a company holds.
• Cash at bank: Balances available in the company’s checking and savings accounts.
• Short-term investments: Highly liquid investments such as treasury bills, marketable securities, and money market funds with an original maturity of three months or less.

Cash equivalents are often short-term, low-risk investments that are close to maturity and can be easily converted into cash with minimal impact on value.

Classification of Cash Flows According to AS-3

According to Accounting Standard 3 (AS 3), cash flows are classified into three main categories:

1.     Operating Activities

2.     Investing Activities

3.     Financing Activities

Each of these activities is classified to help users of the financial statements understand the sources and uses of cash in the company’s normal business operations, investments, and funding activities.

1. Operating Activities

Operating activities include the principal revenue-producing activities of the company and other activities that are not investing or financing activities. Essentially, cash flows from operating activities reflect the cash generated or consumed by the company’s core business operations. These cash flows are critical because they reflect the ability of the business to generate cash from its routine activities.

Examples of operating activities:

• Receipts from the sale of goods or services.
• Payments to suppliers for goods and services.
• Payments to employees.
• Receipts and payments of income taxes.
• Payments for interest and dividends (though there can be some flexibility here depending on how they are classified in specific situations).

Operating cash flow is essential because it shows how much cash a business can generate from its core operations, without needing to rely on external financing.

Calculation: Operating cash flow can be calculated using two methods:

• Direct Method (explained below).
• Indirect Method, which adjusts net income for changes in working capital and non-cash items.

2. Investing Activities

Investing activities refer to the purchase and sale of long-term assets and other investments not included in cash equivalents. Investing activities generally reflect how a company allocates its resources to generate future cash flows. It involves the acquisition and disposal of long-term assets, such as property, plant, equipment, and investments in securities.

Examples of investing activities:

• Purchases of property, plant, and equipment (capital expenditures).
• Sale of property, plant, and equipment.
• Purchases and sales of securities (such as stocks and bonds).
• Loans made to other entities (and receipts of repayments of those loans).

The net cash provided by or used in investing activities tells how much cash the company is investing for future growth and what it receives from the sale of its assets.

Calculation: The cash flows from investing activities are typically calculated by subtracting the outflows from the inflows related to acquisitions and disposals of long-term assets and investments.

3. Financing Activities

Financing activities reflect the cash flows associated with the company's owners and creditors. This category shows how a company raises capital and repays its debts. Financing activities can be from equity (owners) or debt (borrowed funds).

Examples of financing activities:

• Issuance of shares or bonds (inflows).
• Repayments of loans or bonds (outflows).
• Payment of dividends to shareholders (outflows).
• Borrowing or repaying funds to and from creditors.

Calculation: The cash flow from financing activities is the net result of these cash inflows and outflows, indicating whether the company is raising or returning funds to its shareholders and creditors.

Cash Flow Statement Preparation under the Direct Method

The Direct Method of preparing the cash flow statement involves reporting the specific cash inflows and outflows related to operating activities. This method presents a more detailed view of the actual cash receipts and cash payments during the period, making it easier to understand how the company generates cash from its primary operating activities.

Under the Direct Method, the following steps are generally involved in preparing the operating section of the cash flow statement:

1.     Receipts from Customers: The first step is to calculate the cash inflows from customers. This is usually the total revenue recognized from sales of goods and services, adjusted for changes in accounts receivable (i.e., sales made on credit). Cash receipts are derived by subtracting the increase in receivables or adding back the decrease in receivables to sales revenue.

Formula:

$$\text{Receipts from Customers} = \text{Revenue from sales} + (\text{Decrease in Accounts Receivable}) - (\text{Increase in Accounts Receivable})$$

2.     Payments to Suppliers: The next component involves calculating the payments made to suppliers for goods and services. This includes the cost of goods sold adjusted for changes in inventory and accounts payable. Essentially, it reflects the amount of cash that has been used to pay for raw materials, services, and goods that are necessary for the company’s operations.

Formula:

$$$$

$$\text{Payments to Suppliers} = \text{Cost of Goods Sold} + (\text{Increase in Inventory}) - (\text{Decrease in Inventory}) + (\text{Decrease in Accounts Payable}) - (\text{Increase in Accounts Payable})$$

3.     Payments to Employees: The third step is calculating the cash outflow related to employee compensation. This involves wages, salaries, and other employee benefits. The calculation typically takes the form of adjusting the expense for changes in accrued wages or benefits.

Formula:

$$$$

$$\text{Payments to Employees} = \text{Employee Expenses} + (\text{Increase in Accrued Wages}) - (\text{Decrease in Accrued Wages})$$

4.     Other Operating Cash Payments: This section involves other cash payments related to operations, such as taxes, interest payments, and any other operational costs not already accounted for.

Formula:

$$$$

$$\text{Other Operating Payments} = \text{Interest Expense} + \text{Tax Expense} \pm \text{Changes in Accruals}$$

5.     Cash Generated from Operations: After calculating the cash inflows and outflows from the operating activities, the net cash flow from operating activities is determined by subtracting total outflows from total inflows. This value represents the actual cash generated by the company’s core operations during the period.

Formula:

$$$$

$$\text{Net Cash from Operating Activities} = \text{Receipts from Customers} - \text{Payments to Suppliers} - \text{Payments to Employees} - \text{Other Operating Payments}$$

This approach gives users of the cash flow statement a very transparent view of the cash movements directly related to the company's operations.

Comparison with the Indirect Method

While the Direct Method is generally considered more informative as it directly shows cash receipts and payments, it is less commonly used in practice due to its complexity and the extensive data required. Instead, the Indirect Method is often used for preparing cash flow statements because it starts with net income and adjusts for changes in non-cash items, working capital, and other activities. The indirect method is simpler and often requires less detailed information.

Example of Preparing Cash Flow Using Direct Method

Let’s consider a hypothetical company with the following data for a fiscal year:

• Revenue from sales: ₹1,000,000
• Cost of goods sold: ₹600,000
• Employee expenses: ₹200,000
• Interest payments: ₹20,000
• Taxes paid: ₹50,000
• Changes in accounts receivable: Increase of ₹30,000
• Changes in inventory: Increase of ₹20,000
• Changes in accounts payable: Increase of ₹10,000
• Change in accrued wages: Increase of ₹5,000

Step 1: Calculate Receipts from Customers

$$$$

$$\text{Receipts from Customers} = \text{Revenue} + (\text{Decrease in Accounts Receivable}) - (\text{Increase in Accounts Receivable})$$

Step 2: Calculate Payments to Suppliers

$$$$

$$\text{Payments to Suppliers} = \text{Cost of Goods Sold} + (\text{Increase in Inventory}) - (\text{Increase in Accounts Payable})$$

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