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 a Cash Flow Statement: A Deep Dive into AS-3

The Cash Flow Statement, a crucial component of financial reporting, provides insights into the movement of cash and cash equivalents within a company during a specific period. It complements the balance sheet and income statement by highlighting the actual cash inflows and outflows, offering a more dynamic view of a company's financial health. A key element in understanding the cash flow statement is the definition of "cash and cash equivalents" and the classification of cash flows into different activities, all governed by Accounting Standard 3 (AS-3). This essay will delve into these aspects, explaining how cash flow is calculated under each activity as per AS-3 and describing the preparation of the cash flow statement using the direct method.  

Defining Cash and Cash Equivalents

AS-3 defines "cash" as including cash on hand and demand deposits with banks or other financial institutions. This is the most liquid form of asset, readily available for immediate use.  

"Cash equivalents" are defined as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. These are essentially near-cash items that a company can quickly turn into cash when needed. The standard emphasizes that the key characteristic of a cash equivalent is its high liquidity and low risk.  

Examples of cash equivalents include:

  • Short-term deposits: These are deposits with a maturity of three months or less. The short maturity ensures that the risk of value fluctuation is minimal.
  • Money market instruments: These are highly liquid debt instruments with short maturities, such as treasury bills and commercial paper.  
  • Cash funds: These are mutual funds that invest in highly liquid, short-term securities.

It's important to note that not all short-term investments qualify as cash equivalents. For instance, investments in equity securities, even if they are liquid, are generally not considered cash equivalents because their value can fluctuate significantly. Similarly, investments in debt securities with longer maturities (more than three months) are also not considered cash equivalents due to the higher risk of interest rate changes affecting their value.  


Classifying Cash Flows: The Three Pillars

AS-3 mandates that cash flows be classified into three main categories:  

1.    Operating Activities: These activities relate to the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. They generally involve the day-to-day transactions that drive the company's core business.  

2.    Investing Activities: These activities relate to the acquisition and disposal of long-term assets and other investments not included in cash equivalents. They represent capital expenditures made to build the business for the future.  

3.    Financing Activities: These activities relate to changes in the equity and debt capital of the enterprise. They involve how the company is funded, including transactions with shareholders and lenders.  

Calculating Cash Flow from Each Activity as per AS-3

1. Operating Activities:

Cash flow from operating activities can be calculated using either the direct method or the indirect method. AS-3 encourages the use of the direct method, although it allows for the indirect method as well. Both methods ultimately arrive at the same figure for net cash flow from operating activities, but they differ in how they present the details.  

·        Direct Method: This method involves reporting the gross cash receipts and gross cash payments from operating activities. It provides a more transparent picture of the actual cash flows related to the core business operations. Examples of cash inflows and outflows under this method include:  

    • Cash receipts from customers: This includes cash sales and collections from accounts receivable.  
    • Cash payments to suppliers: This includes payments for inventory purchases and other operating expenses.  
    • Cash payments to employees: This includes salaries, wages, and other employee benefits.
    • Cash payments for other operating expenses: This includes rent, utilities, and other day-to-day expenses.
    • Cash payments for interest: While sometimes categorized under financing, AS-3 allows for interest paid to be classified as operating if it is related to the core business.
    • Cash payments for taxes: This includes income taxes and other taxes related to operations.

·        Indirect Method: This method starts with net profit (or loss) and adjusts it for non-cash items and the effects of changes in working capital to arrive at cash flow from operating activities. Common adjustments include:  

    • Depreciation and amortization: These are non-cash expenses that reduce net profit but do not involve a cash outflow.  
    • Changes in accounts receivable: An increase in accounts receivable implies that sales were made on credit, and cash has not yet been collected. This is deducted from net profit. A decrease is added back.  
    • Changes in inventory: An increase in inventory implies that cash was used to purchase more inventory. This is deducted from net profit. A decrease is added back.
    • Changes in accounts payable: An increase in accounts payable implies that expenses were incurred but not yet paid in cash. This is added to net profit. A decrease is deducted.  
    • Gains or losses on the sale of assets: These are non-operating items that affect net profit but are related to investing activities. They are adjusted out from operating activities, and their cash impact is shown in the investing activities section.  

2. Investing Activities:

Cash flows from investing activities include:

  • Cash outflows for the purchase of property, plant, and equipment (PP&E): These are capital expenditures made to acquire long-term assets.  
  • Cash inflows from the sale of PP&E: This includes cash received from selling existing assets.
  • Cash outflows for the purchase of other long-term assets: This includes investments in intangible assets, such as patents and trademarks.
  • Cash inflows from the sale of other long-term assets: This includes cash received from selling intangible assets.  
  • Cash outflows for the purchase of investments: This includes investments in equity securities, debt securities, and other financial instruments (excluding cash equivalents).
  • Cash inflows from the sale of investments: This includes cash received from selling investments.  
  • Loans made to other entities: Cash given as loans.
  • Collection of loans: Cash received from loan repayments.

3. Financing Activities:

Cash flows from financing activities include:

  • Cash inflows from the issuance of equity securities: This includes cash received from issuing common stock or preferred stock.  
  • Cash outflows for the repurchase of equity securities: This includes cash paid to buy back the company's own shares (treasury stock).  
  • Cash inflows from the issuance of debt: This includes cash received from borrowing money through loans, bonds, or other debt instruments.
  • Cash outflows for the repayment of debt: This includes cash paid to repay principal on loans or bonds.
  • Cash outflows for the payment of dividends: This includes cash paid to shareholders as dividends.  
  • Cash inflows from other financing sources: This includes any other cash received from financing activities, such as contributions from owners.
  • Cash outflows for lease principal payments: This includes the portion of lease payments that reduces the outstanding lease liability.  

Preparing the Cash Flow Statement under the Direct Method

The direct method of preparing the cash flow statement involves the following steps:

1.    Identify the cash inflows and outflows from operating activities: This involves analyzing the company's accounting records, such as cash receipts and disbursement journals, to identify all cash transactions related to operating activities.  

2.    Classify the cash flows: Categorize each cash flow as either operating, investing, or financing.  

3.    Prepare the operating activities section: List the gross cash receipts and gross cash payments from operating activities. Calculate the net cash flow from operating activities by subtracting total cash outflows from total cash inflows.

4.    Prepare the investing activities section: List the cash inflows and outflows from investing activities. Calculate the net cash flow from investing activities.

5.    Prepare the financing activities section: List the cash inflows and outflows from financing activities. Calculate the net cash flow from financing activities.

6.    Calculate the net increase or decrease in cash and cash equivalents: This is done by adding the net cash flows from operating, investing, and financing activities.  

7.    Reconcile the beginning and ending cash and cash equivalents: Add the net increase or decrease in cash and cash equivalents to the beginning balance of cash and cash equivalents to arrive at the ending balance. This ending balance should match the cash and cash equivalents balance on the balance sheet.  

Example (Simplified):

Let's assume a company has the following transactions:

  • Cash sales: $100,000
  • Cash payments to suppliers: $60,000
  • Purchase of equipment: $20,000
  • Proceeds from issuing common stock: $30,000
  • Payment of dividends: $10,000

Cash Flow Statement (Direct Method):

Cash Flow Statement
 
Cash Flows from Operating Activities:
Cash receipts from customers        $100,000
Cash payments to suppliers          ($60,000)
Net cash from operating activities   $40,000
 
Cash Flows from Investing Activities:
Purchase of equipment             ($20,000)
Net cash from investing activities  ($20,000)
 
Cash Flows from Financing Activities:
Proceeds from issuing common stock  $30,000
Payment of dividends             ($10,000)
Net cash from financing activities  $20,000
 
Net increase in cash               $4

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