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.
Defining Cash and Cash Equivalents
AS-3 defines "cash" as including cash on hand and demand
deposits with banks or other financial institutions.
"Cash
equivalents" are defined as short-term, highly liquid investments that are
readily convertible to known amounts of cash and
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.
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.
2. Investing
Activities: These activities relate to the acquisition and disposal of long-term
assets and other investments not included in cash equivalents.
3. Financing
Activities: These activities relate to changes in the equity and debt capital of
the enterprise.
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.
·
Direct
Method: This
method involves reporting the gross cash receipts and gross cash payments from
operating activities.
- 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.
- 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.
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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