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 Flow
Statement: Concepts, Classifications, and Direct Method
What is Cash
and Cash Equivalent?
In the context of the cash flow statement, the terms
"cash" and "cash equivalents" refer to liquid assets that
are readily available for use or conversion into cash. Specifically:
·
Cash
refers to the amount of currency and coins held by an organization, including
balances in checking accounts, or any other form of immediate liquidity accessible
for operational needs.
·
Cash Equivalents are short-term, highly liquid investments that are
easily convertible to a known amount of cash and have a maturity period of
three months or less from the date of acquisition. These include short-term
deposits, marketable securities, and Treasury bills, provided that they are not
subject to significant fluctuations in value.
The inclusion of cash equivalents in the cash flow
statement ensures that users can see a comprehensive picture of an entity's
liquidity, especially when cash needs fluctuate due to business operations.
The cash flow statement, as per Accounting Standard
(AS) 3, classifies cash flows into three major activities:
1. Operating
Activities:
o This category
includes cash inflows and outflows from the core business operations.
Essentially, any transaction that generates revenue or expenses, or relates to
the company's day-to-day activities, falls under this heading.
o Operating
activities typically include receipts from sales of goods and services,
payments to suppliers for goods and services, salaries and wages payments, and
interest payments or receipts related to operating income.
o Operating cash
flows reflect the entity's ability to generate cash from its core business
operations, which is crucial for understanding the sustainability of its
operations.
2. Investing
Activities:
o Investing
activities deal with cash flows related to the acquisition and disposal of
long-term assets, such as property, equipment, intangible assets, or financial
investments.
o Cash inflows from
investing activities could include proceeds from the sale of property or
investments in securities, while outflows might include cash spent on
purchasing fixed assets or making loans.
o This section gives
insight into the company's strategies for growth or contraction, including its
capital expenditure decisions and investment strategies.
3. Financing
Activities:
o Financing
activities refer to cash flows related to the borrowing and repayment of funds,
including equity transactions such as issuing shares or repurchasing stock.
o Cash inflows might
include money raised from issuing equity or debt, while cash outflows could
include dividends paid, repayments of debt principal, or buybacks of shares.
o These activities
help gauge how a company finances its operations, including how it raises
capital, handles debt, and returns value to shareholders.
Calculation of
Cash Flow in Each Activity
As per AS-3, the cash flow in each activity is
calculated as follows:
1. Operating
Activities:
o Under the Indirect Method, the cash flows from
operating activities are derived by adjusting the net profit for changes in
working capital and non-cash expenses.
§ Start with the net
income for the period.
§ Adjust for
non-cash transactions (e.g., depreciation, amortization).
§ Adjust for changes
in working capital (e.g., increases or decreases in receivables, payables,
inventory).
§ Subtract any
non-operating cash flows like interest or tax paid.
o Under the Direct Method, cash flows are calculated
by directly reporting receipts and payments from operations, such as:
§ Cash receipts from
customers.
§ Cash payments to
suppliers and employees.
§ Cash paid for
operating expenses (taxes, interest).
§ Cash received for
interest or dividends.
2. Investing
Activities:
o For investing
activities, the focus is on the movement of cash in and out due to changes in
long-term assets.
§ Add any cash
inflows from the sale of property or equipment.
§ Subtract cash
outflows for the purchase of assets or investments.
3. Financing
Activities:
o Financing
activities deal with cash movements between the company and its owners or
creditors.
§ Cash inflows may
come from issuing debt or equity, while cash outflows include repaying debt,
issuing dividends, or repurchasing shares.
Preparation of
Cash Flow Statement under the Direct Method
The direct method is one of the ways to prepare the
cash flow statement. The main difference between the direct and indirect
methods lies in how the operating cash flows are calculated. Here is how the
direct method is used to prepare the statement:
1. Cash
Receipts from Customers:
- This includes all the cash received
from sales of goods or services during the period. It excludes any
receivables or non-cash transactions. The formula is:
- Cash receipts
from customers = Sales – Increase in Accounts Receivable + Decrease in
Accounts Receivable
2. Cash
Payments to Suppliers:
- Cash payments to suppliers and
employees for goods and services are included here. This section includes
cash outflows for the purchase of inventory, raw materials, or any other
supplies.
- Cash
payments to suppliers = Cost of Goods Sold + Increase in Inventory +
Increase in Accounts Payable – Decrease in Accounts Payable
3. Cash
Payments to Employees:
- Payments to employees include wages,
salaries, and other compensation. It's an essential part of the direct
method to calculate the total cash outflows for employee-related expenses.
- Cash
payments to employees = Operating Expenses – (Depreciation + Non-Cash
Employee Benefits)
4. Interest
and Tax Payments:
- Interest paid and taxes paid are
treated separately under the direct method, as they are considered
operational outflows.
- Interest
payments = Interest Expenses – Non-Cash Financing Costs
- Tax payments
= Tax Expense – Changes in Tax Liabilities
5. Other Operating
Cash Inflows and Outflows:
- Other operating cash flows may
include refunds, insurance reimbursements, or any other operating cash
activities that are not captured under the major headings of receipts or
payments.
Benefits and Challenges of the Direct Method
Benefits:
- Clarity: The direct
method provides a more straightforward and intuitive view of cash inflows
and outflows.
- Detailed Cash Insights: It gives
more granular details, such as exact receipts from customers and cash
payments to suppliers and employees, which can help users of financial
statements better understand the company’s liquidity position.
Challenges:
- Data Intensive: The direct
method requires more detailed information, making it cumbersome for
companies to implement, especially for large organizations with vast
transaction volumes.
- Lack of Consistency: Because the
direct method is not commonly used in practice, different companies might
have different approaches to determining what constitutes an operating
receipt or payment.
Conclusion
The cash flow statement is an essential financial
statement that provides critical insight into a company's liquidity, solvency,
and overall financial health. Understanding the distinction between cash and
cash equivalents, along with the categories of cash flows—operating, investing,
and financing—helps stakeholders make more informed decisions regarding the
financial position of a business.
While the direct method offers a more detailed and
transparent view of cash flows from operating activities, its implementation is
less common due to the complexity involved in tracking and reporting cash
inflows and outflows. Regardless of the method used, the cash flow statement
provides an essential framework for analyzing the company’s ability to generate
cash, manage its financial obligations, and create value for shareholders.
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