Chapter 11: Classification of Cash Flows Flashcards
Classification of Cash Flows
Definition: Cash flows are classified into operating, investing, and financing activities in the statement of cash flows.
Importance: Helps explain how the cash balance changed from the beginning to the end of the period.
Cash and Cash Equivalents
Cash includes cash and cash equivalents. Cash equivalents are short-term, highly liquid investments.
Criteria for Cash Equivalents:
Readily convertible to known amounts of cash.
Three months or less to maturity.
Insignificant risk of changes in value.
Examples: Treasury bills, money market funds, commercial paper.
Statement of Cash Flows Categories
Operating Activities: Cash flows from core business operations.
Investing Activities: Cash flows from buying and selling long-term assets.
Financing Activities: Cash flows from issuing or repurchasing the company’s own bonds or stock.
Purpose: Explain changes in cash from the beginning balance to the ending balance on the statement of financial position.
Standard: International Accounting Standard 7 (IAS 7) defines these categories for comparability.
Cash Flows from Operating Activities
Definition: Cash flows from operating activities (or cash flows from operations) encompass cash inflows and outflows directly related to revenues and expenses on the statement of earnings.
Direct Method:
Components (Inflows): Cash received from customers, dividends, and interest on investments.
Components (Outflows): Cash paid for services, goods for resale, salaries, wages, income taxes, and interest on borrowings.
Calculation: Net cash provided or used in operating activities is the difference between inflows and outflows.
Indirect Method:
Calculation: Starts with net earnings, adjusts for non-cash items, arriving at net cash inflow/outflow from operating activities.
Differences Between Net Earnings and Cash Flows from Operating Activities
Explanation: Discrepancy arises due to accrual accounting where revenues and expenses are recognized without considering cash collection or payment timing.
Direct vs. Indirect: Both methods compute the same net cash provided by (used in) operating activities, as demonstrated by the example provided.
Importance of Cash Flows from Operating Activities
Significance: Reflects the actual cash generated or used by core business operations.
Consistency: Regardless of the method used (direct or indirect), the cash flow from operating activities remains the same.
Understanding: Vital for assessing a company’s liquidity and ability to meet short-term obligations.
Direct Method of Cash Flows from Operating Activities
Description: The direct method reports specific cash inflows and outflows related to operating activities. Inflows include cash received from customers, dividends, and interest, while outflows comprise payments for services, goods, salaries, wages, income taxes, and interest on borrowings.
Advantages: Provides detailed, transparent information about cash transactions, enhancing clarity for stakeholders.
Disadvantages: Less commonly used due to the detailed data required and higher implementation costs.
Indirect Method of Cash Flows from Operating Activities
Description: The indirect method starts with net income and adjusts it for non-cash items and changes in working capital to derive cash flows from operating activities. Common adjustments include depreciation, changes in accounts receivable, accounts payable, and inventory.
Advantages: Easier and less costly to implement as it starts with readily available net income data from the income statement.
Disadvantages: May be less transparent as it doesn’t provide a detailed breakdown of specific cash inflows and outflows, relying on adjustments from net income.
Cash Flows from Investing Activities
Definition: Cash flows from investing activities encompass cash inflows and outflows associated with the acquisition and disposal of long-lived productive assets and investments in other companies’ securities.
Inflows: Cash received from the sale or disposal of property, plant, and equipment, and from the sale or maturity of investments in securities.
Outflows: Cash paid for the purchase of property, plant, and equipment, and for investments in securities.
Calculation: Net cash provided by (used in) investing activities is the difference between these cash inflows and outflows.
Net Cash Flow in Investing Activities
Example: National Beverage experienced a net cash outflow of $25,302 in fiscal year 2021 for investing activities.
Explanation: The outflow resulted from total purchases of property, plant, and equipment exceeding cash received from their sales.
Significance: Reflects the company’s investment decisions in long-term assets and securities, indicating financial strategies and expansions.
Cash and Cash Equivalents
Importance: Cash and cash equivalents represent highly liquid assets that can be quickly converted into cash. They include currency, bank deposits, and short-term investments with maturities of three months or less.
Beginning and Ending Balances: These balances indicate the amount of cash and cash equivalents at the start and end of the reporting period, as shown on the statement of financial position.
Example: For fiscal year 2021, National Beverage had cash and cash equivalents of $304,518 at the beginning of the period, which decreased to $193,589 at the end of the period due to the net cash flows from operating, investing, and financing activities.
Cash Flows from Investing Activities
Definition: Cash flows from investing activities encompass cash inflows and outflows associated with the acquisition and disposal of long-lived productive assets and investments in other companies’ securities.
Inflows: Cash received from the sale or disposal of property, plant, and equipment, and from the sale or maturity of investments in securities.
Outflows: Cash paid for the purchase of property, plant, and equipment, and for investments in securities.
Calculation: Net cash provided by (used in) investing activities is the difference between these cash inflows and outflows.
Net Cash Flow in Investing Activities
Example: National Beverage experienced a net cash outflow of $25,302 in fiscal year 2021 for investing activities.
Explanation: The outflow resulted from total purchases of property, plant, and equipment exceeding cash received from their sales.
Significance: Reflects the company’s investment decisions in long-term assets and securities, indicating financial strategies and expansions.
Typical Cash Flows from Investing Activities
Inflows: Cash received from the sale or disposal of property, plant, and equipment, and from the sale or maturity of investments in securities.
Outflows: Cash paid for the purchase of property, plant, and equipment, and for investments in securities.
Purpose: Provides insight into the company’s capital expenditure and divestment activities, influencing its overall financial health.
Cash Flows from Financing Activities
Definition: Cash flows from financing activities involve cash inflows and outflows related to external sources, such as owners and creditors, used to finance the
enterprise.
Inflows include cash received from borrowing (notes, mortgages, bonds) and issuing shares to shareholders.
Outflows consist of cash paid for repaying principal, interest on borrowings (if classified as financing activity), repurchasing shares, and dividends to shareholders.
Calculation: Net cash provided by (used in) financing activities is the difference between these cash inflows and outflows.
Importance: Indicates how the company secures funding and manages its financial obligations through borrowing, equity issuance, and shareholder transactions.
