Cash Flow Statement
With the development and publication of SFAS 95, the primary categories of cash flow are defined as operating, investing and financing activities. SFAS 95 also defined cash to include cash equivalents with maturities of 90 days or less, such as treasury bills, commercial paper and money market funds Compelling Reasons for requiring a statement of Cash Flow: * Information provided: The statement of cash flows can provide the information that other financial statements can’t provide.The other financial statements such as Balance Sheet, which represents the company’s financial condition at a specific point in time, the Income Statement, which presents the results of operations, i.
e. profit or loss, for a specific period of time, and the Statement of Owners’ Equity, which details the changes in the value of the owners’ stake in the company. In accrual accounting, these other documents are based on when transactions took place, rather than when cash changed hands.The Statement of Cash Flows provides the data on what happened from a cash perspective. They present relevant information about the cash receipts and cash payments of an enterprise during a period. Statements of financial position include information that is often used in assessing an entity’s liquidity and financial flexibility, but a statement of financial position provided only an incomplete picture of either liquidity or financial flexibility unless it is used in conjunction with at least a cash flow statement.There are 3 major categories for the information that is reported on the Statement of Cash Flows.
Cash Flow Statement Essay Example
They are operating activities, investing activities, and financing activities. Between the three major areas, every aspect of a business’ transactions is covered. For example, it shows how a company purchases and finances an asset instead of just showing the amount. * Usefulness:The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, can help investors, creditors, and others to (a) assess the enterprise’s ability to generate positive future net cash flows; (b) assess the enterprise’s ability to meet its obligations, its ability to pay dividends, and its needs for external financing; (c) assess the reasons for differences between net income and associated cash receipts and payments; and (d) assess the effects on an enterprise’s financial position of both its cash and noncash investing and financing transactions during the period; (e) improve the comparability of different firms’ operating performance by eliminating the effects of different accounting methods.For example, in Balance sheet, some companies may use FIFO method to measure inventory while some others may use LIFO method; (f) assess future cash flows, provide feedback about actual cash flows; (g) Cash flow statement helps for appraisal of various capital investment programmers to determine their profitability and viability. Support and Criticisms for Statement of Cash Flows: * A general criticism is that cash flow statements are not meaningful for some institutions such as financial institutions, small businesses, investment companies and non-for-profit organizations. Thus, the information in the statement of cash flows is not useful.
In the case of financial institutions, the identification of the core operating activities is important, because they differ markedly from nonfinancial companies in this respect. Consider commercial banking institutions, where the core operations can be divided between on–balance sheet activities and off–balance sheet activities.The off–balance sheet activities consist primarily of fee-based activities for services rendered that do not create an asset or a liability. These create no problem for the cash flow presentation because they appear on the income statement and flow directly through the operating section of the cash flow statement. The major problems are created by activities that have significant impact on the balance sheet. They are: 1) managing the accounts of depositors, which appears on the balance sheet as liabilities; 2) lending money to customers, which appears on the balance sheet as assets; and 3) trading in securities, which appears on the balance sheet as assets.If these are a bank’s core operations, one would expect them to be in the operating activities section of the cash flow statement.
Instead, customer deposits are listed as financing activities, while loans to customers and securities activities appear in the investing activities section. As a result, the figure for “cash provided by operations” is meaningless. In other words, the breakdown of cash flows into operating, investing, and financing activities—as presently constituted for financial institutions—is not useful to readers of the financial statements. A totally new form of presentation is needed to provide useful cash flow information. * Reporting of Operating ActivitiesAlthough the accounting profession talks about the importance of comparability of financial information, the fact that interest paid is treated as an operating activity while dividends paid is treated as a financing activity makes it difficult, if not impossible, to compare the performance of companies that make different financing choices. Analysts have resorted to their own measures to make such comparisons. One of the most common is earnings before interest, taxes, depreciation, and amortization (EBITDA); however, other means to compare exist, with no commonly agreed upon measure for all to use.
Up to now, the accounting profession has simply ignored the issue. The only analytical measure that has been dealt with by the accounting profession is earnings per share, because this must be presented on the income statement. A second problem affecting the operating activities involves the financing of receivables.Years ago, receivables were financed through borrowing, with receivables pledged as collateral. The monies received were treated as a financing activity, which was appropriate. In recent years, however, increasing concern on keeping debt off the balance sheet has led companies to replace the above treatment with sales of receivables, with and without recourse. Economically, these activities still represent a form of financing.
The accounting rules, however, allow these transactions to be treated as operating activities instead of financing activities. This makes these transactions doubly attractive to companies: They keep the borrowing off the balance sheet and inflate cash provided by operations. Economically, the ledge of accounts receivable is the same as the sale of accounts receivable, but they are treated differently in the cash flow statement. This treatment is inconsistent. Another problem that causes distortions in operating cash flows stems from the treatment of dividends received as an operating activity rather than as an investing activity. When a company has significant investments in affiliated companies, it has the ability to manipulate its own “cash provided by operations” by increasing the dividends it receives from such companies. This simple technique has been used by many companies to inflate operating cash flows.
Furthermore, dividend income comes from investments.If the former is shown in the section of operating activities, and the latter placed in investing activities, the financial statement reader will not be able to visualize the whole picture of investment strategy. Another potentially serious distortion to operating cash flows comes from the rule that requires taxes to be treated as an operating activity, even when the gain being taxed is included in investing activities. For example, consider a company that has low operating profit but has a large gain from the sale of investments. The bulk of the pretax income is from this gain, and therefore the bulk of the income tax expense is related to this gain.On the statement of cash flows, however, the gain is removed from operating activities and included under investing activities instead, as part of the proceeds from the sale of the investments. But the income tax expense on that gain remains in the operating activities sections, generating substantial negative cash from operations.
This clearly is misleading, and violates the matching rules required on the income statement. * The Investing Activities Section For many years, the distinction between cash equivalents (investments having no principal risk) and other marketable securities has caused serious confusion for the untrained reader of financial statements.Cash equivalents are treated as part of cash, while marketable securities are shown as investing activities. Where a company’s portfolio manager does a lot of trading and switching between these two types of securities, very large numbers will appear in the investing activities section as “purchases of marketable securities” and “sales of marketable securities. ” It is not uncommon to see financial statements in which these numbers represent the largest cash flows. Were one to ask the untrained reader what the most significant events for the company were during the year, the answer might be the purchasing and selling of marketable securities.Yet these numbers are irrelevant for understanding the company’s performance.
They merely clutter up the statement and cause confusion. Another major problem with the investing activities section is that it is based on the rule that only cash amounts may be shown in investing and financing activities. Thus, for example, if one company acquired another at a cost of $10 billion, but only $1 billion of it was in cash, with the rest paid in the form of debt and equity instruments, the cash flow statement would show only the $1 billion cash amount paid as the cost of the acquisition. The other $9 billion would be relegated to a footnote. The untrained reader would get a false picture of the true cost of the acquisition.This is another example showing the deficiency of the current rules in preparing the cash flow statement. The rules ignore the vision of a complete transaction.
* Indirect Method vs. Direct Method 1. Advantages of Indirect Method The principal advantage of the indirect method is that it highlights the differences between net income and NCFO. Highlighting these differences is useful when using NCFO as an alternative performance metric to report the cash flow and accrual components of net income. As a result, the indirect method helps users understand the leads and lags between NCFO and net income. It highlights the operating changes in non-cash working capital accounts.For example, the indirect method highlights any buildup of operating receivables (payables) that decrease (increase) NCFO relative to net income, or the reduction of operating receivables (payables) that increase (decrease) NCFO relative to net income.
2. Disadvantages of Indirect Method The principal disadvantage of the indirect method is that it does not report actual operating inflows and outflows. It reports only one cash flow for operating activities — NCFO. For this reason, operating activities are reported net, not gross, under the indirect method. As a result, the indirect method is less informative than the direct method supplemented by a reconciliation of net income and NCFO.It is also criticized for repeating information already presented in the income statement and the comparative balance sheet. 3.
Advantages of Direct Method SFAS-95 notes that the principal advantage of the direct method is that it is more informative than the indirect method because it reports operating cash receipts and payments. In a fundamental sense, the direct method is finer, or more informative, than the indirect method. The direct method with the reconciliation provides all the information provided by the indirect method plus information on gross operating inflows and outflows. Accordingly, report users could effortlessly transform a direct method cash flow statement into an indirect method cash flow statement.However, report users cannot effortlessly transform an indirect method cash flow statement into a direct method cash flow statement because information on gross operating inflows and outflows is not provided. Accordingly, the direct method is finer, or more informative, than the indirect method. 4.
Disadvantages of Direct Method Those companies that use the direct method are required under SFAS-95 to provide a supplemental reconciliation of net income and NCFO. As a result, the direct method requires more work than the indirect method. Additionally, some accountants caution that a direct method cash flow statement seemingly duplicates similar information presented in the income statement and thereby may undermine user perception of the usefulness of accrual basis income measurement.In response to the FASB Exposure Draft, which favored but did not propose to require the direct method, many spokesmen for corporate management claimed that the direct method is impractical and costly to apply. More specifically, they claimed that the direct method would require costly modifications of accounting information systems to routinely generate information on operating cash inflows and outflows not previously accumulated. Additionally, few public companies issued direct method statements of changes in financial position prior to the adoption of SFAS-95 than the indirect method. Influence of this statement * How can the Statement of Cash Flows be used by the investment community to determine how healthy a company may be?One primary use is to help determine future risk.
A company generally will record the revenue that drives earnings when their customers receive their merchandise, whether the customer has paid for the merchandise or not. The Statement of Cash Flows can show the investment community how much cash is actually collected. So, if earnings are good yet cash collections are not, the investor should be worried: future earnings could be at risk if bad debt becomes an issue. * Investors can also get a feel for whether or not a company is playing earnings games by comparing net income on the Income Statement with Cash from Operating Activities from the Statement of Cash Flows.Investment analysts typically like to see a ratio of those two numbers close to one, because the closer it is to one, the higher-quality the earnings are considered. * Investment experts also like to compare the rates at which net income and operating cash are growing. If the two have historically moved at similar rates but cash is now slowing, it represents an early warning sign that the company may soon experience issues.
Accounting experts pay a great deal of attention to accounts receivable, representing what customers owe the company. When receivables rise at a faster pace than sales, the company may be having trouble collecting what its customers owe.Since cash isn’t flowing in as it should be, a rise shows up as a negative on the cash-flow statement. * An analysis of the Statement of Cash Flows can also provide an early warning that demand for the company’s products are softening. Because the purchase of inventory requires cash, an increase in inventory causes cash to fall. On the other hand, when liabilities such as accounts payable increase, so should a company’s cash balances. By delaying payment to its creditors, management can free up cash.
This is not always a good thing for the company to do, because it could be stringing its customers, partners, and vendors along. Possible Changes and the reasons for the proposed changes * Direct Method vs. Indirect Method