cash flow statement theory

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Cash Flow Statement Theory for the mba project reports of osmania university

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A cash flow statement is a financial report that describes the source of a company's cash and how it was spent over a specified time period. Because of the varied accrual accounting methods companies may employ, it is possible for a company to show profits while not having enough cash to sustain operations. A cash flow statement neutralizes the impact of the accrual entries on the other financial statements. It also categorizes the sources and uses of cash to provide the reader with an understanding of the amount of cash a company generates and uses in its operations, as opposed to the amount of cash provided by sources outside the company, such as borrowed funds or funds from stockholders. The cash flow statement also tells the reader how much money was spent for items that do not appear on the income statement, such as loan repayments, long-term asset purchases, and payment of cash dividends. Cash flow statements classify cash receipts and payments according to whether they stem from operating, investing, or financing activities. It also provides that the statement of cash flows may be prepared under either the direct or indirect method, and provides illustrative examples for the preparation of statements of cash flows under both the direct and the indirect methods. CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS At the beginning of a company's life cycle, a person or group of people come up with a idea for a new company. The initial money comes from the owners, or could be borrowed. This is how the new company is "financed." The money owners put into the company, or money the company borrows, is classified as a financing activity. Generally, any item that would be classified on the balance sheet as either a long-term liability or an equity would be a candidate for classification as a financing activity. The owners or managers of the business use the initial funds to buy equipment or other assets they need to run the business. In other words, they invest it. The purchase of property, plant, equipment, and other productive assets is classified as an investing activity. Sometimes a company has enough cash of its own that it can lend money to another enterprise. This, too, would be classified as an investing activity. Generally, any item that would be classified on the balance sheet as a long-term asset would be a candidate for classification as an investing activity.

Now the company can start doing business. It has procured the funds and purchased the equipment and other assets it needs to operate. It starts to sell merchandise or services and make payments for rent, supplies, taxes, and all of the other costs of doing business. All of the cash inflows and outflows associated with doing the work for which the company was established would be classified as an operating activity. In general, if an activity appears on the company's income statement, it is a candidate for the operating section of the cash flow statement. ACCRUAL AND ITS EFFECT ON FINANCIAL STATEMENTS Generally accepted accounting principles (GAAP) require that financial statements are prepared on the accrual basis. For example, revenues that were earned during an accounting period may not have been collected during that period, and appear on the balance sheet as accounts receivable. Similarly, some of the collections of that period may have been from sales made in prior periods. Cash may have been collected in a period prior to the services rendered or goods delivered, resulting in deferred recognition of the revenue. This would appear on the balance sheet as unearned revenue. Sometimes goods or services are paid for prior to the period in which the benefit is matched to revenue (recognized). This results in a deferred expense, or a prepaid expense. Items such as insurance premiums that are paid in advance of the coverage period are classified as prepaid. Sometimes goods or services are received and used by the company before they are paid for, such as telephone service or merchandise inventory. These items are called accrued expenses, or payables, and are recognized on the income statement as an expense before the cash flow occurs. When buildings or equipment are purchased for cash, the cash flow precedes the recognition of the expense by many years. The expense is recognized over the life of the asset as depreciation. One of the main benefits of the cash flow statement is that it removes the effect of any such accruals or deferrals. METHODS OF PREPARING THE CASH FLOW STATEMENT Small business owners preparing a cash flow statement chan choose either the direct or the indirect method of cash flow statement presentation. The operating section of a cash flow statement prepared using either method converts the income statement from the accrual to the cash basis, and reclassifies any

activity not directly associated with the basic business activity of the firm. The difference lies in the presentation of the information. Companies that use the direct method are required, at a minimum, to report separately the following classes of operating cash receipts and payments: RECEIPTS Companies are encouraged to provide further breakdown of operating cash receipts and payments that they consider meaningful. Companies using either method to prepare the cash flow statement are also required to separately disclose changes in inventory, receivables, and payables to reconcile net income (the result of the income statement) to net cash flow from operating activities. In addition, interest paid (net of amount capitalized) and income taxes paid must be disclosed elsewhere in the financial statements or accompanying notes. An acceptable alternative presentation of the indirect method is to report net cash flow from operating activities as a single line item in the statement of cash flows and to present the reconciliation details elsewhere in the financial statements. The reconciliation of the operating section of a cash flow statement using the indirect method always begins with net income or loss, and is followed by an "adjustments" section to reconcile net income to net cash provided by operating activities. Regardless of whether the direct or the indirect method is used, the operating section of the cash flow statement ends with net cash provided (used) by operating activities. This is the most important line item on the cash flow statement. A company has to generate enough cash from operations to sustain its business activity. If a company continually needs to borrow or obtain additional investor capitalization to survive, the company's long-term existence is in jeopardy. The presentation of the investing and financing sections is the same regardless of whether the statement is prepared using the direct or indirect method. The final section of the cash flow statement is always a reconciliation of the net increase or decrease in cash for the period for which the statement is prepared, with the beginning and ending balances in cash for the period. ANALYZING AND CLASSIFYING COMMON TRANSACTIONS

Transactions on the balance sheet also must be analyzed and converted from the accrual to the cash basis in preparation of the cash flow statement. Every balance sheet account reflects specific activity. There are only a few distinctive transactions that affect each account. Following are examples of some of the common transactions affecting balance sheet items: Accounts receivable increases when the company sells merchandise or does a service on credit, and decreases when the customer pays its bill. Accounts receivable is associated with the income statement account Sales or Revenue. The change in accounts receivable or the cash collected from customers is classified as an operating activity. Inventory increases when the company buys merchandise for resale or use in its manufacturing process, and decreases when the merchandise is sold. Inventory is associated with the income statement account Cost of Goods Sold. The change in inventory or the cash paid for inventory purchases is classified as an operating activity. Prepaid insurance increases when the company pays insurance premiums covering future periods and decreases when the time period of coverage expires. Prepaid insurance is associated with the income statement account Insurance Expense. The change in prepaids or the amount paid for insurance is classified as an operating activity. The Land, Building, and Equipment accounts increase when the company purchases additional assets. They also undergo a corresponding decrease when the assets are sold. The only time the income statement is affected is when the asset is sold at a price higher or lower than book value, at which time a gain or loss on sale of assets appears on the income statement. The amount of cash used or received from the purchase or sale of such assets is classified as an investing activity. The gain or loss is classified as an adjustment in the operating section on a cash flow statement prepared using the indirect method. Accumulated depreciation increases as the building and equipment depreciates and decreases when building and equipment is sold. Accumulated depreciation is associated with depreciation expense on the income statement. Depreciation expense does not appear on a cash flow statement presented using the direct method. Depreciation expense is added back to net income

on a cash flow statement presented using the indirect method, since the depreciation caused net income to decrease during the period but did not affect cash. Goodwill increases when the parent company acquires a subsidiary for more than the fair market value of its net assets. Goodwill amortizes over a time period not to exceed 40 years. Goodwill is associated with amortization expense on the income statement. Amortization expense appears in the operating section of a cash flow statement prepared using the indirect method. Amortization expense does no