Accounting Sample Essay on Cash Flow Statements

Cash Flow Statements

Introduction

            Regulatory authorities require commercial entities to issue among other statements, the statement of cash flows during periodic financial reporting. This paper discusses the nature, preparation process and importance of cash flow statements.          .

Importance of Cash Flow Statements

            Generally, Accepted Accounting Principles and International Accounting Standards require companies to prepare financial statements at the end of trading period using the accrual basis of accounting. The accrual accounting basis recognizes expenses when they are incurred as opposed to when they are actually paid for. Similarly, revenues are recognized in the period in which sales were made and not when payment is received. This ensures that expenses and revenues for a particular financial period are attributed to that particular period. The final impact of this method of accounting is that actual cash balance differs from the balance reflected in income statement. According to Sheeba (2011), the sole importance of preparing cash flow statements is to reconcile these balances to portray the actual cash flow position of the firm to stakeholders such as investors and the public. Management may also find cash flow statements helpful in short term financial planning, tracing activities that generate, and those that use cash and in evaluation of the firms efficiency in cash management.

Structure of Cash Flow Statements

            The cash flow statement is normally divided into three broad components. These are operating activities, financing activities and investing activities. Operating activities are the main cash generators for the firm, for example, purchase and sale of goods that the company deals in. Financing activities provide the firm with capital to finance its operations for example issue of shares and loan acquisition. Investing activities involve investment in assets that facilitate the firm’s operations, for example, purchase of property plant and equipment.

            Classification of transactions in the cash flow statements enables users of financial statements to analyze the firm’s sources carefully and easily, and use cash according to their area of interest (Albrecht, Stice, Stice & Swain, 2007). Investors for instance, would be interested in the firm’s ability to pay dividends. The dividend payment and share issue records are classified under financing activities. The investor can quickly obtain relevant information by focusing his analysis on this section of the cash flow statement. Similarly, management staff may only be interested on finding out whether the firm’s day-to-day operations are generating the expected amount of cash. This information can be easily extracted from the cash flow statement by focusing on the operating activities section. Classification of transactions also facilitates easy comparison of cash flow statements of different companies. By focusing on a particular category of transactions, an analyst can evaluate a company’s weaknesses and strengths in that particular area.

Direct and Indirect Methods of Cash Flow Statement Preparation

            The two methods only differ in the manner in which cash flow from operating activities is determined.  According to Whittington and Delaney (2011), while preparing the statement under indirect method, to determine cash used or generated from operating activities, the net income as calculated in the income statement is adjusted for items that do not involve actual cash movement. For example, depreciation and amortization expenses subtracted while determining net income is added back. Similarly, gains recognized in the income statement that do not involve actual cash receipt are subtracted from the net income. Changes in working capital are then added or subtracted appropriately. For example, an increase in creditors balance compared to the previous period is added, as this is interpreted that the firm has used less cash to pay less creditors, retaining more cash that is treated as an inflow. Similarly, increase in debtors is treated as an outflow because the company has recovered less cash from its debtors. The increase is thus subtracted from net income. Tax paid is disclosed separately under this method.

            The direct method however, does not determine cash from operating activities by adjusting the net income. Under this method, cash from operating activities is calculated by adding all gains that involve cash inflow to sales. All expenses that involve cash outflow such as cash used to purchase goods sold, interest, taxes and other cash expenses are then deducted directly from sales. Under both methods, cash from financing and investing activities is determined in a similar manner. Cash used or generated from investing and financing activities are added or subtracted from the operating income with respect to the nature of transactions that occurred under those categories. For example, purchase of equipment classified under investing activities would be subtracted because it involves cash outflow. Disposal of equipment that would however be added as cash is received from the disposal. Issue of shares or loan acquisition involves cash receipt therefore would be added. The totals under each category are then summed up to obtain the actual cash balance at the end of the period.        

Conclusion

            The two methods of preparing cash flow statements are similar the only difference between them being the methods they use in calculating cash from operating activities. Most public companies use the indirect method of cash flow presentation. The method is preferred because it is easier and less costly to use. Financial Accounting Standards Board (FASB) prefers the direct method as it is more consistent with the purpose of cash flow statement (Rich, Jones, Mowen & Hansen, 2009). However, the ultimate goal of a cash flow statement is to reconcile cash, the cash balance that is achieved by both methods as they yield the same results, thus FASB allows both methods to be used in financial reporting.

References    

Albrecht W., Stice J., Stice E., Swain M. (2007). Accounting: Concepts and Applications.

 Mason, OH: Thompson Higher Learning. Retrieved on April 4, 2014 from;

http://books.google.co.ke/books?id=sYlWqWB0sz4C&pg=PA635&dq=categories+classes+in+a+cashflow+statement%3B+operating+activities,+financing+activities,+investing+activ&hl=en&sa=X&ei=woY9U576HsmGswbvkIGQDQ&redir_esc=y#v=onepage&q=categories%20classes%20in%20a%20cashflow%20statement%3B%20operating%20activities%2C%20financing%20activities%2C%20investing%20activ&f=false

Rich J., Jones J., Mowen M., Hansen D. (2009). Cornerstones of Financial Accounting,

Current Trends Update.  Mason, OH: South-Western Cengage Learning. Retrieved on April 4, 2014 from;

http://books.google.co.ke/books?id=R5KkeedXyq4C&pg=PA567&dq=FASB+allows+both+indirect+and+direct+cash+flow+method+because&hl=en&sa=X&ei=5LI9U9zBGKGI4ATczICwCw&redir_esc=y#v=onepage&q=FASB%20allows%20both%20indirect%20and%20direct%20cash%20flow%20method%20because&f=false

Sheeba K. (2011).  Financial Management. New Delhi. Pearson Education India. Retrieved         on April 4, 2014 from;

http://books.google.co.ke/books?id=pOrLPYAzx9MC&pg=PA55&dq=importance+of+cashflow+statement&hl=en&sa=X&ei=-oU9U_ycJ43Usgaw64DACw&redir_esc=y#v=onepage&q=importance%20of%20cashflow%20statement&f=false