Accounting Standard 3
Such information is disclosed in the cash flow statement indicating cash flows from operating, investing and financing activities during an accounting period.
Cash flow statement is one of the important financial statements prepared along with income statement and balance sheet. This statement is prepared to provide information regarding the cash flows of an enterprise.
Such information helps the stakeholders to assess the ability of the enterprise to generate cash and cash equivalents. This assessment regarding an entity’s ability to generate cash, its timing and certainty helps the stakeholders in taking various economic decisions.[/vc_column_text]
What is Cash and Cash Equivalents?
Cash equivalents are highly liquid, short term investments held for the purpose of meeting the short term cash commitments of an enterprise. Investments are categorized as cash equivalents only when these have short maturity period ranging between three months or less.
This means that such investments must be the ones that get readily converted into cash. Also, such investments are low in risk as they are not subject to any material changes in value.
For example, short term marketable securities are treated as cash equivalents as these are highly liquid and can be converted into cash readily.
It is important to note that any movement of cash between cash or cash equivalent items is excluded from cash flows of an enterprise. This is because such movement of cash is not part of operating, investing and financing activities. Rather, it comes under cash management of an enterprise.
Presentation of Cash Flow Statement
Every business entity should present its cash flows in a cash flow statement by classifying the same into operating, investing and financing activities. This classification is important as it helps the users in assessing the impact of such activities on the financial position as well as the cash balance of an enterprise.
Further, such information about cash flows can be used to determine connection between such activities.
The primary or the principal revenue generating activities of your business refer to the operating activities. These are the main activities that involve production and sale of your goods and services.
Cash generated from operating activities helps the stakeholders in assessing the level of solvency of your business. It indicates the ability of your business operations to generate cash in order to maintain its operating capability and meet its financial obligations. Such obligations include making new investments and repaying loans.
Further, information about the operating cash flows in the previous accounting periods helps in forecasting future operating cash flows. Also, the operating activities of a business help in determining the net profit or net loss of your business.
Following are the examples of cash flows from operating activities:
I. Cash Inflows from
- Sales of goods and services
- Royalties, fees, commissions and other revenues
II. Cash Outflows by paying
- an insurance company for premiums and annuities
- income taxes
Cash flows from investing activities indicate the degree of expenditures made to acquire resources that generate future income and cash flows. These include acquisition and disposal of long-term assets as well as investments not considered as cash equivalents.
Such outlays are mandatory as these expenditures help in maintaining the operating capacity of your business.
Following are the examples of cash flows from investing activities:
I. Cash Inflows from
- from sales of fixed assets
- in the form of interest on loans and advances made to third parties
- from repayment of loans or advances made to third parties
- as dividend from investment in other businesses
- by selling shares , warrants or debt instruments of other enterprises
II. Cash Outflows by making payments
- to acquire fixed assets
- as loans advances to third parties
- to acquire shares, warrants or debt instruments of other enterprises
Financing activities refer to the capital or long-term funds of your business.These activities are the outcome of changes in the proportion and structure in the owner’s capital and borrowings of your business.
The elements of cash flow from financing activities include (i) inflows from additional borrowing and equity financing and (ii) outflows for repayment of debt, dividend payments and equity repurchases.
Following are the examples of cash flows from financing activities:
I. Cash Inflows from Issuing
- debentures, loans, etc
II. Cash Outflows from
- Cash repayments of the amounts borrowed
- Dividends paid on equity
- Interest paid on debt
Reporting Cash Flows from Operating Activities
Operating activities are the main source of income and expenditure for a business. A business entity must report cash flow from operating activities using the following two methods:
A. Direct Method
As per the direct method, all the major categories of cash receipts and cash payments of the business entity are reported. Major heads of cash inflows and outflows such as cash received from trade receivables, expenses paid etc are considered under this method.
Since items are recorded on accrual basis in the income statement, certain adjustments are made to convert them into cash basis.
B. Indirect Method
Under the indirect method, the cash flow from operating activities is calculated by adjusting the company’s net profit or loss. These adjustments are made in respect of:
Reporting Cash Flows from Investing and Financing Activities
A business entity is required to separately report major classes of gross cash receipts and gross cash payments on account of investing and financing activities.
However, cash flows from certain operating, financing and investing activities need to be recorded on a net basis.
Cash Flow on Net Basis
The cash flow as a result of following operating, investing and financing activities needs to be reported on a net basis:
- Receipts and payments in cash on behalf of clients when these cash flows indicate the activities of the client instead of those of the business entity
- Payments and receipts in cash for items in which the amount involved is large, turnover is quick and maturities are short
Likewise, the cash flows specified below that result from the activities of a financial entity may be reported on a net basis:
- Receipts and payments in cash for accepting or repaying deposits with fixed maturity date
- Placing deposits with or withdrawing deposits from other financial entities
- Cash advances and loans given to clients and repayment of such advances and loans
Foreign Currency Cash Flows
Cash flows as a result of foreign currency transactions must be recorded in the reporting currency of the business entity. These are recorded as follows:
Foreign currency amount x Exchange rate between the reporting currency and foreign currency on the date when such cash flows arise
The business entity may use a rate that is close to the actual exchange rate. This can be done if by doing so the result, to a greater extent, is the same as would be the case if the exchange rates on the date of cash flows were used.
The reporting of the impact of changes in the exchange rate on cash and cash held in foreign currency should be done separately. These should be recorded as a separate part of the reconciliation of the changes in cash and cash equivalents during a given accounting period.
Extraordinary items are not regular in nature. These are non-recurring items and hence cash flows related to such items should be classified and disclosed separately.
Such items are declared separately as originating from operating, investing and financing activities.
Interest and Dividend
If your main business is that of lending and borrowing, then interest paid, interest received and dividends received are categorized as operating activities. Whereas, dividend paid is a financing activity.
However, if your main business does not relate to lending and borrowing, then payment of interest and dividends are categorized as financing activities.
Taxes on Income and Gains
As a business, you pay a host of taxes such as income tax, dividend tax and capital gains tax. Thus, all the cash flows arising out of taxes on income should be disclosed separately.
Moreover, such cash flows should be classified under operating activities unless these can be specifically identified with investing and financing activities.
Non-cash transactions include those financing and investing transactions that do not require the use of cash or cash equivalents. Such transactions should be excluded from your cash flow statement.
These non-cash transaction should be recorded elsewhere in the financial statements. Such transactions should be recorded in a way that it represents all the relevant information about investing and financing activities.
The business entity should disclose the amount of considerable cash and cash equivalent balances held by the business entity but are not available for use by it. This should be accompanied by a commentary by the management.