2.2 Statement of Cash Flows

Statement of Cash Flows (ASC 230)

The Statement of Cash Flows is a required financial statement under US GAAP (ASC 230) that details the cash receipts, cash payments, and net change in cash, cash equivalents, and restricted cash during a reporting period. Reconciling cash flows helps investors and creditors assess an entity's liquidity, solvency, financial flexibility, and quality of earnings (by comparing accrual Net Income to actual cash flows).

Definitions and Reconciling Scope

Under US GAAP, cash equivalents are short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near their maturity (original maturity of three months or less from the acquisition date) that they present insignificant risk of changes in value due to interest rate changes. Examples include:

• U.S. Treasury bills
• Commercial paper
• Money market funds

[!IMPORTANT] ASC 230 requires that restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The restrictions must be disclosed in the footnotes.

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Classification of Cash Flows

All cash inflows and outflows must be categorized into three distinct categories: operating, investing, and financing activities.

1. Operating Activities

Operating cash flows represent the cash effects of transactions that enter into the determination of Net Income. They reflect the cash generated or consumed by the entity's core ongoing business operations.

• Cash Inflows: Cash receipts from the sale of goods or services, collections on accounts receivable, interest received on loans or debt securities of other entities, and dividends received from equity investments of other entities.
• Cash Outflows: Cash paid to suppliers for raw materials or inventory, cash paid to employees for services, cash paid to government for income taxes, cash paid for interest on borrowings, and cash paid for other operating expenses.
• US GAAP Note: Under US GAAP, interest received, interest paid, and dividends received are classified as operating activities. Dividends paid are classified as financing activities.

2. Investing Activities

Investing cash flows represent cash flows associated with the acquisition and disposal of long-term assets and other investments (excluding cash equivalents and trading securities).

• Cash Inflows: Cash received from selling property, plant, and equipment (PP&E); cash received from selling or redeeming debt or equity instruments of other entities; cash received from collecting the principal on loans made to other entities.
• Cash Outflows: Cash paid to purchase PP&E; cash paid to purchase debt or equity instruments of other entities; cash paid to make loans to other entities.

3. Financing Activities

Financing cash flows represent cash flows associated with transactions involving the entity's owners (equity) and creditors (debt/borrowings).

• Cash Inflows: Cash received from issuing common or preferred stock; cash received from issuing bonds, notes, or mortgages.
• Cash Outflows: Cash paid to shareholders as dividends; cash paid to repurchase treasury stock; cash paid to repay the principal amount of borrowings (including the principal portion of finance lease payments).

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Operating Cash Flows: Indirect vs. Direct Method

Entities may choose between two methods of presenting cash flows from operating activities. Regardless of the method chosen, the net operating cash flow will be identical.

The Indirect Method

The indirect method reconciles Net Income to Net Cash Provided by Operating Activities. This is the method used by the vast majority of U.S. public companies because it links the accrual-based income statement to the cash-based reality. The reconciliation adjusts net income for:

1. Non-cash items: Depreciation, amortization, bad debt expense, and deferred tax expense, which are added back to net income because they reduced net income but did not consume cash.
2. Non-operating items: Gains on the sale of assets are subtracted, and losses on the sale of assets are added back. The cash proceeds from the sale of long-term assets are presented in the investing activities section, so the gain or loss must be removed from the operating section to avoid double-counting.
3. Changes in working capital: Changes in operating assets and liabilities are adjusted as follows:
   • Operating Assets: An increase in an operating asset (e.g., Accounts Receivable, Inventory, Prepaid Expenses) is subtracted from net income. A decrease is added.
   • Operating Liabilities: An increase in an operating liability (e.g., Accounts Payable, Accrued Expenses, Unearned Revenue) is added to net income. A decrease is subtracted.

Example Calculation:

Suppose a company has Net Income of $500,000.

• Depreciation expense is $80,000.
• Accounts receivable increased by $30,000.
• Inventory decreased by $15,000.
• Accounts payable decreased by $20,000.
• Gain on sale of equipment is $10,000.

Reconciliation: $\text{Operating Cash Flow} = \$500,000 \text{ (Net Income)} + \$80,000 \text{ (Depreciation)} - \$10,000 \text{ (Gain)} - \$30,000 \text{ (AR Increase)} + \$15,000 \text{ (Inventory Decrease)} - \$20,000 \text{ (AP Decrease)} = \$535,000$

The Direct Method

The direct method reports major classes of gross cash receipts and payments. Key lines include cash collected from customers, cash paid to suppliers, cash paid to employees, cash paid for interest, and cash paid for income taxes. Under US GAAP, if an entity elects to use the direct method, it is mandated to disclose the indirect method reconciliation in a separate schedule in the footnotes.

Direct Method Line Calculations:

• Cash Collected from Customers: Net Sales − Increase in Accounts Receivable + Increase in Unearned Revenue.
• Cash Paid to Suppliers: Cost of Goods Sold + Increase in Inventory − Increase in Accounts Payable.
• Cash Paid to Employees: Salaries Expense − Increase in Salaries Payable.

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Non-Cash Investing and Financing Activities

Significant investing and financing transactions that do not require the use of cash must be disclosed in a supplemental schedule or footnote, rather than on the face of the cash flow statement.

• Examples: Purchasing land by issuing a note payable, converting bonds payable or preferred stock into common stock, or acquiring property through a lease (recording a right-of-use asset and lease liability).