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The Statement of Cash Flows Does Not Lie

From the date I graduated from college in May 2009 until a few weeks ago, I did not have  a single opportunity to accomplish any reading as it pertains to academic related accounting materials. I was indeed very tied up with completing the different components of the graduate school application process. Researching Master of Accounting programs, intensively preparing for the GMAT, and meeting the application requirements of four different programs took up all my spare time from June 2009 through February 2010. Waiting to receive admissions decisions on my graduate school applications, I recently started laying the groundwork for my preparation for the CPA exam. I intend to complete all four sections of the CPA exam in year 2011. Before dashing to buy any CPA review materials, I thought it would be wise to brush up on the topics that I didn’t fully grasp while I was completing my B.S. in Accounting. Consequently, I spent the past couple of weeks getting reacquainted with the statement of cash flows.

If I have good recollection, the only time I was exposed to a lecture on the statement of cash flows was in my Intermediate II course. Thus, the little I learned backed then was not fully cemented in my memory.  The textbook I used to revisit the chapter on the statement of cash flows is Intermediate Accounting 15 E by Stice, Stice, and Skousen whereas I was assigned Intermediate Accounting 11 E by Kieso, Weygandt, and Warfield for my Intermediate II class. I have the feeling that the former offers a better emphasis on applied learning and I love it! Anyway, let’s talk statement of cash flows. The purpose of this post is not to discuss the technical aspects of the statement of cash flows but rather to talk about its purposes and applications. Before we get to that, let me give you a brief overview of the statement of cash flows. The statement of cash flows is a categorized cash basis report on operating, investing, and financing activities. The statement of cash flows strictly reflects the inflows and outflows of cash and cash equivalents during a period (usually a year); it doesn’t include transactions that don’t have a direct effect on cash receipts and payments. Contrarily, the other two primary financial statements are derived from the use of accrual basis accounting.

The statement of cash flows did not become a primary financial statement until 1971 when the APB issued Opinion No. 19 officially making it a requirement that a funds statement be included as one of the three primary financial statements. However Opinion 19 omitted to provide specific guidelines and rules on how to produce a statement of change in financial position as the statement of cash flows was then called. It is not until 1987 that the FASB issued Statement No. 95 which, by superseding APB Opinion No. 19, created the official appellation: statement of cash flows. While providing for an official definition for the statement of cash flows, FASB Statement No. 95 also enunciated the rules and format to be used when creating the statement of cash flows. As you might have already realized, the statement of cash flows is relatively new when compared to the balance sheet andthe income statement. This might explain why the statement of cash flows doesn’t get nearly as much of the business news and academic (as related to college accounting curriculum) coverages  as the other two primary financial statements do. Despite its relative newness, the statement of cash flows provides some very useful information on the financial performance of a company. According to Intermediate Accounting 15 E by Stice, Stice, and Skousen, there are three majors reasons why the statement of cash flows should not be overlooked: “sometimes earnings fail, everything is on one page, and it’s used as a forecasting tool”.

  • Sometimes Earnings Fail: Because of the use of accrual accounting and allocations derived from the use of different accounting methods, the income statement  fails to sometime give an accurate picture of the economic performance of a company during a certain period. Depreciation and amortization methods, provisions for obligations, and assets write offs are some of the non cash transactions that can affect the accuracy of earnings. Because it is a categorized cash basis report on operating, investing, and financing activities, the statement of cash flows not only provides key information on a firm’s liquidity and solvency but it also indicates the amount, timing, and probability of future cash flows. Last but not least, it provides a leveled playing field when comparing different firms’ operating performance by nullifying the effects of the use of dissimilar accounting methods.
  • Everything Is on One Page: “If you were stuck on a desert island and could receive only a single financial statement each year ( by bottle floated in on the waves), you would probably choose the cash flow statement” (Intermediate Accounting 15 E by Stice, Stice, and Skousen). As noted earlier, the statement of cash flows  provides cash variation with regard to operating, investing, and financing activities. In other words, the statement of cash flows in itself is a snap shot of a company’s overall performance during the year.  First, the operating activities section of the statement of cash flows quantifies the net change in cash resulting from operations. Second, the investing activities section quantifies the net increase or decrease in the cash value of long lived assets. Third and last, the investing activities section itemizes the amount of cash that a company took in and paid out in order to finance its activities. Additionally, it should be noted that under US General Accepted Accounting Principles (GAAP), non cash activities may be disclosed within the statement of cash flows itself.
  • It Is Used as a Forecasting Tool: The statement of cash flows can also be used as an excellent analytical and forecasting tool. It indicates the amount, timing and probability of future cash flows. For instance, most lending institutions used what’s called a pro forma statement of cash flows which is a prediction of the inflow and outflow of cash for a business. This is to assess if a business will experience a cash shortage in the foreseeable future thus preventing it from repaying the loan on time or defaulting altogether on it. The statement of cash flows also provides the possibility to compute certain ratios to assess a company’s financial strength. Some examples of cash flow ratios are: cash flow to net income, cash flow adequacy, and cash times interest earned. If you are interested to find out more about these ratios, you can look them up with a search engine like Google.

Just as many people out there, I never gave much importance to the statement of cash flows. However, that was the case until I spent the last two weeks studying its features, its purpose, and its applications. It was indeed a really enlightening study. A very close look at a company’s statement of cash flows will provide a more accurate picture of the current and future health of a business than the other primary financial statements will. I am in no way de-emphasizing the purpose of the balance sheet and of the income statement but I am rather admitting to the fact that the statement of cash flows is a key aspect of financial reporting and as such it would be a grave mistake to overlook it. I hope after reading this post, readers will make a real effort to get themselves reacquainted with statement of cash flows so they can too realize it deserves as much attention as the other two primary financial statements.

2 Comments

  1. Comment by NEERAJ SHARMA:

    More improtant point remains unlighting is cash flow reflects the financial health of any organisation. changes over the period of time can give the bigger vision to understand the organisation financials. more over one can able to predict the trends for future.

    Regards,

    Neeraj Sharma

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