Statement of cash flows and the purpose of its preparation
In accounting and finance, the term cash flows refers to the receipts and payments of cash that occur during a particular period of time. Companies disclose the details of their cash flows for an accounting period by publishing a statement known as the statement of cash flows (SCF).
Under major accounting frameworks, like GAAP and IFRS, the statement of cash flows is the basic and most important component of the set of financial statements that companies publish for the use of their investors and other stakeholders. It tells the users of the statement how much cash the company has received and paid during the relevant accounting period. In addition, it reveals the sources and disbursements of cash, i.e., how the cash has been generated and how it has been utilized during the reporting period.
A company’s overall cash flows during its accounting period are generally categorized as operating, investing, and financing cash flows. To properly report these three types of cash flows, the statement of cash flows is divided into three sections: the operating activities section, the investing activities section, and the financing activities section.
The preparation of the statement of cash flows is mandatory for those companies that are required to prepare and present their financial statements in accordance with major accounting frameworks like international financial reporting standards (IFRSs) and generally accepted accounting principles (GAAPs).
Purposes of the statement of cash flows
The main purposes of preparing a statement of cash flows are as follows:
(1). Explanation of the change in cash and cash equivalents:
The statement of cash flows shows the details of cash generated and cash used by all operating, investing, and financing activities of a business. It, therefore, helps stakeholders understand why the company’s cash and cash equivalents have changed during the period concerned.
(2). Anticipation of operational performance and future cash flows:
The management, creditors, and both actual and potential stockholders are interested in knowing the ability of the company to generate sufficient positive cash flows in the future. This information is particularly important in assessing the company’s ability to meet its obligations and to pay dividends. The statement of cash flows helps these stakeholders understand how the company is managing its cash and enables them to anticipate its operational performance and cash flows in the future based on the current receipts and disbursements of cash.
(3). Accounting framework and legal requirement:
The statement of cash flows is one of the basic components of financial statements that are prepared and published while working under international financial reporting standards (IFRSs) and generally accepted accounting principles (GAAPs). The preparation of this statement is, therefore, mandatory for those companies that are legally required to follow any of these two accounting frameworks for preparing their financial statements.
(4). Information about non-cash investing and financing activities:
Companies also engage in various investing and financing activities that do not involve the use of cash. Such activities are known as non-cash investing and financing activities. These activities may have a significant impact on the future cash flows and profitability of the entity, so their disclosure to the users of financial statements is very important. For this purpose, a company that performs any significant non-cash investing and financing activities during its reporting period must disclose them either in a separate schedule or in the footnotes to the statement of cash flows.
The examples of non-cash investing and financing activities that are generally significant for a company and its stakeholders are given below:
- Acquiring land or another asset in exchange for issuing the common stock.
- Issuance of common stock to discharge a debt or liability.
- Purchase of equipment in exchange for issuing a note.
- Conversion of preferred stock to common stock.
- Conversion of bonds payable to common stock.
(5). The difference between net income and related net cash flows from operating activities:
A review of both the statement of cash flows and the income statement can help stakeholders understand the reasons why the net income for an accounting period and the related net cash flows from operating activities are different from each other.
(6). Usefulness in business acquisition:
The statement of cash flows is used as a key document when an acquirer examines the financial statements of a potential acquiree. The acquirer analyzes this statement to evaluate if the acquisition price is reasonable, because he would not be interested in paying a price that is not justified by the cash flows of the acquiree’s business.
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