Investing activities section of statement of cash flows

Investing activities section is the second section of the statement of cash flows that reports the cash flows arising from the sale and acquisition of long term assets and investments. It typically involves the movement of cash on account of following activities:

• purchase and sale of productive long-term assets,
• purchase and sale of investments,
• making and collecting loans, and
• purchase and sale of intangible assets.

The acquisition or sale of long term assets and investments during a period can be determined by making an analysis of opening and closing balances from comparative balance sheet. An addition in the balance of an asset indicates that the company has acquired or constructed an asset during the period. A reduction, on the other hand, indicates that the asset has been sold during the period. Such acquisitions and sales are known as investing activities and the rest of this article explains how inflows and outflows of cash caused by such activities is reported in the statement of cash flows.

Contents:

• Understanding cash and non-cash investing activities
• Acquisition and sale of long-term productive assets
• Purchase and sale of investments
• Cash flows from making and collecting loans
• Purchase and sale of intangible assets
• Format

Understanding cash and non-cash investing activities:

The assets are acquired using cash or other medium of exchange. When a medium other than cash is used to acquire an asset we call it a non-cash investing activity. For example, a company can purchase a piece of equipment for $1,000 by making payment in cash which is a cash transaction or it can purchase a tract of land by issuing shares to the vendor which is a non-cash transaction. When we prepare a statement of cash flows, we are concerned only with cash transactions. The significant non-cash investing activities are, however, disclosed in the foot notes under the caption ‘non-cash investing and financing activities’.

Purchase and sale of long term productive assets:

Long term productive assets (also named as non-current assets or fixed assets) are purchased to keep and use in business for a long period of time. They are capital assets and are purchased to maintain or enhance the production or trading capabilities of the entity. Examples of such assets include plant and machinery, equipment, tools, building, vehicles, furniture and land etc. Since long term assets are not purchased with the intention of resale in the ordinary course of business, the cash flows resulting from their purchase and sale (including any gain on their sale) is classified as ‘cash flows from investing activities’ and is reported under investing activities section of the statement of cash flows.

Gains or losses on sale of fixed assets:

The sale of a used fixed asset normally results in a non-operating gain or loss. As non-operating gains or losses are included for the determination of net operating income, their effect is eliminated from the net operating income in the operating activities section. It is done in the following way:

1. Deduct from net operating income any gain on sale of fixed assets included in income statement.
2. Add to net operating income any loss on sale of fixed assets included in income statement.

Consider the following example for understanding hoe these gains and losses are handled while preparing a statement of cash flows:

Example:

The Big Brand company earned a net income of $65,000 for the year 2013. During the year, it sold one of its old plants for $6,400 and purchased a tract of land for $1,500. The plant was purchased several years ago for $10,000 and was being depreciated using straight line method. The accumulated depreciation – plant at the time of sale was $4,000.

Required:

1. Calculate gain or loss (if any) on sale of plant. How should it be adjusted in operating activities section assuming company uses indirect method to prepare its statement of cash flows?
2. How should sale of plant and purchase of land be reported in the statement of cash flows?

Solution:

(1). Gain on sale of plant and its presentation:

Gain on sale of plant = Sale proceeds – Book value of the plant
= $6,400 – $6,000*
= $400

*10,000 – 4,000

The gain on sale of plant is a non-operating gain and it must be deducted from the net income in operating activities section. Its presentation is given below:

(2). Presentation of the sale of plant and purchase of land:

The sale of plant and purchase of land are investing activities. The cash flows resulting from these activities must be shown in investing activities section. Their presentation is given below:

Sale and purchase of investments:

The cash flows resulting from purchase and sale of investments that are not treated as cash equivalents or trading securities is classified as ‘cash flows from investing activities’ and is reported in investing activities section of the statement of cash flows. It usually involves sale and purchase of long term investments in debt and equity instruments of other companies. Examples of debt instruments (also known as debt securities) are government bonds, corporate bonds and mortgages. The holder of such instruments is entitled to receive a periodic interest income. Equity instruments (also known as equity securities) are the stocks of other companies that entitle the holder to receive a dividend income.

Interest and dividend income and their treatment:

According to US generally accepted accounting principles (GAAP), cash received for interest and dividend is classified as ‘cash flows from operating activities’ whereas international financial reporting standards (IFRS) allow the treatment of interest and dividend income received in cash as operating or investing cash inflow. The IFRS, however, requires such cash flows be reported on consistent basis from period to period.

Example:

The Big Brand company purchased 2,000 shares of company A @ $50 per share during the year 2013 for investment purpose. The Big Brand also received dividend of $1,200 in cash during the year from company B.

Required: How should Big Brand classify above cash flows on a statement of cash flows?

Solution:

(1). The purchase of shares for investment must be classified as investing activity in the following way:

The receipt of cash dividend of $1,200 may be classified as either operating or investing cash inflow if financial statements are prepared in accordance with IFRS. However, if US-GAAP are to be followed, the cash received for dividend should be classified as operating cash inflow.

Cash flows from making and collecting loans:

The loans and advances given to others are investing activities and the cash flows resulting from such activities is shown in investing activities section. The repayment of such loans and advances is also investing activity with the exception of any interest received thereon. The interest earned on loans and advances are just like interest earned on normal investments and is reported in the statement of cash flows according to US-GAAP or IFRS as discussed above.

Purchase and sale of intangible assets:

The intangible assets (also known as intangible fixed assets) like copyrights, trademarks, patents, and goodwill are purchased to improve or enhance trading or manufacturing capabilities. They are therefore, classified as investing activities and cash flows resulting from sale or purchase of such assets is reported under investing activities section of the statement of cash flows.

Amortization of intangible assets:

While preparing statement of cash flows, the treatment of amortization of intangible assets is similar to depreciation on fixed assets. It is a non-cash expense and is added back to net operating income in operating activities section if indirect method is used. Like depreciation, amortization has nothing to do with investing activities section.

Example:

The Big Brand company purchased a patent for $500,000 on 1st January, 2013. The patent is to be amortized over its economic useful life of 5 years using straight line method. On 31st December, 2013 the company’s income statement showed a net operating income of $350,000. The company is ready to prepare its statement of cash flows for the year 2013.

Required:

1.  What is the use of amortization on patents to prepare the operating activities section of the statement of cash flows if indirect method is employed.
2. How should the cash flows occurring as a result of the acquisition of patents be reported in investing activities section?

Solution:

(1). Presentation of operating activities section:

Cash of $500,000 was paid at the time of acquisition of patents. No cash payment is made when amortization is recorded. Amortization on patents is a non-cash expense and must be added back to net operating income in the operating activities section. Its presentation is given below:

*$500,000/5 years

(2). Presentation of investing activities section:

The cash paid to purchase patents is to be disclosed in investing activities section as follows:

Format of investing activities section:

The general format of investing activities section is illustrated below. It is just an illustration, not a complete list of all cash inflows and outflows resulting from investing activities of a company:

The various cash flows resulting from investing activities of Big Brand company have been discussed in above examples. We can prepare complete format of the investing activities section of the company as follows: