ACCT1110 Chap.8 The Cash Flow Statement
The Cash Flow Statement
A profitable company can run out of money and an unprofitable one can be flush with it, because profit is measured on the accrual basis and cash is measured by the bank. The cash flow statement explains the difference and shows where the money came from: trading, selling assets, or raising funds.
Those three answers are the operating, investing and financing sections, and together they must account for every dollar of movement in the cash balance.
Classification causes most of the early errors, and one habit fixes them. Read the instruction line.
Past papers on this course have specified, inside a single question, that interest paid is to be shown in financing, that all tax paid sits in operating, and that dividend revenue is to be treated as investing. Those sentences are the marking key; applying a default remembered from elsewhere produces a defensible answer and a low mark.
Depreciation, meanwhile, belongs in no section at all, because no cash moved.
The operating subtotal can be reached two ways. The direct method lists the flows themselves and converts any accrual figure by the movement in its related balance, so sales become receipts once the change in receivables is applied.
The indirect method starts at profit, adds back non cash expenses, removes gains belonging to other sections, and adjusts for working capital movements. Both arrive at the same number, so a disagreement between them is a sorting error rather than a rounding one.
What this chapter covers
- 01
Why profit and cash answer different questions
- 02
Operating, investing and financing
- 03
Items whose section the question dictates
- 04
Converting sales into receipts from customers
- 05
Converting cost of sales into payments to suppliers
- 06
Adding back the non cash charges
- 07
Working capital movements and their signs
- 08
Deriving dividends paid and disposal proceeds
An operating section built by the direct method, with four conversions
- +1Receipts from customers: sales of $812,000 less the $17,000 rise in receivables, because that rise was invoiced and not collected, gives $795,000.
- +1Payments to suppliers: start at cost of sales $486,000, deduct the $5,000 fall in inventory because that much came out of existing stock, then deduct the $9,000 rise in payables because that much is unpaid, giving $472,000.
- +1Payments for operating expenses: $141,000 less the $38,000 of depreciation, which is not a payment, gives $103,000. Income taxes paid: the $34,000 expense plus the $3,000 fall in the payable gives $37,000.
- +1Total the section: receipts of $795,000 less payments of $472,000, $103,000 and $37,000. Interest is excluded because the question placed it in financing.
Key terms
- Operating activities
- The cash effects of the trading the entity exists to do, covering customers, suppliers, employees and normally tax.
- Investing activities
- Cash spent acquiring long lived assets and cash received from disposing of them, reported at the full proceeds rather than at the gain.
- Financing activities
- Cash raised from and returned to the providers of capital, including share issues, borrowings and dividends paid.
- Direct method
- Presenting the operating section as the receipts and payments themselves, which is why it begins from the cash records.
- Indirect method
- Presenting the operating section as profit adjusted for non cash items and working capital movements, which is why it begins from the income statement.
- Working capital movement
- A change in receivables, inventory, prepayments, payables or accruals, each of which either ties cash up or releases it.
- Non cash expense
- A charge such as depreciation that reduced profit without any payment, and is therefore added back in the indirect reconciliation.
The Cash Flow Statement FAQ
Where do interest and dividends belong?
Wherever the question says. Interest paid and dividends received may be classified in more than one section depending on the entity's policy, so exam questions state the treatment they want and that statement overrides any general rule. Dividends paid are financing, because they return capital to owners. Income tax paid is normally operating unless the question directs otherwise.
Why is depreciation added back in the indirect method?
Because it reduced profit without any cash leaving. The indirect method starts from profit and removes everything inside it that was not a cash flow, so every non cash charge is added back. The same reasoning removes a gain on disposal, which increased profit while the actual cash effect is reported in full under investing.
How are dividends paid worked out when they are not given?
From the retained earnings account. Opening retained earnings plus profit less closing retained earnings leaves the amount taken out, which is the dividend. Where the account rose by $4,600 while profit of $160,721 was added, $156,121 must have been distributed, and it is reported as a financing outflow.
What appears in investing when an asset is sold at a gain?
The proceeds, not the gain. Proceeds equal the carrying amount at the date of sale plus the gain, or the carrying amount less the loss. Equipment with a carrying amount of $5,300 sold at a profit of $4,600 produced proceeds of $9,900, and that is the investing inflow; the original cost never appears anywhere in this statement.
Exam move
Practise the two methods on the same set of figures until they agree. Building the operating section directly and then rebuilding it indirectly is the only exercise that reliably exposes a sign error, because a mistake shows up as a difference rather than as a plausible number.
Then drill the two derivations on their own: dividends from the retained earnings movement, and proceeds from the carrying amount and the gain.
Each is one line, each is worth about two marks, and each appears in nearly every past paper. Before any of that, make reading the classification instruction the first thing you do, because it changes the answer more than any arithmetic in the question.
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