Accounting – Chapter 5: Reporting and Interpreting Cash Flows
Classification of Cash Flows
Statement of cash flows explains how the cash balance at the beginning of the period
changed to another cash balance at the end of the period. It includes cash and cash
equivalents – shortterm, highly liquid investments that are both:
1. Readily convertible to known amounts of cash
2. So near their maturity that there is little risk that their value will change if interest
Generally, an investment qualifies as a cash equivalent only when it has an original
maturity of three months or less from the date of acquisition.
Cash flows are reported based on operating activities, investing activities and financing
Cash Flows from Operating Activities
Cash flows from operating activities: are cash inflows and outflows directly related to
earnings from normal operations. (Revenues and expenses reported on the income
These are not affected by accruals, deferrals and allocations that result from the timing of
revenue and expense recognition.
There are 2 alternative approaches for presenting the operating activities section of the
1. The direct method reports the components of cash flows from operating activities
listed as gross receipts and gross payments.
The difference between the inflows and outflows is called the net cash inflow (outflow)
from operating activities.
Direct method is used less, as it is more expensive to implement.
2. The indirect method starts with profit for the period and then eliminates noncash
items to arrive as net cash inflow (outflow) from operating activities.
Revenues are recorded when earned without regard to when related cash is collected and
expenses are recorded in the same period as the revenues – not under an accrual basis.
The total amount of cash flows from operating activities is always the same, whether it is
computed by using the direct or indirect method.
Cash Flows from Investing Activities
Cash flows from investing activities are cash inflows and outflows related to the purchase
and disposal of longterm productive assets and investments in the securities of other
companies. – sale or purchase of property, plant and equipment or sale or purchase of
investments in securities.
Difference is called net cash inflow (outflow) from investing activities.
Cash Flows from Financing Activities Cash flows from financing activities include exchanges of cash with external sources
(owners and creditors) to finance the enterprise and its operations.
I.e. cash received from borrowing on notes, mortgages and bonds from creditors, issuing
shares to shareholders and cash paid for repayment of principal to creditors, interest on
borrowings if it is classified as a financing activity, repurchasing shares from owners, and
dividends to shareholders.
Difference is called net cash inflow (outflow) from financing activities.
Net Increase (Decrease) in Cash
The combination of these 3 activities must equal the net increase (decrease)