Principles of Financial Accounting: Statement of Cash Flows - Classification of Cash, Flows Operating Investing Financing

What It Is

Classification of cash flows is a crucial concept in financial accounting that helps users understand a company's financial performance and position. It involves categorizing cash inflows and outflows into three main types: operating, investing, and financing. This classification is essential for preparing the statement of cash flows, which provides a comprehensive picture of a company's liquidity and solvency. For example, if a company buys $10,000 of inventory, it would be classified as an investing activity, as it involves the acquisition of a long-term asset.

Key Concepts & Formulas

• Operating Activities: Cash flows from the core business operations, such as sales, cost of goods sold, and operating expenses.
  • Example: A company generates $100,000 in sales and incurs $60,000 in cost of goods sold. The gross profit is $40,000 ($100,000 - $60,000).
• Investing Activities: Cash flows related to the acquisition or disposal of long-term assets, such as property, plant, and equipment, and investments.
  • Example: A company buys $50,000 of land for a new factory.
• Financing Activities: Cash flows related to the issuance or repayment of debt and equity, such as loans, bonds, and stock issuances.
  • Example: A company issues $20,000 in bonds to raise capital.
• Direct Method: A method of presenting cash flows from operating activities by showing major classes of gross cash receipts and payments.
  • Example: Cash received from customers = $100,000; Cash paid to suppliers = $60,000.
• Indirect Method: A method of presenting cash flows from operating activities by adjusting net income to reconcile it with net cash provided by operating activities.
  • Example: Net income = $40,000; Adjustments for changes in working capital = $10,000.
• Cash Flow from Operations (CFO): The net result of operating activities, calculated as net income + depreciation + changes in working capital.
  • Example: CFO = $40,000 + $10,000 + $5,000 = $55,000.
• Cash Flow from Investing (CFI): The net result of investing activities, calculated as cash inflows from sales of assets - cash outflows for purchases of assets.
  • Example: CFI = $20,000 - $50,000 = -$30,000.
• Cash Flow from Financing (CFF): The net result of financing activities, calculated as cash inflows from issuance of debt and equity - cash outflows for repayment of debt and equity.
  • Example: CFF = $20,000 - $10,000 = $10,000.
• Net Change in Cash: The total change in cash and cash equivalents, calculated as CFO + CFI + CFF.
  • Example: Net Change in Cash = $55,000 - $30,000 + $10,000 = $35,000.

Journal Entry Examples

1. Investing Activity: Purchase of land for $50,000.

Dr. Land $50,000 Cr. Cash $50,000

Explanation: The land account is debited to increase its balance, and the cash account is credited to decrease its balance.

1. Financing Activity: Issuance of bonds for $20,000.

Dr. Cash $20,000 Cr. Bonds Payable $20,000

Explanation: The cash account is debited to increase its balance, and the bonds payable account is credited to increase its balance.

1. Operating Activity: Sale of goods for $10,000.

Dr. Cash $10,000 Cr. Sales $10,000

Explanation: The cash account is debited to increase its balance, and the sales account is credited to increase its balance.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts.
   • Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Not considering the indirect method when presenting cash flows from operating activities.
   • Correction: The indirect method adjusts net income to reconcile it with net cash provided by operating activities.
3. Mistake: Not calculating the net change in cash correctly.
   • Correction: Calculate the net change in cash by adding CFO, CFI, and CFF.

Exam Tips

1. Tip: When presenting cash flows from operating activities, use the direct method if possible, as it is more straightforward.
2. Tip: Be careful when using the indirect method, as it requires adjustments to net income to reconcile it with net cash provided by operating activities.
3. Tip: Make sure to calculate the net change in cash correctly by adding CFO, CFI, and CFF.

Quick Practice

1. A company generates $100,000 in sales and incurs $60,000 in cost of goods sold. What is the gross profit?
   • Answer: $40,000 ($100,000 - $60,000)
   • Explanation: The gross profit is calculated by subtracting the cost of goods sold from sales.
2. A company buys $50,000 of land for a new factory. What is the investing activity?
   • Answer: -$50,000 (outflow)
   • Explanation: The investing activity is the purchase of land, which is a cash outflow.
3. A company issues $20,000 in bonds to raise capital. What is the financing activity?
   • Answer: $20,000 (inflow)
   • Explanation: The financing activity is the issuance of bonds, which is a cash inflow.

Last-Minute Cram Sheet

1. Operating Activities: Cash flows from the core business operations.
2. Investing Activities: Cash flows related to the acquisition or disposal of long-term assets.
3. Financing Activities: Cash flows related to the issuance or repayment of debt and equity.
4. Direct Method: A method of presenting cash flows from operating activities by showing major classes of gross cash receipts and payments.
5. Indirect Method: A method of presenting cash flows from operating activities by adjusting net income to reconcile it with net cash provided by operating activities.
6. Cash Flow from Operations (CFO): The net result of operating activities.
7. Cash Flow from Investing (CFI): The net result of investing activities.
8. Cash Flow from Financing (CFF): The net result of financing activities.
9. Net Change in Cash: The total change in cash and cash equivalents.
10. Dividends are NOT an expense – they go directly to retained earnings.