Question

Describe the three classifications of cash flows, and provide examples of activities that would appear in each classification. Additionally, with regards to Ethics: Manipulating Data to Reach Target Cash Flow read the following: Augusta Clothing, Inc., sells formal clothing to young professionals at its five retail stores. The company’s fiscal year ends on December 31. The company’s president and CEO, Teresa Pacheco, just received a draft of the statement of cash flows from the controller, David Rodriquez. Teresa is very interested in the results since a significant part of her annual bonus depends on generating at least $400,000 in cash from operating activities. A summary of the statement is provided in the following:

Lily Beckworth, the chief financial officer (CFO) for Augusta Clothing, Inc., is approached by Teresa:

Teresa: Lily, have you seen the statement of cash flows?

Lily: No, not yet. Last I heard David was just about done with it.

Teresa: He just dropped off a copy for my review.

Lily: Excellent. How does it look?

Teresa: Overall it looks fine, but something must be wrong with the operating activities number. I assumed it would be well above $400,000. Can you take a look at it and make sure we exceed $400,000?

Lily: I’ll do what I can.

Teresa: Great. I knew I could depend on you. Shortly after this discussion,

Lily returned with revised numbers:

Lily: Teresa, here is the corrected statement of cash flows (see as follows). I was able to reclassify a portion of cash received from the sale of long-term investments to the operating activities section to get to $403,000.

Teresa: Excellent! Thanks, Lily, I knew you could do it!

Required: What impact did the reclassification of cash flows have on the total net increase in cash? Explain. Are Lily’s actions ethical? Explain. If you were the CFO, how would you handle Teresa’s request? (If necessary, review the presentation of ethics in Chapter 1 “What Is Managerial Accounting?” for additional information.)

Answer 1

Three classification of Cash Flow are:-

1) Cash Flow from Operating activities, 2) Cash Flow from Investing activities and 3) Cash Flow from Financing activities.

1) Cash From Operating activities :- Is the net inflow or outflow of cash from the Company's main activities of business of buying or selling of goods or providing services. The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash flow to maintain operating capacity of the entity, repay loans and make new investments without recourse to the external sources of financing. Eg- increase/ decrease in current assets/current liabilities.

2) Cash from Investing activities :- Cash from Investing activities is the inflow or outflow of cash from acquisition or disposal of long term assets and other assets not included in cash equivalents. Eg. Sale or purchase of assets/investments.

3) Cash from Financing activities :- Cash from Financing activities is the inflow or outflow of cash as a result of change in the size and composition of the equity and borrowing of the entity. Eg. Sale of stock, repayment of debt, purchase of Company's stock etc.

In the above case, reclassification of cash from sale of long term investments to cash from operating activities will not have any effect on the total increase in cash. Only it will reduce cash from investing activities and increase cash from operating activities but total increase in cash will remain same.

No, Lily's action is not ethical. Cash from investing activities should not be reclassified as cash from operating activities. Only cash which are generated through the principle business of the entity should be classified as cash from operating activities.

If i would be the CFO, i would have not classified the cash from investing activities as cash from operating activities rather i would have explained the effect of reclassifying investing activities to operating activities.