Question

Your friend, Diana Wood, recently completed the second year of her business and just received annual financial statements from her accountant. Wood finds the income statement and balance sheet informative but does not understand the statement of cash flows. She says the first section is especially confusing because it contains a lot of additions and subtractions that do not make sense to her. Wood adds, “The income statement tells me the business is more profitable than last year and that's most important. If I want to know how cash changes, I can look at comparative balance sheets.

”Write a half-page memorandum to your friend explaining the purpose of the statement of cash flows. Speculate as to why the first section is so confusing and how it might be rectified. Any sources used to support the information included in your memorandum should be cited using APA Style.

Answer 1

Cash flow statement provide details of how the cash is generated by an entity during a particular reporting period and how it is applied. It takes into consideration the opening balances of cash and cash equivalents, adds the cash generated, deducts the cash payment and reconcile it with closing balance of cash and cash equivalents.

It has 3 sections a)Cash Flow from Operating Activity b) Cash flow from Investing Activity c)Cash flow from Financing Activity.

Purpose of Statement of Cash flows are as follows:-

a)To provide information about historical changes in cash and cash equivalents

It aims at providing about how the cash has been genrated during the year and how it has been utilised.The information will be provided for current year and immediate previous year. Merely,looking at comparative balance sheet will only show the amount of cash at the end of the respective reporting period.

b)To asses the ability to genrate cash and cash equivalents

It is intended to provide the stakeholders information about the efficiency of the company in generating cash and cash equivalents. Some companies may look profitable as per their income statement but whether they have enough cash for payment of their debts and creditors has to be assessed using cash flow statement.

c) To understand the timing and certainity of their generation

The historical analysis of cash flow statement can set a trend regarding the years in which company could generate fair amount of cash flows and the probability of generating it.

Speculation regarding the first section of Cash flow statement being confusing.

There might be a possibility that Cash flow statement has been prepared using indirect method. In indirect method we take Net Profit as per Income statement and adjust the effect of non cash expenditure/income such as depreciation, profit on sale of machinary etc.Further, we adjust the profit for any deffered or accrued expenses and receipts.

This confusion may be removed if the entity choses to prepare the cash flow as per Direct Method.Under the direct method major information about receipts and payment can be obtained from the accounting records and financial statement.