Question

Discuss and answer at least two of the questions listed below in detail.

Review: What is the purpose of the statement of cash flows? Why would we want to convert accrual basis net income to cash basis when creating the statement of cash flows? Differentiate between these three activities: operating, financing, and investing. Provide at least two examples of each.

What are the two methods to prepare the cash flow statement? Discuss in detail how cash operating activities are determined in both methods. Describe the whole process.

What are some of the arguments in favor of using the Direct Method as opposed to the Indirect Method?

Answer 1

The primary purpose of preparing a cash flow statement is to provide information about cash receipts, payments and the net change resulting from operating, investing and financing activities. Accrual basis net income is converted to cash basis to determine and evaluate the amount of cash in hand and the flows that have taken place during the period. This is also done in order to evaluate the liquidity of the company.

Operating activities are those activities that relate to the operations of the company. It takes into account the changes in the different line items of working capital. Examples; Increase in debtors, Decrease in creditors, increase in inventory

Investing activities indicate those cash flows that make a change to the fixed assets or other non current assets of the company. Examples; Purchase of machinery, Sale of investments

Financing activities are those cash flows that make a change to the capital structure of the company. Examples are issue of share capital, repayment of loan, payment of interest, etc.

The two methods of preparing the cash flow statement are direct and indirect methods Under indirect method, the net income is adjusted for non cash and non operating items such as depreciation, loss on sale of asset etc. The resulting figure is further adjusted for changes in working capital as well. This gives the figure of cash flows from operating activities.

Under direct method, the format is a bit different for cash from operating activities.It involves layingout all the receipts and payments such as cash from sales, cash payment for purchases, etc. In short, a profit and loss statement on cash basis is to prepared for cash from operating activities.