Question

Forrest Gardner, owner of Gardner's Gardens, just completed his first year in business and has received financial statements that have been prepared by his accountant. Gardner finds the income statement and balance sheet to be informative, however, he does not understand the statement of cash flows. He says that the first section is especially confusing.

Write a summary explaining the following:

1. Purpose and sections of the cash flow statement.

2. Explain why the first section may be confusing.

Answer 1

1) Purpose and sections of the cash flow statement

The purpose of the cash flow statement or statement of cash flow is to provide information about a company's gross receipts and gross payments for a specified period of time.

The gross receipts and gross payments will be reported in the cash flow statement according to one of the following classifications: operating activities, investing activities, and financing activities. The net change from these three classifications should equal the change in a company's cash and cash equivalents during the reporting period.

In addition to the cash amounts being reported as operating, investing, and financing activities, the cash flow statement must disclose other information, including the amount of interest paid, the amount of income taxes paid, and many other significant investing and financing activities.

The cash flow statement is one of the primary financial statements used in business operations, including small businesses. Creating a cash flow statement illustrates the amount of cash the business generated during the reporting period. The cash flow statement also details the cash used during the period, helping management see where the money is going. The cash flow statement consists of three primary sections plus an optional supplemental section.

(a) Operating Activities

The first section of the cash flow statement illustrates the cash received and used during normal operating activities. This section provides the changes in the ledger account balances for your current assets and current liabilities. These accounts are your accounts payable, accounts receivable, prepaid insurance and unearned revenues. When you sell products or services, that activity is reported here.

Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.

(b) Investment Activities

The second section is dedicated to investment activity. All of a company's investments are listed under this category. Any purchase or sale of property, equipment and plants also qualify under the investment section. The ledger accounts to review for this section include the long-term investments account, vehicles, capital equipment accounts, land and buildings. If you run a cafe or restaurant, buying a new grill or oven would qualify under this section. Report any equipment you buy for your regular business operations here.   

(c) Financing Activities

The third section of the cash flow statement lists the information for the company's financing activities. Financing activities include purchases of bonds and stock as well as dividend payments. Some of the ledger accounts include your equipments and paid-in capital accounts, notes and bonds payable, stock and retained earnings.

2) Why Operating activity segment is confusing

Operating activities

Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.

The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically do so include:

Cash collected from customers, Interest and dividends received, Cash paid to employees, Cash paid to suppliers. Interest paid and Income taxes paid.

The main issue with this method is it’s difficult and time consuming feature to create. Most of the companies don’t record and store accounting information by customers, suppliers, or vendors. Business events are recorded with income statement and balance sheet accounts like sales, materials, and inventory. It’s difficult for most companies to compile the information with this method.

For example, in order to calculate the receipts and payments from each source of income, you have to use a unique formula. The receipts from customers equals net sales for the period plus the beginning accounts receivable less the ending accounts receivable. Similarly the payments made to suppliers is calculated by adding the purchases, ending inventory, and beginning accounts payable then subtracting the beginning inventory and ending accounts payable.

Alwayz keep in mind that these methods only work if accounts receivable is only used for credit sales and accounts payable is only used for credit purchases. That's why most companies don’t issue this method. It’s difficult to gather the information.

The direct method also requires a reconciliation report be created to check the accuracy of the operating activities.

For Gardening business, Forrest Gardner, owner of Gardner's Gardens, require it's cash flow statement to be prepared with the direct method. So for his accountant, it's more confusing to prepare the operating activities section.