Is it logical that interest paid is classified as a cash outflow in the Operating Activities section of the statement of cash flows but that dividends paid are included in the Financing Activities section? Explain

Answer 1

An argument can be made that it is inconsistent to report interest paid in the Operating section and dividends paid in the Financing section. Both represent returns to providers of capital: interest to creditors and dividends to stockholders. Furthermore, the cash raised from each of these sources—the amounts borrowed from creditors and the amounts contributed by stockholders—is classified as an inflow in the Financing section of the statement. The rationale normally given for this treatment is that interest enters into the determination of net income; thus, the cash expended in interest should appear in the Operating section. Many believe that this is illogical and that both interest paid and dividends paid belong in the Financing section.