Describe the various sections of the statement of cash flows

Answer 1

Overview of the Statement of Cash Flows

The first section of the statement of cash flows derives cash flow from operations. Both U.S. GAAP and IFRS permit firms to report cash flow from operations in either of two ways:

1 . Direct Method

The direct method reports the amounts of cash received from customers less cash disbursed to suppliers, employees, lenders, and taxing authorities.

Most firms present the operating sections of their statements of cash flows using the indirect method; some think this will change within the next decade or so. A firm that uses the direct method in reporting cash flow from operations must also reconcile net income with cash flow from operations, which gives the same information as in the indirect method.

2 . Indirect Method

The indirect method begins with net income for a period and then shows adjustments to net income to convert revenues to cash received from customers and to convert expenses to cash disbursed to various suppliers of goods and services. Most companies use this method.

While U.S. GAAP and IFRS permit firms to report cash flow from operations using either the direct or the indirect method, a firm that presents the preferred direct method must also show a reconciliation between net income and cash flow from operations. The reconciliation can appear either at the bottom of the statement of
cash flows or in a separate note.

The majority of firms report cash flow from operations using the indirect method. Before the FASB or IASB expressed preference for the direct method, most firms used the indirect method, so both preparers and users had become familiar with it. Experienced financial
analysts who use the statement of cash flows generally understand the adjustments required to convert net income to cash flow from operations. The indirect method shows separately changes in inventories, accounts receivable, and accounts payable, whereas the direct method does not. For companies using the direct method, the analyst can refer to the balance sheet to infer the changes. Analysts often look at unusual changes in those three items. A significant
increase in inventory might indicate falling sales; a significant increase in accounts receivable might indicate the firm is selling to customers in financial difficulty; an increase in accounts payable might indicate that the firm is unable to pay its vendors on time.

Overview of Adjustments to Net Income to Compute Cash Flow from
Operations Under the Indirect Method

There are several types of adjustments required to compute cash flow from operations from net income. The reconciliation of net income to cash flow from operations that a firm using the direct method must provide is essentially the indirect method.

The reconciliation shows the adjustments required to convert net income, measured on an accrual basis, to the amount of net cash flow generated from operations during the period.

One adjustment is an addition to net income each year for depreciation (and amortization). because it uses no cash during that period. Depreciation appears as an expense on the income statement. The events causing the firm to recognize depreciation expense, however, consume not cash but other assets such as buildings and equipment.

The reconciliation starts with net income, which included a subtraction for depreciation expense. Because depreciation reduces net income but does not use cash, the reconciliation adds back the depreciation amount to derive cash flow from operations. Subtracting
depreciation expense to arrive at the amount of net income reported on the first line of the reconciliation and then adding the same amount of depreciation expense on the second line as a reconciling adjustment to net income results in a zero net effect on cash flow from operations.

Thus, the reconciliation's addition for depreciation removes the effect of a noncash expense from operating cash flows.