2 Statement of cash flows in detail
2.1 What is Statement of cash flows?
Statement of cash flows simply summarizes the changes in cash and cash equivalents over a period of time as a result of different business activities resulting in cash flows. For this purpose business activities are divided into three categories:
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.
2.2 Not just Cash but Cash equivalents as well!
Statement of cash flows does not only provide information on hard cash but also about cash equivalents. Cash equivalents are simply those short term investments which are held more as cash rather than as investments. Cash equivalents are:
- Short term (three months or less)
- High liquid investments i.e. readily convertible to known amounts of cash
- Subject to insignificant risk of variations in value of investment
Any instrument or investment that fulfils the criteria will be considered as cash equivalent. for example equity shares are not cash equivalents as they are mostly not redeemable or short term in nature or experience fluctuating redeemable value. However, if shares are acquired close to maturity then they will be treated as cash equivalents.
2.3 Short term borrowings from bank
Sometime banks allow their customers to withdraw exceeding the actual amount available or when there is no cash available in the account. This facility to withdraw surplus cash from the bank helps customers to meet urgent needs. This is a short term borrowing which is paid back in really short period of time. However to consider bank overdraft as cash equivalents, entity should be using this facility as part of its cash management activity and uses it frequently causing the bank balance to fluctuate from normal (positive or credit balance) to overdrawn (negative or debit balance).
Effect of treating overdraft as a borrowing and cash equivalent
- If overdraft is not treated as cash equivalent then it will form part of short term borrowings and will presented as a financing activity in the statement of cash flows.
- If overdraft is treated as cash equivalent then it will be cancelled out against other cash and cash equivalents, as it is a contra balance, to arrive at the figure of net cash and cash equivalents.
2.4 Movements in cash equivalents
Movements in cash and cash equivalents shall not be treated as cash flows or in other words such if a term deposit with the bank is matured and the same amount is reinvested in debentures maturing in a month time then this shall not be reported as a movement in operating, investing or financing activity on the face of statement of cash flows. This is a usual practice of entities which is known as cash management.