For purposes of preparing a statement of cash flows, the FASB has defined cash as including botn cash and cash equivalents.
Cash equivalents are short-term, highly liquid investments, such as money market funds. commercial paper. and Treasury bills. Transfers of money between a company’s bank accounts and these cash equivalents’ are not viewed as cash receipts or cash payments.
Money is considered cash regardless of whether it is held in currency. in a bank account, or form of case equivalents. However. any interest received from owning ca ·t equivalents is included in cash receipts from operating activities. Cash equivalents are limited to short-termhighly liquid investments such as those specified above.
Marketable securities, such as investments in the stocks and bond- of other companies, do not qualify as cash equivalents. Therefore. purchases and sales of marketable securities do result in cash flows that are reported in the snucme-it of cash flows as investing activities.
Critical Importance of Cash Flows from Operating Activities In the long run, a business must generate positive net cash flows from its operating activities if it is to survive.
A business with negative cash flows from operations will not be able to raise cash from other sources indefinitely. In fact. the ability of a business to raise cash through financing activities is highly dependent on its aoility to generate cash from its notional business operations.
Creditors and stockholders are reluctant to invest in a company that does not generate enough cash from operating activities to ensure prompt payment of maturing liabilities, interest, and dividends. Neither can a company expect to survive indefinitely on cash provided by investing activities. At some point. plant assets, investments. and other assets available for sale will be depleted.
The Approach to Preparing a Statement of Cash Flows
The items listed in an income statement and a balance sheet represent -c balances of specific general ledger accounts. Notice, however. that the captions used in v-c statement of cash flows do not correspond to specific ledger accounts. A statement o . cash flows summarizes cash transactions during the accounting period. The general is maintained on the accrual basis of accounting, not the cash basis.
Thus iuch us “Cash received from customers $870,OOO” not appear’as the balance in a specific ledger account. . In a very small business, it may be practical to prepare a statement of ~ash flows dircctly from the special journals for cash receipts and cash.payments,
For most businesses, however, it is easier to prepa.re the statement ‘of cash flows by examining the’ income statement and the changes during the period in all of the balance sheet accounts except for Cash. This approach is based on the -entry system of accounting; any transaction affecting cash must also affect some other asset, liability, or owners’ equity account,
The change in these other accounts’ makes clear the nature of the cash transaction.
To illustrate this approach, assume that the Marketable Securities controlling account of Allison Corporation shows the following activity during the year:on sales of marketable securities. Increases in the Marke’table Securities account represent the cost of securities purchased during the year. These debit entries provide the basis for the item “Purchases of marketable securities $(65,000)” appearing in the investing activities section of the statement of cash flows (page 555).
Thus increases in the asset marketable securities correspond to an ‘outflow of cash. Decreases of $44,000 represent the cost of securities sold during the year. Remember, however, that the income statement shows that these securities were sold at a loss
The cash proceeds from these sales, which also ‘appear .in the statement of cash flows, may be conputcd as follows: -By looking at the changes occurring in the Marketable Securities account and the relatcJ income statement account, we were able to determine quickly two items appearing In (he company’s statement of cash flows. We could have assembled the same information from the company’s cash journals, but we would have had to review the journals
• for the entire year and then add together the cash. flows of numerous individual transactions. In summary, it.usually is more efficient to prepare a statement of cash flows by anulyziug the changes in noncash accounts in the balance sheet than by locating and combining numerous entries in the company’s journals