Classification of Cash Flows - Cash flow statements, Cost Accounting | Cost Accounting - B Com PDF Download

Classification of Cash Flows Statement

The cash flow statement during a period is classified into three main categories of cash inflows and cash outflows i.e. operating, investing and financing activities.

(i) Cash Flows from Operating Activities

Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing and financing activities. Operating activities include cash effects of those transactions and events that enter into the determination of net profit or loss.

A business’s normal operations result in both cash receipts and cash payments. Cash receipts result from selling goods and providing services. The cost of goods sold and other operative expenses result in cash disbursements. The revenues and expenses reported in the income statement, however, do not coincide with the cash receipts and payments as we prepare the income statement on an accrual basis. The receipts and payments of cash for these revenues and expenses may occur in either an earlier or later period than the period we report the revenues and expenses.

Following are examples of cash flows from operating activities:

1. Cash receipts from the sale of goods and the rendering of services;
2. Cash receipts from royalties, fees, commissions, and other revenues;
3. Cash payments to suppliers for goods and services;
4. Cash payments to and on behalf of employees;
5. Cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits;
6. Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and
7. Cash receipts and payments relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purposes.

(ii) Cash Flows from Investing Activities 

Investing activities are the acquisition and disposal of long term assets and other investments not included in cash equivalents. In other words, investing activities include transactions and events that involve the purchase and sale of long-term productive assets (e.g. land, building, plant and machinery etc.) not held for resale and other investments. The following are examples of cash flows arising from investing activities:

1. Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalised research and development costs and self-constructed fixed assets;
2. Cash receipts from disposal of fixed assets (including intangibles);
3. Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes);
4. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes);
5. Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise); (f) cash receipts from the repayment of advances and loans made to third parties (other than advances and loans of a financial enterprise);
6. Cash receipts and payments relating to future contracts, forward contracts, option contracts, and swap contracts except when the contracts are held for dealing or trading purposes, or the transactions are classified as financing activities.

(iii) Cash Flows from Financing Activities

Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise. Following are the examples of cash flows arising from financing activities:

1. Cash proceeds from issuing shares or other similar instruments;
2. Cash proceeds from issuing debentures, loans notes, bonds and other short term borrowing.
3. Cash repayments of amounts borrowed i.e. redemption of debentures, bonds etc.
4. Cash payments to redeem preference shares.
5. Payment of dividend.

Special Items

In addition to the general classification of three types of cash flows, Accounting Standard-3 (Revised) provides for the treatment of the cash flows of certain special items as under:

(a) Foreign Currency Cash Flows

Cash flows arising from transactions in a foreign currency should be recorded in an enterprise’s reporting currency by applying to the foreign currency amount the exchange rate between the reporting currency and foreign currency at the date of cash flow. A rate that approximates actual rate may be used if the result is substantially the same as would arise if the rates at the date of cash flows were used. Unrealised gains and losses arising from changes in foreign exchange rates are not cash flows. However, the effect of exchange rate changes on cash and cash equivalents held or due in foreign currency is reported in the cash flow statement in order to reconcile cash and cash equivalents at the beginning and the end of the period. This amount is presented separately from cash flows from operating, investing and financing activities and includes the differences, if any, had those cash flows been reported at the end of period exchange rates.

(b) Extraordinary Items

The cash flows associated with extra-ordinary items such as bad debts recovered, claims from insurance companies, winning of a law suit or lottery etc. are disclosed separately as arising from operating, investing or financing activities as the case may be, in the cash flow statement.

(c) Interest and Dividends

According to Accounting Standard-3 (Revised), the treatment of interest and dividends, received and paid, depends upon the nature of the enterprise, that is, financial enterprises and other enterprises.

(i) In the case of financial enterprises: Cash flows arising from interest paid and interest and dividends received, should be classified as cash flows from operating activities.

(ii) In the case of other enterprises:

• Cash flows arising from interest paid should be classified as cash flows from financing activities.
• Cash flows arising from interest and dividends received should be classified as cash flows from investing activities;
• Dividends paid should be classified as cash flows from financing activities.

In all cases, cash flows from interest and dividends received and paid should be disclosed separately. Also the total amount of interest paid during the period is disclosed in the cash flow statement whether it has been recognised as an expense in the Statement of Profit & Loss or capitalised in accordance with AS-10, Accounting for Fixed Assets.

(d) Taxes on Income

Cash flows arising from taxes on income should be separately disclosed and should be classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities. Taxes on income arise on transactions that give rise to cash flows that are classified as operating, investing or financing activities in a cash flow statement. While tax expense may be readily identifiable with investing or financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transactions. Therefore taxes paid are usually treated as cash flows from operating activities. However, in case it is possible to identify the tax cash flow with an individual transaction that gives rise to cash flows that are classified as investing or financing activities, it is appropriate to classify the tax cash flow as an investing or financing activity.

(e) Acquisition and Disposals of Subsidiaries and other Business Units

The aggregate cash flows arising from acquisitions and from disposals of subsidiaries or other business units should be presented separately and classified as investing activities.

(f) Non-cash Transactions

Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a cash flow statement. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities. The exclusion of non-cash transactions from the cash flow statement is consistent with the objective of a cash flow statement as these do not involve cash flows in the current period. Following are examples of noncash transactions:

1. The acquisition of assets by assuming directly related liabilities.
2. The acquisition of an enterprise by means of issue of shares.
3. Conversion of debt into equity.