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12.1 Purpose of the Statement of Cash Flows

Learning Objective

  1. Define the purpose of the statement of cash flows.

Question: Most organizations prepare four financial statements for external reporting purposes: income statement, balance sheet, statement of owners’ equity, and statement of cash flows. Financial accounting courses cover the first three statements in detail and often provide an overview of the statement of cash flows. This chapter will focus on preparing the statement of cash flows and on using the resulting cash flow information for analytical purposes. What information is provided in the statement of cash flows?

 

Answer: The statement of cash flowsA financial statement that provides cash receipt and cash payment information and explains the change in cash for a period of time. provides cash receipt and cash payment information and reconciles the change in cash for a period of time. Cash receipts and cash payments are summarized and categorized as operating, investing, or financing activities. Simply put, the statement of cash flows indicates where cash came from and where cash went for a period of time.

Assume you keep track of your individual cash transactions for an entire year in a check register (e.g., checks written and paycheck deposits) and suppose you have hundreds of transactions for the year. Rather than showing every single transaction in a formal report, the statement of cash flows summarizes these transactions. For example, all cash receipts from paychecks are added together and shown as one line item, all cash payments for rent are added together and shown as one line item, all cash payments for food are added together and shown as one line item, and so on. The goal is to start with the beginning of the year cash balance, add all cash receipts for the year, subtract all cash payments for the year, and find the resulting end-of-year cash balance. Although the formal statement of cash flows is not quite this simple, the concept is the same.

 

Question: Why did the Financial Accounting Standards Board (FASB) create the statement of cash flows in 1987?

 

Answer: The statement of cash flows was created due to a lack of cash flow information on the income statement, balance sheet, and statement of owners’ equity. The income statement shows revenues and expenses using the accrual basis of accounting, but it does not indicate how much cash was received for revenues or paid for expenses. The balance sheet shows assets, liabilities, and owners’ equity at a point in time, but it does not show how much cash was received or paid for these items. The only cash information provided on these statements is the change in cash from the end of last period to the end of the current period derived from the cash line item on the balance sheet (often called cash and cash equivalents).

Owners, creditors, and managers wanted more cash flow information. They often asked such questions as: Why did cash go down? How much cash was received related to net income? How much cash was paid for the purchase of equipment? How much cash was received from issuing bonds? As a result of the demand for more cash flow information, the FASB formally created the statement of cash flows in 1987 (Statement of Financial Accounting Standard No. 95, which can be found at http://www.fasb.org). Most companies are now required to prepare the statement of cash flows along with the other three statements. We begin the process of explaining how to prepare this statement in the next section.

Business in Action 12.1

Cash Flows at Southwest Airlines

Southwest Airlines was in the enviable position of generating $1,600,000,000 in cash from operating activities for the year ended December 31, 2010. However, cash on the balance sheet only increased $147,000,000 for the same period. Why did total cash go up by such a small amount compared to the $1,600,000,000 increase in cash from operating activities? The statement of cash flows provides the information necessary to answer this question. Southwest spent $493,000,000 on property and equipment (planes, parts, etc.) and $155,000,000 to pay off long-term debt. Southwest also purchased $772,000,000 in short-term investments.

Key Takeaway

  • The statement of cash flows provides cash receipt and cash payment information and reconciles the change in cash for a period of time. The primary purpose of the statement is to show what caused the change in cash from the beginning of the period to the end of the period.

Review Problem 12.1

  1. Describe the purpose of the statement of cash flows.
  2. Why did the FASB create the statement of cash flows?

Solution to Review Problem 12.1

  1. The purpose of the statement of cash flows is to provide a summary of cash receipt and cash payment information for a period of time and to reconcile the difference between beginning and ending cash balances shown on the balance sheet. The statement of cash flows clarifies how cash was generated and how cash was used for a period of time.
  2. The FASB created the statement of cash flows because owners, creditors, managers, and other stakeholders wanted more information regarding cash receipts and cash expenditures. Although the balance sheet shows cash balances at the end of each period, no further information is provided on the balance sheet, income statement, or statement of owners’ equity regarding cash flow activities. The statement of cash flows takes care of this problem.