Question

BTN 12-4 Your friend, Diana Wood, recently completed the second year of her business and just received annual financial statements from her accountant. Wood finds the income statement and balance sheet informative but does not understand the statement of cash flows. She says the first section is especially confusing because it contains a lot of additions and subtractions that do not make sense to her. Wood adds, “The income statement tells me the business is more profitable than last year and that’s most important. If I want to know how cash changes, I can look at comparative balance sheets.”

Required

Write a half-page memorandum to your friend explaining the purpose of the statement of cash flows. Speculate as to why the first section is so confusing and how it might be rectified.

Short answer

Date: XX/XX/XXX

To: Diana Woods

From: Mr. X

Subject: Purpose of the statement of cash flow and speculation of its first section

The main purpose of preparing the cash flow statement is to view changes in the business's cash position. It helps in the determination of the ability of the business entity to meet the long-term and short-term cash requirements. The income statement is prepared on an accrual basis; therefore, it does not provide information regarding the income realized in cash.

The first section includes many additions and deductions for non-cash expenses and current assets and liabilities changes.

Step-by-step solution

Definition of Cash Flow from Operation

Cash flow from operationincludes all the cash inflows and outflows from daily business operations. It includes cash inflow from sales of products and cash paid to the vendor for the inventory acquisition.

Purpose of the statement of cash flow

1. The main purpose of preparing the cash flow statement is toascertain thecash movements.

1. It is prepared to determine the earnings realized in cash.
2. The ability of the business entity to meet the long-term and short-term cash obligations.

Explanation regarding the first section or operating section of the statement of cash flow:

1. It reports the business entity's net income and then adds line items and deducts from it to determine the cash income realized.
2. Firstly, adjustments are made for non-cash expenses. Depreciation and loss from the sale of fixed assets are added back to the net income, and gains from the sale of a fixed asset are deducted from the net income.
3. Secondly, the current assets and liabilities changes are added and deducted. It is done in the following ways:

Add: Increase in current liabilities and decrease in current assets

Less: Increase in current assets and decrease in current liabilities

This process will convert net income into cash realized income. The first section of the cash flow statement includes all of these additions and deductions.