The Classification of Cash Flows

Since cash and cash equivalents are combined, the statement of cash flows does not report transactions between cash and cash equivalents such as cash paid to purchase cash equivalents and cash received from selling cash equivalents. However, all other cash receipts and cash payments are classified and reported on the statement as operating, investing, or financing activities. Individual cash receipts and payments for each of these three categories are labeled to identify their originating transactions or events. A net cash inflow (source) occurs when the receipts in a category exceed the payments. A net cash outflow (use) occurs when the payments in a category exceed the receipts.

Operating activities Activities that involve the production or purchase of merchandise and the sale of goods or services to customers, including expenditures related to administering the business. include those transactions and events that determine net income. Examples are the production and purchase of merchandise, the sale of goods and services to customers, and the expenditures to administer the business. Not all items in income, such as unusual gains and losses, are operating activities (we discuss these exceptions later in the chapter). Exhibit 16.1 lists the more common cash inflows and outflows from operating activities. (Although cash receipts and cash payments from buying and selling trading securities are often reported under operating activities, new standards require that these receipts and payments be classified based on the nature and purpose of those securities.)

EXHIBIT 16.1 Cash Flows from Operating Activities

Point: The FASB requires that cash dividends received and cash interest received be reported as operating activities.

Investing activities Transactions that involve purchasing and selling of long-term assets, includes making and collecting notes receivable and investments in other than cash equivalents. generally include those transactions and events that affect long-term assets—namely, the purchase and sale of long-term assets. They also include (1) the purchase and sale of short-term investments in the securities of other entities, other than cash equivalents and trading securities and (2) lending and collecting money for notes receivable. Exhibit 16.2 lists examples of cash flows from investing activities. Proceeds from collecting the principal amounts of notes deserve special mention. If the note results from sales to customers, its cash receipts are classed as operating activities whether short-term or long-term. If the note results from a loan to another party apart from sales, however, the cash receipts from collecting the note principal are classed as an investing activity. The FASB requires that the collection of interest on loans be reported as an operating activity.

EXHIBIT 16.2 Cash Flows from Investing Activities

Financing activities Transactions with owners and creditors that include obtaining cash from issuing debt, repaying amounts borrowed, and obtaining cash from or distributing cash to owners. include those transactions and events that affect long-term liabilities and equity. Examples are (1) obtaining cash from issuing debt and repaying the amounts borrowed and (2) receiving cash from or distributing cash to owners. These activities involve transactions with a company’s owners and creditors. They also often involve borrowing and repaying principal amounts relating to both short- and long-term debt. GAAP requires that payments of interest expense be classified as operating activities. Also, cash payments to settle credit purchases of merchandise, whether on account or by note, are operating activities. Exhibit 16.3 lists examples of cash flows from financing activities.

EXHIBIT 16.3 Cash Flows from Financing Activities

Point: Interest payments on a loan are classified as operating activities, but payments of loan principal are financing activities.

Decision Insight Cash Monitoring Cash flows can be delayed or accelerated at the end of a period to improve or reduce current period cash flows. Also, cash flows can be misclassified. Cash outflows reported under operations are interpreted as expense payments. However, cash outflows reported under investing activities are interpreted as a positive sign of growth potential. Thus, managers face incentives to misclassify cash flows. For these reasons, cash flow reporting warrants our scrutiny.