Accounting Standards Codification 230 (ASC 230) was released to address the more specific topic of the Statement of Cash Flows and how it should be organized. An important aspect of financial reporting to note is that the standard does not recommend, it requires
this statement to be included due to the importance of cash flow to the operations of a business. One can have a great business but if it can’t keep the bills paid on time, then it won’t last very long!
When creating a Statement of Cash flows, the three important categories are:
- Operating Activities
The operations of a business are the primary activities that it engages in to generate revenues to operate. These include a wide variety of transactions involved in providing that service to the customer. Furthermore, this is also the catch-all category for collecting those items not included in the Financing or Investing categories below.
- Financing Activities
Items such as borrowing money or issuing shares to investors for capital are what make up the category of financing. This is important to break out separately than those of the operations as it helps show if the company is sinking into debt or emerging from it. If a company is only surviving by continually borrowing more and more money, then it will show up here.
- Investing Activities
An investing activity is related to items such as large capital purchases of property and equipment, buying and selling of securities, or lending out money to third parties. It is important to separate this out from operations due to the potential for a company to be running a loss based on operations, a sign of a weak performing company, which is masked by the company having had a great (unsustainable) year in the stock market.
Since accounting is typically measured on an accrual basis rather than cash basis for larger companies, the cash flow statement has further importance in providing information to investors. The non-cash effects of the accrual basis of accounting are removed in the statement of cash flows. This includes items such as expenses driven by depreciation, which makes the company appear less profitable yet isn’t an expense the company actually pays out. For this reason, it is important to review the cash flows of a company, not just the income statement and balance sheet!
*Technical versions of the standards, authoritative literature can be found in the Financial Accounting Standards Board website.
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