There are three ways of classifying cash flows, which we look at in this article.
Cash Flow Classifications
Cash flows should be classified under the following headings:
- Operating activities
- Investing activities
- Financing activities
All cash flows should be included in one of these three categories.
By dividing out the cash flows into different categories, users can understand what caused the overall change in the entity’s cash position in the period.
Cash flows from operating activities should be reported using either:
- the direct method, or
- the indirect method
The direct method takes the cash inflows and deducts cash outflows, reporting each under major categories of income and expenditure.
Essentially, it starts from scratch, showing the cash coming in, cash going out, and what’s left afterwards.
The indirect method takes the profit or loss figure from the Statement of Comprehensive Income and adjusts it for the effects of any non-cash items, deferrals, accruals and any items of an investing or financing nature.
Essentially, it takes the profit figure and makes adjustments.
The direct method is preferred.
Importance of classification
Keep an eye out in your exam for how the cash flows should be classified.
For example, for most firms, buying and selling investments will be an investing activity.
However, if a company is an investment firm, the buying or selling of investments will fall under its normal operating activities, instead of investing activities.
Sometimes a cash flow could fall under more than one category, if this happens, select the most relevant classification and use it consistently.
Also remember that items of investing or financing activities may be presented in the statement of comprehensive income.
So if you see an item in the statement of comprehensive income, don’t assume it’s automatically from operating activities.
Exam tip: how to check your cash flow statement
There are two ways of checking your cash flow statement.
- First, the direct method and the indirect method should equal each other. If you happen to draft both sets in the exam, I hope you don’t, but if you do, they should equal each other.
- Secondly, if you take the net cash flow total from the statement of cash flows, and add it to the opening cash on hand balance, this should equal your closing cash balance in the statement of financial position. This method should be quicker to calculate.