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The Cash Flow Concept and Calculation Methods
Cash flow statements are the responsibility of organizations; reports should be prepared regularly and reflect the current activities. Cash flow is referred to in Section 230 of the Accounting Standards Codification (FASB, 2018). There is an established set of methods for reporting cash flows; however, organizations do not always follow it. The difference in regulatory policy and practice may arise due to an organizations desire to simplify reporting methods.
Cash flow is the net amount of cash or cash equivalents that transfer in and out of business. An explanation of the change in an entitys total cash during the reporting period is required (FASB, 2018). GAAP defines three types of cash flows: operating, investing, and financing activities (FASB, 2018). Operating activities may include revenue from the sale of goods or services, interest payments, rent payments, and wages. Investing activities include any source and use of cash from a companys investments, such as the purchase or sale of assets. Cash flows from financing activities involve receipts related to the raising of additional capital, such as dividends. Explanations bring clarity to financial statements and aim to increase transparency.
There are two methods for calculating cash flow: the direct and indirect method. The direct method sums up all out-of-pocket payments and receipts (Klammer, 2018). FASB recommends that companies use the direct method (FASB, 2018). The indirect method measures how much a company has earned or spent from various sources over a given period (Klammer, 2018). Many companies prefer the indirect method because it is easy to prepare a cash flow statement using information from the other two general financial statements, the income statement and balance sheet, so there is a discrepancy between guidance and practice (Arnold et al., 2018). The direct method provides greater transparency because it allows the management to identify all sources of cash receipts.
In conclusion, despite well-defined cash flow policies, reality often diverges from theory. It is much easier for large organizations to use the indirect method of calculating cash flow. The direct method of accounting, which complies with the recommendations, provides transparency since it takes into account all the companys transactions for the specified period. Since the guidelines are advisory, there is no need for organizations to adhere to them. The use of the direct method of accounting would improve the clarity of financial statements for the benefit of clients and investors.
References
Arnold, A. G., Ellis, R. B., & Krishnan, V. S. (2018). Toward effective use of the statement Of cash flows. Journal of Business and Behavioral Sciences, 30(2), 46-62. Web.
FASB. (2018). Accounting Standards Codification. Web.
Klammer, T. (2018). Statement of cash flows: Preparation, presentation, and use. Wiley.
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