BUS103: Introduction to Financial Accounting

Although the cash flow statement is a very useful tool, it has its own limitations which must be kept in mind at the time of its use.

Learning Objective

• Identify the factors that make the statement of cash flows of limited use

Key Points

• Cash flow statements, just like Income Statements and Balance Sheets, are prepared using past information. It therefore does not provide complete information to assess the future cash flows of an entity.
• As a cash flow statement is based on a cash basis of accounting, it ignores the basic accounting concept of accrual.
• Cash flow statements are not suitable for judging the profitability of a firm, as non-cash charges are ignored while calculating cash flows from operating activities.
  

Terms

• accrual basis accounting
  a method that records income items when they are earned and records deductions when expenses are incurred
• accrual basis accounting
  A method of accounting where income is not recorded until earned and expenses are not recorded until incurred.
• cash-basis accounting
  a method where revenue is recorded when cash is received, and expenses are recorded when cash is paid
  

The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets. Although the cashflow statement is a very useful tool of financial analysis, it has its own limitations which must be kept in mind at the time of its use .

Statement of cash flows

The statement of cash flows includes cash flows from operating, investing and financing activities.

Cash flow statements, just like Income Statements and Balance Sheets, are prepared using past information. It therefore does not provide complete information to assess the future cash flows of an entity. On its own, the statement of cash flows cannot be used to determine the financial position of a company.

The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues to the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses. As a cash flow statement is based on the cash basis of accounting, it ignores the basic accounting concept of accrual.

Cash flow statements are not suitable for judging the profitability of a firm, as non-cash charges are ignored while calculating cash flows from operating activities.