Cash Flow Statements and Accounting Policy Essentials

Posted on Jan 28, 2026 in Accounting and Finance

Cash Flow Statement Fundamentals

A Cash Flow Statement (CFS) is a key financial document that reports the detailed changes in a company’s cash and cash equivalents over a specific period, such as a month, quarter, or year. It tracks the movement of cash inflows (money deposited) and cash outflows (money spent) within the business.

Purpose of a Cash Flow Statement

The primary purpose of preparing a CFS is to provide insight into a company’s liquidity and financial health by showing where its cash came from and how it was used.

• Liquidity Assessment: It helps determine if a company generates enough cash to meet its short-term operating expenses and obligations (pay bills, debt, etc.). A company can be profitable on its income statement but still have insufficient cash to operate.
• Operational Efficiency: It reveals the quality of a company’s earnings by showing how much of the net income came from actual cash flow, as opposed to non-cash accounting adjustments like depreciation.
• Forecasting and Planning: It is a vital tool for management to forecast future cash flows, make informed capital budgeting decisions, and maintain an optimum cash balance (avoiding both idle excess cash and a cash shortage).
• Investor/Creditor Analysis: It is used by investors and creditors to assess the risk of investing in or lending to the firm, evaluating its ability to pay interest and dividends.

Main Activities and Preparation Methods

The CFS is organized into three main sections, which categorize the sources and uses of cash:

Operating, Investing, and Financing Activities

• Operating Activities: Cash flows related to the company’s core, day-to-day business operations (e.g., manufacturing, selling goods/services).
  • Inflows: Cash receipts from customers, royalties, commissions.
  • Outflows: Cash payments to suppliers, employees, for operating expenses, interest, and taxes.
• Investing Activities: Cash flows related to the acquisition or disposal of long-term assets and investments.
  • Inflows: Cash receipts from the sale of fixed assets (Property, Plant, and Equipment – PPE) or investments.
  • Outflows: Cash payments to purchase fixed assets (Capital Expenditures – CapEx) or to acquire investments in other companies.
• Financing Activities: Cash flows related to debt and equity financing—transactions involving lenders and owners.
  • Inflows: Cash proceeds from issuing shares or new debt (e.g., debentures, loans).
  • Outflows: Cash payments for repaying debt principal, distributing dividends, or repurchasing company stock.

Direct and Indirect Preparation Methods

There are two methods for preparing the cash flow from Operating Activities:

• Indirect Method: This is the more common method. It starts with the Net Income from the income statement and adjusts it for non-cash transactions (like depreciation and amortization) and changes in working capital (changes in current assets and liabilities) to arrive at the net cash flow from operating activities.
• Direct Method: This method reports the major classes of gross cash receipts (e.g., cash received from customers) and gross cash payments (e.g., cash paid to suppliers) for operating activities.

Features, Advantages, and Limitations

Significant Accounting Policies

A Significant Accounting Policy is a specific principle, basis, convention, rule, and practice adopted by a company in preparing and presenting its financial statements. These policies are critical because the choice and application of a policy can significantly affect the reported amounts of assets, liabilities, income, and expenses.

Since Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) often allow for different acceptable methods, management must choose the policy that provides the most true and fair view of the company’s financial position.

Examples of areas requiring a significant accounting policy disclosure include:

• Inventory Valuation: Using FIFO, LIFO, or the Weighted Average Method.
• Depreciation/Amortization: Using Straight-Line, Written-Down Value, or another method.
• Revenue Recognition: Determining when and how sales revenue is recognized (e.g., upon shipment or delivery).
• Foreign Currency Translation: The rates and methods used to convert foreign currency transactions.
• Basis of Presentation: Stating whether the statements follow the accrual basis and which accounting standards are used.

Key Features of Accounting Policies

• Mandatory Disclosure: Accounting standards (like AS 1 or IAS 1) mandate that all significant accounting policies must be disclosed in the notes to accounts.
• Consistency: Policies must be applied consistently from one period to the next to ensure comparability.
• Materiality: Only policies relating to material transactions or items are required to be disclosed.
• Entity-Specific Judgment: Policies are often a result of management’s judgment in selecting the most appropriate method.

Advantages of Significant Accounting Policies

Limitations of Significant Accounting Policies

Would you like to see an example of how a change in a significant accounting policy is disclosed in financial statements?