Classification of Cash Flows
Chapter Forty-Eight
Syllabus topic 4, "Classification of cash flows"
Pages 131 to 133 of 162
In one line
Every cash flow is operating, investing or financing, and operating is defined as whatever the other two are not.
The three definitions
AS 3 paragraphs 5.4, 5.5 and 5.6.
| Activity | Paragraph | Definition |
|---|---|---|
| Operating | paragraph 5.4 | The principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities |
| Investing | paragraph 5.5 | The acquisition and disposal of long-term assets and other investments not included in cash equivalents |
| Financing | paragraph 5.6 | Activities that result in changes in the size and composition of the owners' capital (including preference share capital in the case of a company) and borrowings of the enterprise |
Read the operating definition twice. It has two limbs and the second is a residual: anything that is not investing and not financing is operating. So the method of classification is to test for investing, then for financing, and to let what is left fall into operating.
Why the classification is required
Paragraph 9: an enterprise presents its cash flows in the manner most appropriate to its business, and classification by activity provides information that allows users to assess the impact of those activities on the financial position of the enterprise and the amount of its cash and cash equivalents, and to evaluate the relationships among them.
The relationships among them is the phrase to notice. A company whose operating inflow funds its investing outflow is in a different position from one whose financing inflow does, and only the classification shows which.
The single transaction that splits: paragraph 10
A single transaction may include cash flows that are classified differently. For example, when the instalment paid in respect of a fixed asset acquired on deferred payment basis includes both interest and loan, the interest element is classified under financing activities and the loan element is classified under investing activities.
One cheque, two headings. A student who classifies the whole instalment as investing has lost the interest, and one who classifies it all as financing has lost the asset.
Notice the classification of the interest element here is FINANCING, which is consistent with paragraph 30's general rule for a non-financial enterprise. The chapter on interest and dividends takes that rule in full.
Working the classification
The test, in order.
| Ask | If yes | |
|---|---|---|
| 1 | Does it involve a long-term asset or an investment being bought or sold? | Investing |
| 2 | Does it change the owners' capital or the borrowings? | Financing |
| 3 | Neither? | Operating |
And two overriding rules learned from the chapters ahead.
- Interest paid and dividends paid go to financing for a non-financial enterprise, whatever step three would say.
- Interest and dividends received go to investing for a non-financial enterprise.
- Tax paid goes to operating unless it can be specifically identified with an investing or financing transaction.
The rest of this chapter
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The rest of this subject
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