Introduction of Cash Flow:
The cash flow statement is a report of all the transactions which affect the cash account. The effect may be in a favorable way unfavorable way. It provides all the summarized information about the cash receipt and payment.
The cash flow statement is very important to managers because they can make a future strategy about sales, purchases, and payments.
Cash flow requires information from the balance sheet and Profit & loss for the time period for which the cash flow statement is being prepared.
Cash flow is also an instrument to check errors and frauds in the financial data. There are two ways of making cash flows. The one is called the direct method and the other is called the indirect method.
The only difference between the methods is only in the operating activates of the cash flow while the other two sections are the same in both the method.
The three main components of the Cash flow statement are as follows
- Operating Activates
- Investing Activities
- Financial Activates
Operating activities are made up of mainly from the working capital or you can say that it mainly consists of changes in current assets and current liabilities of the balance sheet.
The investing activities section is affected by the changes in the non-current assets of the balance sheet items.
And at the last financial activities are affected by the changes that come in the capital and long term liability side of the balance sheet. While the net income is obtained from the income statement of the entity.
Paid Interest Expense In The Statement Of Cash Flow:
Interest is the cost of loans borrowed from financial institutions. There are many types of interests which are paid by organization depending on the source.
When the company is in the position of expansion. They always need finances to meet the needs of expanding the business.
Finances can be managing through the addition of more capital by the shareholders and the other way is through bank loans and issuance of other financial securities.
The shareholder is the true owner of the business so there is no interest payable on the paid-up capital but when the organization opted for any bank loans or interest-bearing securities then the company has to pay the agreed interest.
This interest is expense out in the company income statement to the period they relate.
The expense paid on the loans and bonds is an expense out through the income statement. While in the cash flow statement it is treated under the operating activities.
Under the indirect method, we take the profit or loss before tax and interest paid and then we subtract the amount of interest paid during the year.
It will the net of interest expense for the period less the interest accrued but not paid yet.
Under the direct method, we will also treat the interest under the head of operational activity and there is no difference in the calculation part.
As the interest paid will be subtracted from the cash receipt from the customers and other received cash amount.
Why Interest Paid is Included in Operating Activity?
The decision about the inclusion of interest expense in the operating activity of the cash flow statement takes a long time and intense studies along with long debates.
Some members of GAAP have a view that if the source of this expense is present in the finance activity then the interest paid should be included in the financing activity.
While the majority of the members say that because this interest comes from in the normal course of business. So it should be included in the operating activity section.
At the voting, the members with the second view have more votes than the first. That’s why it is included in the operating activities of the cash flow.