Interrelationship of Cash Flow Statement with Other Financial Statements
Cash flow statement is the statement that shows the position of cash inflows and cash outflow in the given period. It is directly related with other financial statements. The statement of cash flow is divided into three parts as cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The Cash flow from operating activities shows the cash flows from the activities done on the regular basis to run the business. It includes the net income of the business, which is obtained from the income statement and some accounts recorded in the balance sheet. The operating section of cash flow uses the cash flows recorded in the income statement, as the very first item in cash flow from operating activities happens to be net income. Similarly, the investing activities section records the cash flows when the company makes investment of long-term nature i.e. capital investment. This section is directly related to the asset side of the balance sheet of the company.
Whenever there is investment in the capital assets, then it is shown in the cash flow statement under investing activities while the same amount is capitalized in the asset section of balance sheet. Similarly, the retained earning section of balance sheet is related to financing section of the cash flow statement. Whenever the company issues the financial instruments like bonds, shares, debentures and others, then it generates positive cash inflow in the cash flow statement while the shareholders’ equity and liabilities side of the balance sheet increases by same amount. In addition to this, when the company uses retained earnings to finance its project, and then the retained earning balance is deducted in the balance sheet while it is recorded in the cash flow statement as cash outflow (The Wall Street Prep Team, 2012). So, no financial statement can be seen in isolation. All the financial statements are developed by taking the reference of other statements.
Difference between direct method and indirect method
We can notice a small difference between the direct method and indirect method of preparing a cash flow statement. When the other sections of cash flows (investing and financing activities) do not have any differences, the difference lies in the cash flow from operating activities section. When we prepare a statement of cash flow using direct method, and then we show the cash collected from our debtors / customers, and the cash that we paid to our creditors as the starting items of cash flow. We use the different items of the income statement in the direct method of preparing a cash flow statement. On the other hand, we use the net income directly from the income statement to start the cash flow statement and then the required adjustments are done to reconcile the net income to the actual cash flow from the operating activities.
In the indirect method, reconciliation of net income is automatically done to derive the actual cash flow from operating activities while this reconciliation must be done manually when making a cash flow statement in direct method (Averkamp, n.d.).
What is GAAP?
GAAP stands for Generally Accepted Accounting Principles. This is the set of accounting rules, procedures and standards that every company must adhere to when they prepare the financial statements. This set of accounting principles helps to generate a uniform standard in preparing the financial statements so that these statements can be understood easily all around the world. These standards are backed by the standards that are set by the regulatory and policy making authoritative bodies, and they form a way of recording and preparing financial statements that are commonly accepted all around the world.
Averkamp, H. (n.d.). What is the difference between the direct method and the indirect method for the statement of cash flows? | AccountingCoach. Retrieved from http://www.accountingcoach.com/blog/direct-and-indirect-method-cash-flows
The Wall Street Prep Team. (2012, April 4). "How are the financial statements linked together?" | Wall Street Prep - Wall Street Prep. Retrieved from http://www.wallstreetprep.com/blog/how-are-the-financial-statements-linked-together/